VENTURE CAPITALISTS: THE REAL ESTATE AGENTS OF TECH
If you have ever spent any time on Zillow or Trulia looking for a home, two pieces of data frame your mindset: price per square foot and comparable homes. These numbers, which come from robust databases and public sources, are used by real estate agents across the country to communicate the value of a home to potential buyers.
There are tons of these metrics and multiples in the real estate world: Gross Revenue Multiple, vacancy rate, cost per room, price per square foot, and so on. But none of these are a measure of value, they are only a measure of price. The pricing multiples in real estate are an indicator of value, but will not give you any insight as to the future returns you can make on a real estate investment.
In real estate pricing does provide excellent insights, and can roughly work as a proxy for value, but only because there is a robust history to support assumptions and multiples. For any apartment, there is extensive monthly data on comparable properties, the market, and other qualitative/quantitative information. This data goes back for years, is updated frequently, and is backed up by objective assessors.
On the other hand, a startup has little historical support for pricing multiples, especially when the startup is compared to another startup that has equally little support for the price multiples. Yet Venture Capitalists determine the value of a startup solely on these pricing metrics and multiples. Instead of price per square foot they use things like revenue per user.
Effectively, this means VC firms are nothing more than glorified real estate agents — traders — for the startup ecosystem. The only difference is that real estate agents can back up their pricing mechanism with extensive objective history, while VC firms cannot.
Back in the Dot Com bust, companies were priced based on website visits. But website visits did not translate into cash back to stakeholders. A few years later, prices were based on users or growth. But users and growth are also not equal to cash back to stakeholders. More recently, as tech stocks plummeted and private valuations were cut, VCs changed their language and are pricing private companies based on unit economics. But guess what, LTV > CAC does not translate to cash back to shareholders either.
The only thing that translates to cash back to shareholders is actual cash back to shareholders. Yes, I’m talking about profit and cash flow.
And the only way to assess this is by value, and not by price.
Some say you can’t create valuation for a startup. This is false and lazy. Revenues, costs, and subsequent cash flows and dividends back to stakeholders can all be estimated. These dividends back to stakeholders are the value and valuation.
But what if those estimates are wrong? Yes, you can argue about the estimates at length, moving parameters up or down based on benchmarks, experience, or research. You can also do what we do and use statistics and probability to assess the volatility of the underlying estimates and account for the riskiness of these estimates, and the subsequent risk of the startup in general.
It is true that some startups simply cannot be assessed, like Elon Musk landing people on Mars, but for the overwhelming vast majority of startups, it is possible to gauge value and stakeholder returns using realistic estimates and statistical analysis.
Price and Value do eventually converge, they always do, but in the startup ecosystem this happens after the VC has left the picture, either through an acquisition, an IPO, or any other exit. At this point, the VC has made their money, and the “burden of proof” falls onto common stockholders, who are left dealing with the painful blowback of unsustainable profitability and negative cash flows.
Real Estate agents function in the same way. If the foundations of the unit are shoddy, like poor installation or termites, this isn’t part of the pricing — it is left for the future buyer to deal with these undisclosed issues and suffer the negative ramifications on the long term value of their home.
As an example, most recently Uber was valued, I mean priced, at $68B, more than Ford or General Motors. Like real estate agents, VCs have attached this price to the company simply because they believe they can sell it off at a higher price, probably through an IPO, and not because this is the real underlying value of the company. Eventually Uber will go public, and the true value of the company will be assessed, and the price and the value will converge as reflected in the stock.
Because VCs are out of the picture by the time value becomes important, they, like real estate agents, have no reason to care about the value, and what happens to the stock or the shareholders. To give you a perspective of this, CB Insights compiled the stock returns of all VC backed tech companies, post IPO, and compared it to the S&P 500
If you were to invest 100 dollars in an ongoing portfolio of VC backed IPOs in 2012, you would make just over 7 dollars in three years. Conversely, if you were to invest those 100 dollars in the S&P 500, you would have made over 60 dollars. Yes, you read that correctly, the S&P 500 outperformed all VC backed companies by over 8.5X from May 2012 to October 2015.
These same results are robust as far back as 1993.
It easy it so say: “So what?” The VCs made money, as did their LPs and founders, so what’s the problem?
In our opinion VCs are doing a disservice to their founders and to their LPs.
First, after the VC has cashed out, the founders remain to pick up the pieces and face the blowback of valuation (paging Jack Dorsey).
But most importantly, VCs are doing a disservice to their LPs. If VCs are essentially nothing more than traders, then intrinsic value can give important insight into maximizing returns on their trades — how much to invest, what equity stake is optimal, when to reinvest and for what amount, and so forth — which will increase the returns on their overall fund. This is especially true for later stage rounds, where the company has traction that can be projected more accurately.
Ironically, better returns for LPs also means better returns for VC partners as well. By incorporating insights from intrinsic value methodology, a fund could improve performance from 16% IRR to 19%, for example. It may not sound like a lot, but those extra three percentage points, when compounded annually over a seven year horizon, make a pretty penny or two.
In an ideal world, VCs would mesh the two approaches: looking at pricing multiples and intrinsic value. If the price is above the value, the company, or the investment, is over-valued. If price is below the value, the company is under-valued and you are getting a good deal.
Unfortunately, because VCs are not beholden to what happens after an exit, the only way this will happen is if LPs demand more rigorous assessments of their fund performance and investment. Until that point we can only hope that one of the leading name-brand VCs will pick up the gauntlet and pull the rest of the players in the ecosystem toward a more sensible methodology for assessing investments.