You Are What Your Numbers Say You Are

Even though I’m a relative newcomer to the venture capital space, with two decades of experience as a banker, hedge fund manager and CFO, it’s not often that I find myself shocked by anything I read in the startup-focused press or hear in meetings; however, a few weeks back as my partner and I were pitching the head of a family office who invests in both venture and other sectors, I found myself floored by our Q&A on the topic of financial due diligence for early-stage investments.

It wasn’t the topic or the questions that shocked me, rather it was the response to my answers that I couldn’t believe. After some thoughtful back and forth, our prospective LP mentioned that he was surprised not only at the depth of our process but that we had one at all, something he said was exceedingly rare in his experience with early-stage VCs.

As I was picking my jaw up off the floor, all I could think to say in response was that this must be an advantage of my having spent the better part of my career in “the real world”. I used that specific phrasing mostly to be funny, but as it happens, this was around the time that the estimable Fred Wilson jostled the venture world for a few days with a blog post entitled “The Great Public Market Reckoning” (highlighting some underlying causes of increasingly excessive valuations in late-stage venture markets, now being exposed under IPO scrutiny), which prompted a series of responses from the industry that make me think that, sadly, this isn’t far from the truth.

I love that Mr. Wilson spoke out on this topic — starting a dialogue we sorely needed to have — and while much of the follow-up to his post appears to have been constructive, some of the sentiments that came out were also troubling and if I’m being honest, as someone who is now a venture capitalist myself, a bit embarrassing for all of us.

For example, the following came from a GP at one early-stage firm (via a New York Times follow-up to Mr. Wilson’s post):

[T]he partners recently combed through their companies and identified the “gross margins” — a measure of profitability — for each one… This was not something the firm regularly looked at… but they were inspired by Mr. Wilson’s cautionary blog post.

This was shocking to me, both on its face and for the fact that a professional investor would admit something like this on the record.

Much of the outside world sees the venture industry as a bunch of kids throwing darts in the dark, which I always thought was at best a lazy narrative, if not outright ignorance, but here we had one relatively well-respected firm effectively announcing that this is more or less what they actually do.

Mr. Wilson’s original post also had one section that I really struggled with for similar reasons:

For the last five or six years, I have been writing here that I very much want to see the wave of highly valued and highly heralded companies that were started in the last decade come public. I have wanted to see how these companies trade because it will help us in the private markets better understand how to finance and value businesses.

And now we are seeing that.

And what we are seeing, for the most part, is that margins matter. Both gross margins and operating margins.

With the heavy caveat that Mr. Wilson has likely forgotten more about investing than I’ll ever know, particularly in the technology startup world, it shouldn’t be news to anyone, let alone professional money managers, that “margins matter”. Nor should professional investors need someone to tell them “how to finance and value businesses.” Isn’t this what we’re paid to do?

How Businesses Are (Objectively) Valued

The long-term value of a company is the present value of its future cash flow (in shorthand, a “discounted cash flow” or “DCF” model). This has always been the case, and likely always will be, for the simple and intuitive reason that investors put capital at risk in order to make a return on that capital, and as such, they must understand how much distributable cash a business can be expected to generate over a defined time-frame, as well as the odds that these expectations will be met (i.e., the three main factors in a DCF model: cash flows, timing, and risk) in order to determine its value today.

DCF models are obviously difficult to use in valuing early-stage companies which generally run cash-negative for several years, but this doesn’t change the fact that ultimately, these companies will be valued based on their ability to return cash to investors. So even if different metrics like revenue multiples are used at the early-stage, investors need to understand what assumptions are used (e.g., unit economics, cost of growth, operating leverage, expected earnings yield, etc.) to convert these revenue-based valuations back to earnings/cashflow-based valuations as these companies mature

Mr. Wilson touches on this in his post, pointing out that software companies should trade at higher multiples because of their superior gross margins (and, I would add, stickier customers and more predictable revenue streams), but it’s also not as simple as software gets multiple A, hardware multiple B, consumer products multiple C, etc.

The specifics of these companies’ economics and business models matter. A software company with 70% gross margins and high customer churn shouldn’t get the same lofty revenue multiple as one with 85% gross margins and better retention rates, nor should a hardware company with 60% gross margins be discounted to the value of one with 25% gross margins. There’s no universal short cut to valuing a business. The details matter.

Zombiecorns

All of this having been said, the self-deceit plaguing the late-stage markets (until the IPO-triggered “reckoning” to which Mr. Wilson referred), is where things have really gone off the rails. Notwithstanding what I believe is lacking in the early-stage VC market, it’s worth noting that the data sets for these companies are quite limited and there is necessarily quite a bit of speculation mixed into any analysis.

By the late stage, however, (to loosely paraphrase Bill Parcells) companies are what their numbers say they are. There may be some companies with sound business models who are simply growing so fast that operating cash is spent faster than it is generated, but for every one of these, there are several companies whose models are simply unsustainable, and blindly assuming that growth will fix the problem just leads to more good money being thrown after the bad.

Raising $100mm+ funding rounds every 6 months isn’t something to celebrate. In fact, it’s usually a cry for help. Anyone who’s seen Ocean’s Eleven will surely remember the opening scene with Brad Pitt’s character, Rusty, teaching a group of actors how to play five-card draw.

Every time I read another of these articles reporting, in reverential tones, how much money a late-stage startup has raised, I’m reminded of the moment when one of the celebrity card-players tries to replace four of his five cards and Rusty says “You don’t want four, you want to fold.”

I sincerely hope the late-stage market figures this out sooner rather than later, because eventually there won’t be anyone left to write the next 9-figure check, and the longer VCs refuse to fold losing hands (or at least take an honest look at what needs to change in order to stop the bleeding before investing more), the worse the ultimate write-downs will be. But more than anything else, I hope that those who haven’t yet will start to treat their positions as those of a professional money manager, because regardless of sector or stage, at a fundamental level, that’s what we all are.