What's In a Valuation?

Originally published on Substack — February 1st, 2022

As everyone with a brokerage account braces for emotional trauma they've rarely if ever experienced before it has been interesting to watch public and private investors react. There are aspects of public and private investing that I have always thought are unnecessarily divided.

When I first started in venture I was focused on early stage companies while public companies sat vaguely on the horizon as comps. "Maybe someday this company can be an Atlassian, and look how great we would do owning 20% of that?"

My next two jobs were both firms that focused on crossover investing, exposing me to both public and private companies. And you quickly realize that companies don't magically move to a different universe when they go public. They're still trying to hire engineers or sales people, trying to launch new products and enter new markets, and they're still going to be meaningful competitors to private entrants. Overall I think you're a better investor, regardless of whether you're investing in public or private companies, if you have exposure to both.

However there are some fundamental differences and one of the biggest is the type of thought process that goes into a valuation. If you had a hedge fund analyst and a venture capitalist on a game show you could ask the question "a company's valuation is primarily based on BLANK."

The analyst might say "the cash flows that a business will produce in the future."

The VC's answer? "The narrative."

The Stories We Tell

There are two potential realities, and every investment will eventually have to deal with at least one of them (sometimes alternating between both of them. The bull case and the bear case. But the numbers start to look pretty different in either case.

For illustration, I'll use one example. We invest in a company that went from $1M to $5M in revenue last year. We invest $25M at a $500M post-money valuation (5% ownership). We expect to see our stake diluted by 20% before an exit (could be conservative depending on the business).

Now think about two scenarios:

The Bull Case

Most venture investments are all about the bull case. What's the best case scenario? How big could this get? "Dream the dream!" This is one reason I've always been confused when VCs find themselves nickel-and-diming on valuations. A lot of firms hold a hard line for particular valuations at certain stages. But why?

If you really are underwriting to the best case scenario then what difference does $400M or $500M post make?

Consider our example. One of the "rules of thumb" in investing is that a solid beginning for a business is to triple-triple-double-double-double. So you have two years of tripling your revenue and then three years of doubling it. Here's what that would look like.

In year 6 lets say the company has an IPO and they expect the next year (forward revenue) to be $648M, growing 80%. Businesses trade at a wide range of multiples, but right now the average forward revenue multiple across software companies is 13x. So this company would be worth $8.4B at IPO. Your return is 13x in 5 years; congrats!

If your hurdle was shooting for this investment to be a 10x then should a $500M entry price have been a hard fast rule for you? No. You had some wiggle room. In fact the last few rounds I've seen getting done for companies going from $1 to $5M in revenue were getting done at $1B+ valuations. But when you're making $25-50M investments you're usually looking for a 5x vs. a 10x so even at $1B entry price this is still a 7x investment in the bull case! Not bad.

If you ask any VC about times it has worked in their favor to be super price-disciplined you won't hear very many stories. But almost every VC will have a story like passing on UiPath because they wanted to pay $1B and the company wanted $1.1B. Now UiPath is a $17B company. Or passing on Benchling because they wanted to pay $350M and the company wanted $415M. Now they're a $6B company. Ultimately if you dream the dream and the dream comes true you won't be asking what kind of bargain you got it for.

The Bear Case

So what about when things don't go as well? You have the same entry price ($500M) but instead of triple-triple-double-double-double you have a business whose growth rate declines each year. What does that look like?

Even this is optimistic for a bear case. The real bear case is going out of business or quickly dropping to 20-30% growth forever. But this is a much less optimistic outcome than you would hope for.

It's in this downside case where the entry price starts to makes a difference. If you paid $1B for this business? You're going to barely get your money back. If you were able to negotiate for $400M vs. $500M? That's the difference between a 5x and a 4x.

There are plenty of examples where a company could have taken a lower valuation. Raised less money. Been more deliberate as they built their business. Who knows if Clubhouse will make a death-defying comeback but I think most people can sit back now and say that a $4B valuation for a pre-revenue beta app was a little pricey.

I think about this scene from Silicon Valley all the time. Richard is trying to decide if he should take what feels like a crazy valuation. He talks to another founder, Javeed, who took a high price, failed to meet milestones, had to take a down round, and settled for a bad acquisition. He asks Javeed if he could have taken less money. Javeed realizes that could have stopped his spiral into a bad outcome and loses his mind.

