Here is the answer I gave in 2009 and (although I could condense it more) remains as valid as ever:
Every time I see the quarterly reports from Fenwick & West on Silicon Valley valuations, I cringe. Not because the story is wrong, but because I know how entrepreneurs and Venture Capitalists (VC) use the valuation medians (that have gone down again) in the report to establish their starting or, worse, their ending negotiation positions. And they are both so wrong.
First off, valuations are never to be discussed by entrepreneurs before the alignment of the grand vision with the VC is established. Whether or not the VC is the right partner has everything to do with a shared vision of the company’s upside potential at the outset, excluding the potential of the newfound company’s ability to execute on that promise.
In many ways, VCs discussing their allegiance to Silicon Valley medians is a testament to what a cookie-cutter business early-stage venture investing has become. Investments in genuinely disruptive innovation have no precedent, and neither do their valuations. Compliance with median valuations is the early detection of a sub-prime investor juggling an equally sub-prime and subordinate entrepreneur.
Don’t step up
Years of sub-prime investing (that has yielded equally sub-prime Limited Partner returns) by inexperienced technology investors have dumbed down the investment thesis to incremental rather than disruptive innovations. That is perhaps the biggest problem venture-investing faces today. The “step-up” approach to investing yields insufficient exit values and allows technology prospects (and acquirers) in less attractive economic circumstances (personal, local, or global) to wait until the dust settles and delay their buying decisions for the next step of that incremental development.
As Ray Lane, former COO of Oracle and now a partner at VC fund KPCB in remarkable honesty, once declared: “[Oracle] customers would have been better of skipping client/server altogether,” describing posthumously the problem of “step-up” innovations best.
Step-up innovations are highly unlikely to generate the $300M+ exits needed to build a decent VC fund return and leaves the VC after the “honeymoon” with a majority stake in the company, unwilling to wait for further miracles and because of the urge to produce cumulative vintage-fund-returns for LPs, to sell out at any price. Many subprime VCs hope that the sum of all tiny subprime returns still yields something of value rather than chase the best outcome for each portfolio company independently. With a lack of exits (of their own making), those same VCs now use cumulative portfolio company revenue reporting to demonstrate to LPs that they are building value and deserve another chance when “exit-markets” miraculously recover. Cumulative portfolio revenues are a poor man’s defense of venture capital.
Think big, or go home
So, the first step to set an excellent valuation for an entrepreneur is to ensure the idea is truly disruptive—disruptive not from a relative perspective (compared to existing competitors) but an absolute perspective. Absolute disruption does not care about competitors because there are none.
Absolute innovation relies on a greenfield of 5/6th of the world’s population that is not (efficiently) served with technology products today but should. Low hanging fruit is the application of technology where a need is already defined, just not with technology implementation. Many ideas come to mind, and marketplaces are fundamental, and I would love to hear about your plans.
The unfortunate aspect of today’s early-stage venture investment climate is that investors who recognize disruptive innovation are hard to find, not in the least because few fund structures are designed to chase them.
Glass half-empty valuations
Many venture investors (I should know, I lived in Palo Alto amongst them for 15 years and became one part-time) cannot detect innovation until they spot it in their rearview mirrors. Replicas or step-ups of a handful of sector investment success still creates an ocean of delayed me-too investments with mediocre exits, steadily decreasing the confidence in venture investing as a high yield asset sector for Limited Partners.
Smaller funds, lower valuations, and risk-averse investments have led to VCs and syndicates huddling together in what I would classify as an informal investor cartel. An investment cartel that uses (the inappropriate) technology segmentation as an artificial standard for the lowest valuation they can get away with. Hence, entrepreneurs should not expect or shop around for higher valuations; you will be snitched on.
I refer to those investments as downside valuations. They are based on the average choices and (lackluster) performance of past investments by all investors, not the unique marriage between the individual investor and entrepreneur. It is also a downside valuation because it is based on the lowest cost-to-entry rather than geared towards the highest chance of success.
Downside valuations are easy to spot. Regardless of the problem the entrepreneur aims to solve, his company value is improperly correlated to the underlying technology architecture or technology categorization.
