8 ms·

The Valuation Trap

89 points by asanwal 12y ago

asanwal 12y ago
I'm skeptical Box can course-correct. They are in a hyper-competitive space with margin pressure and also seem to have pretty poor SaaS fundamentals (high Customer acquisition costs and illusory LTV) Fred felt they could slash their cash burn to put the company on better footing but that kills the growth story that they were pitching to public market investors. The good news in all of this is that it counters to some degree the notion of a bubble as companies with crappy fundamentals are not able to IPO.
- richardwhiuk 12y ago
  It's possible you could argue that the pre IPO markets are or were in a bubble phase and the postponement of the IPO is being caused by the broader market rejecting the hyped valuation as the broader economy isn't in a bubble (unlike dotcom bubble where companies were IPOing at hyper valuation). I'm not convinced I buy that, but it is one way of reading the numbers.
  - carlosrt 12y ago
    TL;DR In the broader economy: "Almost every asset is overvalued," For those of you that followed the hashtag #2014GC last week you saw this: "The quantitative easing and the excess money and the low interest rates have driven pricing up of almost all financial assets to beyond what their intrinsic value might be," Joshua Harris, co-founder and chief investment officer of $161 billion private equity firm Apollo Global Management, said Monday at the Milken Institute's Global Conference in Los Angeles. "So even though we can all chat about the benevolent growth environment that exists in the U.S. and to a lesser extent globally, the ability to make money and invest wisely on that is very, very challenging right now because you're starting at a point in the valuation cycle that is very, very aggressive." Harris added that it's a "time to be cautious" and that Apollo is still looking for investments in sectors that are still relatively depressed. "Almost every asset is overvalued," he said. Source: http://www.cnbc.com/id/101620735 http://www.cnbc.com/id/101620735 Tweet: https://twitter.com/ldelevingne/statuses/460800459972681728 https://twitter.com/ldelevingne/statuses/460800459972681728
applecore 12y ago
When a company is the size of Square and Box, why not just raise a down round—a round of financing that values the company at less than the previous round? Valuations are lower than they were three months ago. Companies that were once worth billions of dollars now find themselves with lower valuations. Prices will always fluctuate as a result of market forces.
- kanamekun 12y ago
  Companies are usually reluctant to raise a down round due to anti-dilution provisions: http://www.businessweek.com/smallbiz/content/jan2009/sb20090123_008974.htm http://www.businessweek.com/smallbiz/content/jan2009/sb20090...
  - taylorwc 12y ago
    Even if there are not anti dilutive preferences, both management and existing investors are likely to leave a down round as their last resort, simply because of the dilutive impact it would have.
Codhisattva 12y ago
The trap exposes the dirty little secret: you're not building a product to sell to customers, you're building a product to sell to investors. The exit is the massage.
- larrys 12y ago
  True but in business that is still a model. The idea in business is to make money. Just like in sports the idea is to win the game. Which is not the same as saying "at all possible costs" but nothing really inherently wrong with playing the game this way. Imo of course. For all the stories that you read about business success you never know what happens behind the scenes. But you also don't know about those that played, say, a fairer game, didn't make it (a lot of money that is) and that you've never heard of either.
  - Codhisattva 12y ago
    I agree it's a business model. Unfortunately I don't think many of the startup participants are aware they are the product.
davidu 12y ago
I'm generally a fan of Fred's posts, but this one is odd. At least he calls it out at the bottom. For starters, he's neither an investor in Square nor Box. There is zero evidence that Square was even prepping their IPO. As far as I'm aware, and I keep my ear to the ground, Square hasn't selected any bankers. They are far from even getting ready. And Box will have no trouble attracting capital. Their valuation is a fraction of Dropbox's. I'm not sure Fred is really in an authoritative position to write this post. He lacks facts about the two examples he cites. Linking to other news stories that are talking about rumors isn't helping tell a realistic story, it just perpetuates the echo chamber, which is not something he generally does.
- fredwilson 12y ago
  Good criticism. I saw an opportunity to make a point I've been wanting to make and jumped on it
  - jacquesm 12y ago
    If there was an 'ethical VC' award I'd be happy to nominate you, there are several occasions now that you've managed to make me note you in this respect. Off the top of my head: caring about where LPs get their cash, listing your conflicts of interest up front and admitting mistakes gracefully. Upvote gladly given, I wished I could give more of them.
rokhayakebe 12y ago
It is interesting to see that both Google and Microsoft were profitable before going public. The ratio from cash raised/revenue at IPO is something investors should look at before buying stock. A company should not go public while loosing money, that is what venture capital exists for.
- quanticle 12y ago
  But, on the other hand, Amazon lost money for years after it went public.
johnrob 12y ago