Season 2, Episode 1 in case you want to watch it. Apparently it isn't funny enough to be a standalone YouTube clip because I couldn't find it anywhere.

What Story Do You Choose to Believe?

As an investor you're trying to use a valuation to balance risk and opportunity. If you look at the bull and the bear case you're looking at a wide range of possible outcomes. You have to ask the question, "what do I believe?" How confident am I in this company’s ability to triple next year? The year after that? Are they hiring enough people to make that happen? The right people? How big is this market? How competitive is it?

You have to decide what you believe. But once you do you have to ask yourself how capable you are of developing conviction if this is a "generational company" at $400M but an “irresponsible risk” at $500M.

The Story's Characters

A private company valuation is a balancing of perspectives. The investor's. The founder's. And the employee's. Each is, or at least should be, an important part of the conversation.

The Investor

The framework above for modeling returns on an investment is roughly how an investor considers the opportunity. In choosing which story to believe (dream the dream vs. worst case scenario) an investor is self-selecting into the journey.

There are two perspectives that can be dangerous for investors (and for the founders that choose to work with them). First, VCs that are too 'big picture,' and barely give consideration to the potential reality a company could face. "Slap a 20x exit multiple and this looks great." Second, the crossover investors who are used to 'mark-to-market' every day and panic when things get rough.

One of the reasons that large crossover investors get a fair bit of criticism is because their perspective is often informed by a much shorter time horizon in the public markets. Not all of them are, but it’s certainly a risk.

“If you’re making a long-term investment, and can’t see a couple weeks around the corner, then what are you doing?” (Dan Primack)

The ideal investor should be one with balance between 'hell-or-high-water' conviction and a long-term perspective of what that conviction requires in good times and bad. These are harder to come by than you would expect.

The Founder

Raising money as a founder isn't easy. Either you struggle to raise money (which even a lot of ultimately very successful founders have experienced), or you have a lot of interest and you have to figure out how to make the right call.

On the one hand a private valuation, even more so than a public one, is a function of supply and demand. As Post Market likes to say, “VC rounds are priced. Not valued.” Any competitive funding round is, by nature, under-valued. As Peter Thiel points out, the clearing price in venture is rarely satisfied. So even $95B for Stripe is technically under-valued because its not the price people would stop buying at. If you went around the world and asked any number of investors, "would you invest in Stripe at $100B? $110B?" I guarantee you that you'd find some yes's. So they've left some money on the table.

But on the other hand it can be dangerous to use an investor's willingness to give you money as a stamp of approval that your engine is working. Founders will often feel that because no investor could know their business as well as the founder how could they effectively value it? But that is true both for a valuation that is too low and too high.

“The nature of the private markets is that if nine smart investors pass, it only takes one relatively dumber investor, and suddenly we’re valued at $16 billion.” (Anonymous WeWork finance team member)

Founders need to be cautious of buying into their own hype. Because if things go poorly the preference stack on a VCs investment will not only hurt them but their employees as well.

The Employees

The employee struggle is the most difficult in this intricate dance because you have very little information and next to no negotiating power. I saw a TikTok that listed "five tech startups that could make you a millionaire if you get hired there in 2022." The video listed Plaid, Brex, Rippling, Databricks, and Notion.

If you split hairs then true, almost any good tech company if you get a job and work there for years you'll likely make a million dollars eventually. But if you broaden the question to what companies will offer "life-changing money," you need to pay attention to the details.

Don't get me wrong. I think all these companies and tons of great later-stage tech companies are phenomenal businesses. But as an employee you need to know what you're getting yourself into. Any company whose valuation is already $5B+ is unlikely to be a place where a typical employee will make life-changing money. That doesn't mean you can't have a phenomenal experience and learn a lot. But when you're considering a valuation and your own equity you need to be realistic about it.

Think about the companies she mentioned in the TikTok. What are their most recent valuations? What does a typical salary look like? Let's say just for an entry level engineer as a benchmark.

Super rough estimates and only assuming the clearing price to make that initial equity grant worth $1M; not considering salary or future equity grants

At these valuations, how long will it take for you to make a million dollars? You have to think like an investor "what do I have to believe for this company to be exceptional?

