Why valuations don’t reflect real value

In the previous post we discussed how the public market values SaaS companies and which metrics you should measure.  Today I want to discuss what happens behind the scenes when investors determine the value of an early stage startup.

The truth is that determining the value of a startup is much more art than science. The reason is that as investors we typically buy into a dream when we invest in a company. Therefore, it is not the company that exists today that we are paying for, but some risk-adjusted pipe dream of what it will be in the future. This makes coming up with an “accurate” valuation impossible since such a valuation simply does not exist (in almost all cases the startup will turn out to be worth much more or much less than the determined valuation).

So if there is no “real” valuation for the startup, how do investors determine it? There are several factors that go into this:

1. Investor demand- very similar to Econ 101, the #1 factor that will impact the valuation is the amount of investor demand your company gets. The more attractive the company is, the more investors will want to “fight” to be in the deal. This is why super attractive companies command an enormous uplift in valuation over the “regular” ones. This is how Uber manages to raise money at a $40B valuation. As investors, we understand that returns are not linear across our portfolio and there are a few companies that will grow way beyond our original expectations. These few companies will practically return all of the fund. Therefore, investors are willing to pay a higher premium for super attractive companies that might fall into this bucket. This was the reason Bessemer was willing to “stomach” what seemed to be a high valuation for early days LinkedIn (but is less than a fraction of the enterprise value today).  In fact, the internal Investment Recommendation that Jeremy Levine circulated states that very clearly: “While this is a fully-priced deal, I believe its risk/reward attributes are quite attractive. The potential upside associated with becoming the global namespace for business people coupled with limited downside given the profitable existing business model make this a compelling opportunity.”

2. Ownership- This may vary a bit by fund size. As a large fund Bessemer Venture Partners has almost unlimited capital but is very constrained with investors’ time. Therefore, we want to have significant enough ownership in companies we invest in and support. The play between the round size and the required ownership of a new investor will also be one of the most important factors in determining the valuation.

3. Total Addressable Market (TAM) – When we invest in companies with a more limited TAM we take that into account when we determine the valuation. Limited TAM will result in lower exit multiples since the company will most likely will hit a glass ceiling at some point. We want to have an opportunity to make decent returns even in this case so will factor the lower exit potential into the entry valuation. On the other hand, when we see a company that plays in a large market with a “winner take all” dynamics we are willing to pay a higher premium for the chance it will eventually become that winner (in the previous example, LinkedIn benefits from a strong network effect and plays in the lucrative professional recruitment market and therefore had a huge upside potential).

4. Comparables- Since we constantly see a lot of deals it just makes sense to compare the valuation of new investment to similar ones we have seen recently. Comparables (or in short “comps”) are also the way the public market values companies. It is probably the easiest and  most natural way for people to determine valuation (“Hey, I have seen a very similar company yesterday and it was worth $500M so this one should be valued the same”). However, using comps has a huge inherent risk. Comps tend to have a self-fulfilling prophecy mechanism which keeps driving market valuations up or down based on what other investors are doing. This is the mechanism that creates bubbles and bursts them. For example, when Facebook acquired Instagram in 2012 for $1B it a lot of people raised their eyebrows. Today, in an environment where Snapchat is valued at $10B, Whatsapp is acquired for $18B, and Kakao is valued at $2.4B it seems almost natural that year-old messaging app YikYak raises a round at a $300-400M valuation when it is used only in 1,500 college campuses and nowhere else.

There are many other more obvious factors that go into determining the valuation (previous round valuation, associated risk, Company’s KPIs, revenue traction etc.) As entrepreneurs, it is worth understanding the things that investors take into account to produce the pre-money number in the term sheet.

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