If your company is losing money every month, then any valuation can present a valuation trap. Founders and investors are both speculating that there will be profits down the road. Sometimes they are right. Sometimes they aren't.
orky56 12y ago
When you raise money, you are taking a gamble on the future. You expect that your current situation will be improved with an inflow of cash that allows you to pursue an opportunity higher hurdle rate. If any of those assumptions were wrong at any point including general macroeconomic issues (like beta), then you are stuck. If an investor has faith that those false assumptions could be reversed or are irrelevant, then you get additional funding. Valuations are just what everyone is willing to cope with.
gyardley 12y ago
Yes, although founders and early employees of companies at this stage can often exit by selling on the secondary market. For individuals the trap is somewhat porous.
marcus_holmes 12y ago
I saw Orion Henry (Heroku) talk about this last year: they got so big they had to make a choice to IPO or accept Salesforce's offer as maybe the last chance to get bought out. Once they got past a certain size suddenly the options shrank. Seems like a sensible thing to talk about in advance: do you want to become the CEO of a public company, or do you want to get bought out and walk away?
- graeme 12y ago
  What about the third option: be sole owner of a (hopefully profitable) private company?
  - fsk 12y ago
    But that isn't VC. When you have outside investors, you have an obligation to give them an opportunity to cash out. If you can bootstrap and own 100%, then you have maximum flexibility.
    - rokhayakebe 12y ago
      How about taking debt, pay off investors at the same multiple they would get from a buyout, and pay the debt over time?
    - lisper 12y ago
      > When you have outside investors, you have an obligation to give them an opportunity to cash out. A moral obligation perhaps, but no legal obligation. As long as you control the board, nothing prevents you from taking investors money and essentially pocketing it as long as you can find enough suckers. In fact, one could view the public market as the suckers of last resort, particularly for companies that don't pay dividends and have two-tiered stock structures (e.g. Google and Facebook).
      - wtvanhest 12y ago
        There are multiple legal ways for VCs to force the company to liquidate their investment. The primary one being redemption rights.
robg 12y ago
Hard not to respect someone who you starting reading and are saying "Yeah, but you are conflicted..." then hit: Epilogue: I am a VC. I am talking my book here. I don’t like to pay sky high valuations. And I like to argue against them. So understand this post in that context. But I am also an investor in companies that have found, and may or will find themselves in the valuation trap. I have lived it, felt it, and suffered from it. It is a real issue
arbuge 12y ago
Downrounds are not a tragedy though. If you can take the money without giving up too much equity (which a high valuation is tantamount to), I would think carefully before considering any other option.
stevenj 12y ago
TIL Facebook had a down round: http://avc.com/2014/05/the-valuation-trap/#comment-1369020357 http://avc.com/2014/05/the-valuation-trap/#comment-136902035...
- prayag 12y ago
  This was mostly due to macro-economics and the fact that the down round was after the Microsoft investment which valued Facebook at 15 Billion. http://www.businessinsider.com/2008/12/facebook-get-ready-for-a-down-round#!IkZMf http://www.businessinsider.com/2008/12/facebook-get-ready-fo...
malanj 12y ago
I've talked to many founders who seem to forget the basic "economic laws of the universe". You have to create more value (if you're feeling pessimistic, more perceived value) than you take to get something out. It's crazy how many founders get excited about how much they've raised, or at what valuation, while forgetting that basic fact. Every dollar you raise is one you need to put to work more effectively than the general market. A high valuation is basically a "discount" applied to any value you create, the higher the discount the more value you need to create to make the equation balance. It's scary to see founders that have significant exits (>$100m) walk away with very little, because they didn't manage to make that fundamental equation balance.
joshfraser 12y ago
If you ever negotiate with a VC on valuation, you'll hear some variation of this story. It's one of their favorite ones to tell. They all love to warn of the risks of taking too high a valuation. There's some truth to it of course, but what you won't hear are the stories of founders who give away too much of their companies and ended up with a tiny share of their company when they exited. Sure, sometimes you can get hurt by having too high of a valuation, but I know a lot more entrepreneurs who worked their asses off only to walk away with a token amount when they sold their company.
jgalt212 12y ago
My view on this is only take on a crazy sky high valuation if it leaves you with tons of cash on hand so that you then have years for runway left. The converse is don't take tons of money, if you then immediately turn around and start spending at an even crazier rate than before. The positive example that immediately comes to mind is Github's $100M investment from Andreesen Horowitz. Of course, perhaps all that money led to some other problems down the road (that are now only coming to light.) To troll, Mr. Horowitz a bit: "Mo Money Mo Problems" --Notorious B.I.G.