Big thanks to the folks at Pave for an awesome equity calculator

Databricks is the most highly valued company on our list at $38B. If you got the $65K of stock they're offering you would have to believe that Databricks will be a $600B+ company before that equity is worth $1M. There are only a few tech companies that have ever achieved that kind of valuation.

Again, this is super rough math. There is also your salary to consider and you would likely get additional equity grants. But when you're considering the value of that initial equity you have to believe in a 15x+ valuation growth for Databricks.

Sometimes you might be at a company that grows massively and generates significant revenue. And still that equity won't go very far.

Okay, so maybe late-stage private company valuations are tough to justify. One logical alternatives is working for public companies. Public companies have seen their valuations massively corrected and now is probably a good time to work for them as a safer option and as those companies continue to grow your equity will appreciate. Just be careful what entry price you have at a public company. Depending on how the market performs and how far we have to go falling from the top you could be waiting for a long time.

War-Time Valuations

Being forced to grapple with how a private company should be valued is much more difficult in times of massive fluctuation. A lot of VCs talk about their jobs being about pattern recognition. But when new data is introduced (like some recent tech IPOs dropping in value by 60%+) you no longer have the benefit of a good data set for pattern recognition.

Times like these are good opportunities to reflect. The last few years VCs and founders have mutually agreed to accept higher and higher valuations. Whether it’s because we believe markets are bigger than expected or companies can grow larger and faster than expected. Whatever your reasoning for paying ever higher valuations it has been an easy thing to do because you would almost always be right. There would always be a markup. That may be less true today so sit back and reflect on your mental frameworks.

Does my returns expectation justify this price?

A typical rule of thumb is looking for investments at the early stages that can be a 10x return and a 3-5x return at the later stages. Most VCs are locked into their returns threshold because they raised a fund on the promise of a particular return profile. So if they (1) can’t change their returns expectation and (2) have to pay “market price” for a company’s valuation then the only thing they can control is (3) what do you believe this company can generate in revenue in the long-run? In other words paying a high valuation can be justified by saying “they’ll grow into the valuation.”

"Most often, companies don't grow fast enough to compensate for rising valuation multiples. When financial researchers do look-backs, they find that high valuation multiples precede low returns. In fact, they literally predict lower returns." (Nnamdi Iregbulem)

The conclusion? Be more disciplined in determining what the future potential of this company is truly worth paying up for.

Am I investing in the best companies?

The process of determining what companies are worth paying up for isn’t easy but that is part of why not everyone can be a good investor. I believe the pain investors are currently feeling is less about how even good companies will now struggle, but a more personal skepticism of their own selection process.

"It is often said that it is "hard to overpay for the best companies." That's true, but my hunch is that the cause of some stress now is investors doubt that they've truly chosen the best companies, and they've potentially bought into too broad a sweep at a local pricing maxima for the power law to work in their favor." (Sarah Guo)

If the recent market correction has made you question the quality of the companies you've invested in then it isn't the companies you should re-evaluate. It's the process you used when deciding to invest.

Steve Jobs’ definition of focus was “how many things have you said ‘no’ to that you actually wanted to do with every bone in your body?” Is your investment criteria focused enough?

Are you learning from your mistakes?

The reason people don't learn more effectively is because when they're right they're too busy telling people about it to reflect on why they were right. And when they're wrong they're too busy finding someone else to blame.

Post-mortems are great opportunities to learn and are used far too rarely in investing. One valuable learning from this period? Why have some companies fared worse than others? In the dot-com almost every public tech company was little more than a money-burning festival with no real business model or fundamentals. Today is different. The companies that have gone public are real businesses. Why have some dropped more than others?

"Companies big and small will be [re-]examined through the lens of growth narratives driven by product diversity. It’s no longer good enough to just handle online storage, or to just facilitate online meetings, or to just empower consumers to freely trade securities. The public markets will likely reward those companies who can diversify their product lines into messaging, analytics, gaming, and more — those special companies and business leaders who continue to bundle value into their platforms." (Semil Shah)

Like Ben Graham said, “In the short run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long run, the market is a weighing machine.” As an investor don’t just vote with your money. Invest in platforms that can be weighed, measured, and found to be lasting organizations.