Something is Rotten in the State of Venture Capital Valuation
One of the most difficult tasks in offering consulting services to startup investors is convincing them that their deeply embedded methodologies or best practices are lacking. This is even more difficult when you pitch them something contrarian to the current group-think about their investment strategies. And this becomes almost insurmountable when you are an outsider who tries to convince investors to consider the business and financial ramifications of their investment, as opposed to the founding team and underlying tech.
The current group-think is to use growth multiples and comparable companies for valuation and financial go-no go scenarios (a good example is here). We believe this methodology is lacking, and we pursue a substantially more robust intrinsic valuation methodology based on fundamentals and free cash flow.
Many investors believe this is a waste of time:
“It’s the founders, not the business, which matters.”
“It’s impossible to give an accurate financial evaluation to an early stage company.”
“Comparables and multiples will dictate the value.”
All of this may be true, but it’s not entirely true. Choosing which startup to back is an art of impulses and risk taking. But it not just an art.
Back in early 2015 I mentored a brilliant group of young techies who developed a wonderful piece of hardware in the med-tech space. Their solution made the lives of “locked-in” patients significantly better for a fraction of the cost of existing solutions.
A fantastic and commendable story, but a horrible business. The problem was that there were very few patients who would need the technology every year, and hospitals/HMOs were problematic clients. In addition, the product had a decade-long life time, meaning no repeat business and no secondary market.
In other words, the strength of the founding team is not enough to guarantee the success of a startup. It’s not even close, actually. Thomas Thurston, one of the leaders in the “Money-Ball” approach to investing, and MD at WR Hambrecht Ventures, has been developing algorithm-based investments for years. Relying on that approach alone, he has shown that less than 20% of the success of a startup is based on the internal factors, specifically the founders.
Remember Zirtual? In August of last year the young startup, which offered virtual personal-assistant services to clients, fizzled out. The company was employing 400 people on a 1099 “Gig” model, which reduces HR costs, but also has a big downside when it comes to employee retention and training. Zirtual realized they needed to retain and train, so they made an active decision to go to “regular” employee status, which immediately raised the average salary of every employee. But because they didn’t plan for this correctly, two weeks later the company went bankrupt and 400 people lost their jobs without any severance, along with $7M of funding.
Mary Kate Donovan, Zirtual’s CEO, blamed her outsourced CFO for misrepresenting cash balances. The CFO blamed Donovan’s poor business management. The reality is that everybody simply dropped the ball, choosing to ignore the nitty-gritty of running a business and balancing between revenue and expenses.
Yes, any financial figure on a spreadsheet is going to be fuzzy for a startup, but understanding the financial ramifications of business decisions is critical. Investors are correct that the actual numbers on a spreadsheet are typically educated guesses, but the variance in those numbers that occurs from various scenarios is critical. If investors had run a simple stress test on Zirtual’s financial model, they could have shown the implications of transitioning from 1099 to regular employee status — from cash flow positive to cash flow negative. More than that, they could have come up with a creative solution. $7M could have been salvaged, 400 people could still be employed, and Mary Kate Donovan could have saved her company.
And then there is the unfortunate story of HomeJoy. Over $60M raised from established insiders — a result of ad-hoc comparables and growth multiples. When investors realized that the company wasn’t hitting their (already unrealistic) growth targets, investors put huge pressure on the company to expand. HomeJoy scrambled and relied on promotional pricing in order to prove “growth”. But the promotional price killed their revenue and customer retention, and the company ended up collapsing under the weight of their expenses.
Multiples and comparables can serve as a rough benchmark, but they should never be used at the expense of fundamentals like revenue, earnings, or free cash flow. In addition, multiples and comparables are too subjective. Comparing a company to the first year of Twitter will yield vastly different results than a comparison the last year of Twitter’s stagnation. In addition, multiples and comps have no way to gauge the impact of business critical decisions, like HomeJoy’s promotional pricing scheme.
It is possible to use multiples and comparables as a gauge, like a higher and lower bound, but important issues, like customers to break-even, require a deeper insight into the fundamentals of a business. Ideally, investors would balance both approaches.
Unfortunately, the existing VC methodology for valuation has permeated throughout the ecosystem, to the point where reversing the trend is going to be difficult and lead to a lot of dead unicorns. We have already seen this in action over the last month, as valuations have been drastically lowered across the board. VCs will blame noob investors or late-stage institutionals who flood the market with dumb money, but the reality is the exact opposite. The current quick-and-dirty multiples and comparables methodology is squarely to blame, and it is solely the VCs who have been championing this careless approach.
And if you don’t believe us, you can hear it straight from McKinsey: “Discounted-cashflow valuation, though it may sound stodgily old school, works where other methods fail, since the core principles of economics and finance apply even in uncharted territories, such as startups.”