89 points by asanwal 12y ago

I'm skeptical Box can course-correct. They are in a hyper-competitive space with margin pressure and also seem to have pretty poor SaaS fundamentals (high Customer acquisition costs and illusory LTV) Fred felt they could slash their cash burn to put the company on better footing but that kills the growth story that they were pitching to public market investors. The good news in all of this is that it counters to some degree the notion of a bubble as companies with crappy fundamentals are not able to IPO.

richardwhiuk 12y ago
It's possible you could argue that the pre IPO markets are or were in a bubble phase and the postponement of the IPO is being caused by the broader market rejecting the hyped valuation as the broader economy isn't in a bubble (unlike dotcom bubble where companies were IPOing at hyper valuation). I'm not convinced I buy that, but it is one way of reading the numbers.
- carlosrt 12y ago
  TL;DR In the broader economy: "Almost every asset is overvalued," For those of you that followed the hashtag #2014GC last week you saw this: "The quantitative easing and the excess money and the low interest rates have driven pricing up of almost all financial assets to beyond what their intrinsic value might be," Joshua Harris, co-founder and chief investment officer of $161 billion private equity firm Apollo Global Management, said Monday at the Milken Institute's Global Conference in Los Angeles. "So even though we can all chat about the benevolent growth environment that exists in the U.S. and to a lesser extent globally, the ability to make money and invest wisely on that is very, very challenging right now because you're starting at a point in the valuation cycle that is very, very aggressive." Harris added that it's a "time to be cautious" and that Apollo is still looking for investments in sectors that are still relatively depressed. "Almost every asset is overvalued," he said. Source: http://www.cnbc.com/id/101620735 http://www.cnbc.com/id/101620735 Tweet: https://twitter.com/ldelevingne/statuses/460800459972681728 https://twitter.com/ldelevingne/statuses/460800459972681728

applecore 12y ago

When a company is the size of Square and Box, why not just raise a down round—a round of financing that values the company at less than the previous round? Valuations are lower than they were three months ago. Companies that were once worth billions of dollars now find themselves with lower valuations. Prices will always fluctuate as a result of market forces.

kanamekun 12y ago
Companies are usually reluctant to raise a down round due to anti-dilution provisions: http://www.businessweek.com/smallbiz/content/jan2009/sb20090123_008974.htm http://www.businessweek.com/smallbiz/content/jan2009/sb20090...
- taylorwc 12y ago
  Even if there are not anti dilutive preferences, both management and existing investors are likely to leave a down round as their last resort, simply because of the dilutive impact it would have.

Codhisattva 12y ago

The trap exposes the dirty little secret: you're not building a product to sell to customers, you're building a product to sell to investors. The exit is the massage.

larrys 12y ago
True but in business that is still a model. The idea in business is to make money. Just like in sports the idea is to win the game. Which is not the same as saying "at all possible costs" but nothing really inherently wrong with playing the game this way. Imo of course. For all the stories that you read about business success you never know what happens behind the scenes. But you also don't know about those that played, say, a fairer game, didn't make it (a lot of money that is) and that you've never heard of either.
- Codhisattva 12y ago
  I agree it's a business model. Unfortunately I don't think many of the startup participants are aware they are the product.

davidu 12y ago

I'm generally a fan of Fred's posts, but this one is odd. At least he calls it out at the bottom. For starters, he's neither an investor in Square nor Box. There is zero evidence that Square was even prepping their IPO. As far as I'm aware, and I keep my ear to the ground, Square hasn't selected any bankers. They are far from even getting ready. And Box will have no trouble attracting capital. Their valuation is a fraction of Dropbox's. I'm not sure Fred is really in an authoritative position to write this post. He lacks facts about the two examples he cites. Linking to other news stories that are talking about rumors isn't helping tell a realistic story, it just perpetuates the echo chamber, which is not something he generally does.

fredwilson 12y ago
Good criticism. I saw an opportunity to make a point I've been wanting to make and jumped on it
- jacquesm 12y ago
  If there was an 'ethical VC' award I'd be happy to nominate you, there are several occasions now that you've managed to make me note you in this respect. Off the top of my head: caring about where LPs get their cash, listing your conflicts of interest up front and admitting mistakes gracefully. Upvote gladly given, I wished I could give more of them.

rokhayakebe 12y ago

It is interesting to see that both Google and Microsoft were profitable before going public. The ratio from cash raised/revenue at IPO is something investors should look at before buying stock. A company should not go public while loosing money, that is what venture capital exists for.

quanticle 12y ago
But, on the other hand, Amazon lost money for years after it went public.

