Making Sense Of VC Valuations – A Guide For The Perplexed

In the startup ecosystem, VCs are the cock of the walk. They’re at the top of the pecking order because they are the ones with all the money. All investors aspire to become VCs because they are the big boys – the alpha males who have the financial firepower to back unicorns and become amazingly rich in the process.

VCs are thought of as being the super-smart whiz kids, who identify the next Googles and Facebooks of the world. They are wined and dined; and invited to all the startup conferences to give the keynote speeches. After all, if they are so rich, they must be very bright! Everyone wants to understand their perspective and benefit from their insights. Since they control what going to happen, everyone wants to anticipate their next move.

This is why it’s so hard for the ordinary investor to understand why the behaviour of VCs often borders on what seems to be irrational to them. They back companies which are burning cash in order to increase their market share without earning any profits – something which flies in the face of common sense.

It’s easy to grab market share by burning cash when you are spending other people’s money. They feel the business model for the VC is based on bubblonomics – sacrifice profits for growth, and when you become huge, then sell to a bigger fool.

When people question their rationale, the standard answer is – “This time it is different.” The media provides a veneer of respectability to actions which seem to be illogical and short-sighted. When you can spend tons on PR, it’s easy to create buzz, so you can fool lots of people a lot of the time by getting them to put lipstick on your favourite pig.

The Power Law

Yet, VCs merrily continue funding loss-making companies – and raising even more money to allow them to continue to grow unprofitably. This is why many observers start doubting their own sanity when they read about these fund raises at stratospheric valuations. What do these VCs see in these companies that they are willing to back them? What are we missing? These guys are rich and smart, and they must see something which you don’t.

We need to be empathetic, and understand that VCs are riding a tiger and they can’t get off. They operate under lots of constraints, which is why they are often forced to do stuff which makes little sense to an objective outsider.

VCs understand the power law – that their returns are going to come from a very small proportion of their companies. The problem is that it is nearly impossible to identify in advance which these companies are going to be. This is why they bet big on potential winners; and encourage them to grow aggressively, even if they haven’t honed their business model as yet. They hope is that they will fix it as they progress.

Their formula is – Go Public, or Go Broke.

They want their companies to achieve escape velocity, even if they blow themselves up in the process of trying. Even if ten of the companies they back go down the tube, the winner will more than make up for this. Seen from this perspective, they are behaving very rationally.

What VCs Chase

This is why the VCs with deep pockets are forced to chase the few eligible companies who fit into their sweet spot. They are compelled to compete with each other, which is why they get into bidding wars. VCs are competitive, and thanks to group thinking, they will often go all in and take outsized irrational risks. Once they have backed a company, they can’t afford to back off, even if it doesn’t seem to be going anywhere. They are forced to speculate on a few big bets, and cannot afford to be left behind because their reputation is at risk if they lag behind.

The problem arises because every VC wants to raise as much money as he can – not as much as he should. This is why they often end up biting off more than they can chew. After all, the more the money you have, the greater the prestige you command. If you have raised a billion dollars, you are more of an alpha male as compared to someone who has only half a billion dollars. Also, the more you raise, the richer you are because your management fees are 2% of your AUM.

Also, since you need to return the LP’s money in 10 years, this is the limit of your time horizon – you need to be able to engineer an exit (liquidity event) in 10 years. And while the rest of the world looks up to VCs with awe, don’t forget that they need to answer to their limited partners.

They have the duty to provide them with outsize returns if they want to maintain their reputation and raise their next fund.

The problem is that when you raise so much money, the choice of companies you can choose to invest in becomes extremely limited. Thus, if you encounter small companies which are very profitable and are likely to do very well in the future, you don’t have the luxury of being able to invest in them, because they’re not going to be able to affect the needle as far as your returns go.

What VCs Back

10 years may seem a long time, but the day of reckoning does finally arrive. The only way they can perform is by keeping on backing these large companies, no matter how they perform. They need to ensure that they continue becoming larger and larger, until they can hand them off to a bigger fool. This is often another VC firm, because they are happy to help each other out.

It’s a close-knit community, and they will buy each other’s lemons to keep the ball in play. As far as the rest of the world goes, the valuations keep on increasing, irrespective of the fact that the business model is completely hollow. Their expectation is that hopefully things will work out in the end.

In Conclusion

The Holy Grail is an IPO, but that’s becoming increasingly hard because the average investor is no longer as naïve as they used to be in the past. They’re able to look past the smokescreen and figure out that the intrinsic value of the company is poor, no matter how huge the company claims that their market share is. After all, it’s easy to buy customers when you offer discounts and cash back schemes, but won’t they leave once the easy money runs out?

While it’s all very well to boast about how revenue is increasing exponentially, if you need to burn money in order to acquire customers and grow your market share, how is that going to be a sustainable model?

While the last 20 years have been great for VCs, I think their business model has had its day. It needs to evolve and adapt, just like all other industries need to.

The VC industry is also due for disruption, because when models don’t make any financial sense, they will collapse. Yes, they may take much longer than you expect, because the world is awash with cheap liquidity, and everyone is hungry to find an edge, no matter what the risk.

I’d love to hear a VCs perspective as well!

[This post by Dr. Aniruddha Malpani first appeared on LinkedIn and has been reproduced with permission.]

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