Glass half-full valuations
Truly disruptive innovation, however, is priceless. If, as an investor, I believe an entrepreneurial idea can feasibly claim access to a monolithic $1B+ revenue opportunity, the difference between putting $10M, $20M, or $50M in the runway and therefore the valuation is somewhat irrelevant (assuming the fund is big enough). The confidence required from both entrepreneur and VC comes from the words of Albert Einstein: “Imagination is more important than knowledge.” Imagination, just like in Einstein’s case, of course, is guided by experience.
So when, and only when, the entrepreneur’s grand vision fits the investor’s imagination should further discussion take place around upside valuations. In our book, not many of today’s VC investments would fit the profile of disruptive innovation and so upside valuation calculations would not apply. Upside valuations differ in granularity and exact makeup for every investment opportunity but go roughly like this:
Upside valuation = (30% of total-addressable-market) divided by (investment risk to get there).
Total-addressable-market is a subject I can write a book about. Most technology companies are embroiled in a short-term rat-race (to feed quarterly earnings hunger to Wall Street) and spend very little time on the vast open greenfield opportunities that take a little longer to plan.
Let’s take computer security software as an example.
Symantec and McAfee attempt to leapfrog each other in this space, with Symantec for now taking the top spot (primarily due to a plethora of acquisitions) from a revenue perspective. By our latest estimate, more than 40 spam and virus vendors exist, and on top of that, most computer users do not use any security software at all. So the pursuit of delivering a truly compelling product in a highly inefficient market makes a ton of sense, even though most investors would qualify the security market as saturated. Clearly, the need is not.
There are many examples of ineffectively served segments, many of which current investors cannot attract, by their structure, lack of relevant experience, and operating credentials. The definition of investment risk in the equation above is multi-faceted. Investment risk consists of the following broad-stroke categories, in no particular order:
- Management team
- Runway required
- Business roadmap
- Business model
- Flex power
- Customer experience
- Product evolution
Without going into detail about each category (beyond the scope of this blog), the report card on those issues determines the amount of discount applied to the total addressable market. It merely discounts the probability of reaching market leadership (loosely defined as 30% ownership) through the proprietary risk assessment of the investor.
Counter to the glass-half-empty valuations; the glass-half-full valuation method does not challenge the absolute value of the idea; it merely discounts the value with the work that needs to be done to build a real business out of it. In many cases, again, assuming the idea is truly innovative, even an aggressively applied discount does not lead to a majority stake in the portfolio company, as it shouldn’t.
In a modern world, a great marriage means you do not own your wife, just like in a significant investment, you do not own the business. Neither of them works very well when extreme pressure is applied.
Upside valuations are applied to take a calculated risk, the risk that makes Venture Capital as an asset class segment so different yet so much more rewarding than traditional Private Equity. Disruptive innovation is priceless and nowadays may consist of many other attributes than just a piece of code. To achieve upside valuations, entrepreneurs need to prove that the value of their idea is not the technology itself but the application of technology to a marketplace.
Ask, never give a valuation first
When an investor likes an entrepreneurial proposition, they will invariably ask for a valuation unless the pitch did not strike a chord. Under no circumstances should an entrepreneur mention a valuation first. This is the entrepreneur’s most potent instrument to verify the authentic alignment with the investor.
Asking the investor for a valuation is like asking a customer to buy, crucial to the closing process. If the investor’s valuation is out of sync (most commonly negatively) with the realistic yet unspoken expectation from the entrepreneur, it is time for the entrepreneur to walk away simply. I had done that with a few big names in the VC industry before I became a VC.
The alignment on valuation speaks volumes about the entrepreneur’s future and the equilibrium of entrepreneur and investor on a deal moving forward. It means that just like in marriage, both parties are in it for the right reasons.
So, an investor who does not want to talk about the upside value is an investor from which you should expect nothing but a downside valuation, undoubtedly similar to the many others in his portfolio. Entrepreneurs should avoid getting stung by sub-prime VC at any cost (including shelving the idea for better times) because money from the wrong investor is a dead-end street anyway.
Valuations are fantastic instruments to gauge (from the beginning) if the entrepreneur and investor are meant for each other. The outcome should be like the innovation; priceless, or else both parties are just wasting their time.