johnrob 12y ago

If your company is losing money every month, then any valuation can present a valuation trap. Founders and investors are both speculating that there will be profits down the road. Sometimes they are right. Sometimes they aren't.

orky56 12y ago

When you raise money, you are taking a gamble on the future. You expect that your current situation will be improved with an inflow of cash that allows you to pursue an opportunity higher hurdle rate. If any of those assumptions were wrong at any point including general macroeconomic issues (like beta), then you are stuck. If an investor has faith that those false assumptions could be reversed or are irrelevant, then you get additional funding. Valuations are just what everyone is willing to cope with.

gyardley 12y ago

Yes, although founders and early employees of companies at this stage can often exit by selling on the secondary market. For individuals the trap is somewhat porous.

marcus_holmes 12y ago

I saw Orion Henry (Heroku) talk about this last year: they got so big they had to make a choice to IPO or accept Salesforce's offer as maybe the last chance to get bought out. Once they got past a certain size suddenly the options shrank. Seems like a sensible thing to talk about in advance: do you want to become the CEO of a public company, or do you want to get bought out and walk away?

graeme 12y ago
What about the third option: be sole owner of a (hopefully profitable) private company?
- fsk 12y ago
  But that isn't VC. When you have outside investors, you have an obligation to give them an opportunity to cash out. If you can bootstrap and own 100%, then you have maximum flexibility.
  - rokhayakebe 12y ago
    How about taking debt, pay off investors at the same multiple they would get from a buyout, and pay the debt over time?
  - lisper 12y ago
    > When you have outside investors, you have an obligation to give them an opportunity to cash out. A moral obligation perhaps, but no legal obligation. As long as you control the board, nothing prevents you from taking investors money and essentially pocketing it as long as you can find enough suckers. In fact, one could view the public market as the suckers of last resort, particularly for companies that don't pay dividends and have two-tiered stock structures (e.g. Google and Facebook).
    - wtvanhest 12y ago
      There are multiple legal ways for VCs to force the company to liquidate their investment. The primary one being redemption rights.

robg 12y ago

Hard not to respect someone who you starting reading and are saying "Yeah, but you are conflicted..." then hit: Epilogue: I am a VC. I am talking my book here. I don’t like to pay sky high valuations. And I like to argue against them. So understand this post in that context. But I am also an investor in companies that have found, and may or will find themselves in the valuation trap. I have lived it, felt it, and suffered from it. It is a real issue

arbuge 12y ago

Downrounds are not a tragedy though. If you can take the money without giving up too much equity (which a high valuation is tantamount to), I would think carefully before considering any other option.

stevenj 12y ago

TIL Facebook had a down round: http://avc.com/2014/05/the-valuation-trap/#comment-1369020357 http://avc.com/2014/05/the-valuation-trap/#comment-136902035...

prayag 12y ago
This was mostly due to macro-economics and the fact that the down round was after the Microsoft investment which valued Facebook at 15 Billion. http://www.businessinsider.com/2008/12/facebook-get-ready-for-a-down-round#!IkZMf http://www.businessinsider.com/2008/12/facebook-get-ready-fo...

malanj 12y ago

I've talked to many founders who seem to forget the basic "economic laws of the universe". You have to create more value (if you're feeling pessimistic, more perceived value) than you take to get something out. It's crazy how many founders get excited about how much they've raised, or at what valuation, while forgetting that basic fact. Every dollar you raise is one you need to put to work more effectively than the general market. A high valuation is basically a "discount" applied to any value you create, the higher the discount the more value you need to create to make the equation balance. It's scary to see founders that have significant exits (>$100m) walk away with very little, because they didn't manage to make that fundamental equation balance.

joshfraser 12y ago

If you ever negotiate with a VC on valuation, you'll hear some variation of this story. It's one of their favorite ones to tell. They all love to warn of the risks of taking too high a valuation. There's some truth to it of course, but what you won't hear are the stories of founders who give away too much of their companies and ended up with a tiny share of their company when they exited. Sure, sometimes you can get hurt by having too high of a valuation, but I know a lot more entrepreneurs who worked their asses off only to walk away with a token amount when they sold their company.

jgalt212 12y ago

My view on this is only take on a crazy sky high valuation if it leaves you with tons of cash on hand so that you then have years for runway left. The converse is don't take tons of money, if you then immediately turn around and start spending at an even crazier rate than before. The positive example that immediately comes to mind is Github's $100M investment from Andreesen Horowitz. Of course, perhaps all that money led to some other problems down the road (that are now only coming to light.) To troll, Mr. Horowitz a bit: "Mo Money Mo Problems" --Notorious B.I.G.