Five Years Too Late

October 9, 2009

The Price is Right

Filed under: Uncategorized — fiveyearstoolate @ 2:13 pm
Stuart Ellman

Stuart Ellman

VC’s have trouble figuring out price. You cannot base it on a multiple of anything because there usually isn’t much of a company, at least in the early stage. Public comparables are also relatively useless because comparables are much later stage companies. You cannot discount cash flows because the cash flow numbers depend entirely on your revenue and earning assumptions. You can look at private comparables (at what price have similar venture deals taken place) but you have no idea if those companies will be successes or failures. So, you look at basic parameters for stage and quality of management. But, what do you do if a company seems great but you know the price is high. Do you chase it, or wait for a “bargain”.

VC’s don’t want to be seen as just chasing high priced deals because if the deals don’t work out the VC looks foolish. Back in the last bubble, VC’s who paid eight and nine figure prices for Kozmo.com, Webvan, Idealab and many others certainly took heat from their limited partners for making such “crazy” investments. But here is the issue: If you are a bargain hunter and only pay single digit valuations for companies, you still lose 100% of your money if those deals fail. On the upside, if you get one of those occurrences where a very low priced deal turns out to be a big win, it seems like you have won the lottery. Those are few and far between.

These are the issues I struggle with every day. A great startup comes in the door. Great team, a superb market and early traction. All companies like this have the attention of many VC’s. Management wouldn’t be that great if they can’t generate significant VC interest. But instead of a normal early startup valuation in the single digits, this company wants (and will be able) to command significantly higher. It is tempting to say, “Oh, just let it go. There are many deals which are almost as good that I can get at far more reasonable valuations”.

Then I remember Priceline, CommerceOne and WebMD. All three deals came into RRE. Priceline at $400mm, WebMD at $200mm and CommerceOne at $85mm. We scoffed, so did most of the venture community. “Way overpriced” was heard from the rafters. I am sure we put that money into other much cheaper deals that probably didn’t work nearly as well as if we had done those three high priced deals.

Some investors, particularly a good friend up in Boston, go by what I call the “pay any price” theory. He believes that 90% of the money made in a fund are from 10% of the deals. So, if it costs twice as much as other deals, it is worth it if it works. It is called taking the big swing. I have to say, I agree. I do not believe you should chase mediocre or even good deals to high valuations. But, if you believe this deal is the moonshot, take the swing. Babe Ruth was not only the home run champion in the 1920’s, he also led the league in being struck out. If you really believe, take the swing. But also be prepared to take the heat if it doesn’t work.

3 Comments »

  1. Stuart, I agree with the principles you outline above. In a previous life as a stock market analyst, I enjoyed the tension between the value and momentum investment camps – which eventually led to the GARP school (growth at the right price). As you say, and as demonstrated by GARP performance numbers, sometimes an ‘expensive’ investment can provide great returns, as long as the price doesn’t fully discount all the growth potential.

    One point on which I’m less inclined to agree is when you say that “Management wouldn’t be that great if they can’t generate significant VC interest”. I would say that the ability to generate significant VC interest merely means the team is well-connected – nothing more, nothing less.

    Potentially very able management can often struggle to generate the competitive investment dynamics you describe. Perhaps management knows its industry backwards, but is just new to start-up world, or perhaps they are based in a obscure location.

    The fact that nearly all VCs focus on warm introductions makes it very difficult for talented outsiders to get their foot in the door. You would argue that a talented person will ‘find a way in’ but it’s often easier said than done.

    I think a great start-up idea would be for a filtering service which could be sold to VCs. The filtering service would be open to everyone and they would evaluate pitches and enter the details in a database which would be available to participating investment firms.

    I don’t believe the current system is very meritocratic and, by extension, could perhaps be contributing to reducing the possible returns.

    Comment by David Semeria — October 9, 2009 @ 3:21 pm

    • David – to your last point, I think it’s an interesting and open question that a lot of us struggle with. I think what Stuart meant was that most strong teams who have great product AND early traction are capable of generating strong investment interest. We see this all the time, but I take your point – and a lot of the “hot” early-stage deals weren’t necessarily competitive initially (and a lot of deals that become competitive languish in a fundraising desert for months before miraculously heating up).

      But to your point about warm introductions, I guess what I’d say is that most entrepreneurs who are capable of generating serious interest in the business itself will be sufficiently networked to get warm introductions to investors. I’d take pains to say that this is certainly not *always* true, and is particularly inapplicable to intensely technical entrepreneurs with early-stage product-focused companies. For those situations I agree that there are inefficiencies in the connection between company and investor, although I haven’t been presented with a better method than the one most investors use. – EDW

      Comment by fiveyearstoolate — October 9, 2009 @ 4:05 pm

  2. MR. ELLMAN:

    You have an amazing blog on your hands—loves it!

    Mr. Ellman, why did your “good friend up in Boston,” go with the 90:10 ratio as opposed to Pareto’s 80:20? I am 100% positive that your good friend has good reason, re: the rule departure, and would love to know why! When your schedule has a moment, would you please share…

    Thank you!

    Comment by autumn — December 19, 2009 @ 10:23 pm


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