Venture capitalists valuing startup companies have a particularly difficult challenge these days, as public company comparable values have plummeted. This makes it even harder for the startup entrepreneur seeking venture capital know what their startup is worth. I’d like to highlight a particular phenomena that may come into play when VCs are valuing startups. This phenomena usually happens sometime after the Series A round, most likely at a Series B or Series C round. I call this the “venture capital valuation valley of death.” (I tried to come up with word for death that started with the letter “v,” but I’m a financier not a poet and alliteration is not my strong point.)
There is a point when a startup ceases to be valued only as a technology/idea and becomes valued a real business. Or, maybe this is more of a hope – after all, venture capital investors often recite the mantra, “we invest to build real businesses, not to do quick flips.” Quick flips are valued off of hype, technology IP and momentum. Real businesses are supposed to be valued off of silly metrics like cash flow multiples. OK, ok, revenue multiples. (Please don’t mention DCF’s. I just don’t care.)
Anyways, sometimes a really interesting technology/idea attracts interest from larger players – “strategics.” If this company is truly game changing or strategic to several potential acquirers then one or more of these larger companies may reach the conclusion that they need to own that technology and will pay a large price for it before the startup has begun creating revenues. Usually the strategics are thinking that they could easily finish the technology development and push the solution through their existing channels to their existing customers and reap significant value.
At this point, the startup may be more valuable to the strategic acquirers than typical financial valuation metrics would suggest. The technology/hype has run ahead of the traditional financial valuation. Now the entrepreneurs and venture capitalists have to make a decision – a) do they sell the startup now based on the promise or b) do they soldier on and try to create a real business. If b), the startup enters the valuation valley of death.
The startup’s value may flat-line or even decrease at this point. Before the startup has significant market traction (and I’m talking about traction in the form of real revenues) it is still going to be valued by strategics based the startup’s technology/promise/hype. Sure, a few customers indicate market adoption, but tiny revenues likely will not motivate buyers to bump their view of the company’s value.
The startup’s value doesn’t have to decline in the valley – it may just flat-line. A decline is possible as potential acquirers may decide to build the technology in-house instead of buying, and as potential bidders drop out the price the startup can get may slide. Also, the hype may wear off as potential buyers realize that there are other companies working on similar technology who they can purchase.
Then, as the company starts to get real customers and generate real revenues a funny thing happens – it starts to “grow” into its hype-based valuation. If the strategic players want to acquire the startup once the startup has a meaningful income statement then the financial nerds try to take over and do a valuation analysis. $XYZ million revenues times ABC revenue multiple indicates a valuation of so-and-so million dollars. If this is less than the hype-based valuation then the financial nerd has to face off against the person at the strategic who wants to buy the startup at the hype-based valuation. I can’t say who will win, but it is a fair guess to say that the business traction created by the startup likely hasn’t created a significant valuation improvement.
Only once the financial valuation grows beyond the strategic/hype-based valuation does the startup’s value increase in the eyes of the strategic players. This is when the startup exits the valuation valley of death.
The startup may be in the valuation valley of death for a number of years. There has to be a real belief that the startup can come out the other end and become a big business. Given the tough fund raising environment startups need to pay careful attention to their cash burn and make sure they have the capitalization to make it out the other end of the valley. Setting and hitting valuation milestones while in the valley of death is key.
Entrepreneurs raising venture capital need to make sure they are on the same page with their investors about the size of business they are hoping to create and the size of exit they are seeking. Make sure your investors have deep enough of pockets to help you accomplish your goals, and make sure their goals are the same as yours.
November 30th, -0001 at 12:00 am
I want to know more about start up valuation.
December 2nd, 2008 at 4:29 am
Healy, don't be so glum. You should have called this the "valuation valley to victory!"
December 2nd, 2008 at 5:44 am
Ha ha Rob, I love that!
December 2nd, 2008 at 6:27 am
Good post Healy. The nice (or not so nice) thing about some Internet businesses is that the visibility into other metrics can give you an indication on customer uptake. Traffic, messages, etc can be a good proxy, as long as you have an idea how you'll make money someday.
I think you should do a post on the different risk profiles a Series A investor faces vs. B & C. For example, as the company pushes through the valley, the burn is going up, and the B & C investors are funding it. The A is already in with their ownership percentage and can play pro rata, so the checks aren't as big. The game get's really tough for B & C investors.
Finally, your post title reminded me of Samuel Jackson in Pulp Fiction: http://www.youtube.com/watch?v=Fd4VSkj0Wks (starting around 7:00). I'm attempting to be funny.
December 2nd, 2008 at 11:48 am
Scott,
I'd more likely say that the nice about about some SaaS businesses (vs. internet businesses) is the visibility you can get into the longer term financial viability/metrics of the business.
Some internet businesses, like Facebook, have had great user uptake but haven't had the revenue uptake yet – the visibility just isn't there. Who would have predicted it would be so hard to make money from something like FB? Remember a year ago (ok, a year and a half) when everyone's question was "what's your Facebook strategy?" Man, things change fast!!
I'm not sure I have enough experience on the Series A vs. B and C investors. I'll put my thinking cap on. I'm starting to notice that smaller funds can't hang with the bigger funds in companies that have larger out-year capital needs that they expect to fill in a Series C or later. I think that the current economic environment may have prompted this, as everyone has to increase reserves on existing portfolio companies, causing belt tightening for funds that are closed…
Healy
ps – it took me a bit to get the Pulp Fiction reference. Thankfully no one is accusing VCs of being righteous!!!
December 3rd, 2008 at 6:53 am
Prasad,
1)For the most part valuations are down, although not as much as public company valuations seem to be. This is most acute for Series B or C or beyond rounds. There does seem to be a sort of bifurcation, where very experienced founders are still getting aggressive Series A valuations (by very experienced, I mean people whose names you’d recognize, people who have founded and sold companies for very large $ amounts and who are known to be great operators) and all others seem to be a bit lower than they were a year ago.
2)I’m not sure I understand this question. By “strategics” in this article I meant public companies who would acquire startups for strategic reasons. (V.S. financial investors like hedge funds or PE shops… or VCs.)
3)The cash flow positive part of a startup’s lifecycle is probably more in the financial valuation are of the graph, perhaps also still in the valley of death depending on how big the cash flows are.
Healy
December 3rd, 2008 at 7:35 am
Oops! Looks liked I misunderstood Strategics. What I was trying to get at is, are VCs still investing in game-changing companies as much as they were doing couple of years ago? Or are they more focused on businesses that will generate revenues without having to acquire millions and millions of customers (like social networks)?
December 3rd, 2008 at 8:37 am
Prasad,
Ok, I understand the question now. It seems that VCs are still interested in game changing companies, at least I hope so as those are the sorts of companies that I'd like to invest in!
December 3rd, 2008 at 5:57 am
Good post Healy.
Here are few questions for you and the other VCs reading this blog:
1. How has the economy impacted valuations of startups, especially those that have not raise money yet?
2. Are VCs still investing in strategics?
3. Finally, is your hype part of the graph same as the valley when all I hear from VCs is focus on becoming cash flow positive.
December 4th, 2008 at 4:02 am
Great post Healy. I guess when you get an offer during the hype that's where you distinguish those entrepreneurs that really really want to build a sustainable business vs. those that are (a bit?) more focused on making money. Must be a tricky situation to be in.
July 6th, 2010 at 6:15 pm
Pleeeeaaase learn the difference between "phenomena" (plural) and "phenomenon" (singular)!