Five Years Too Late

December 15, 2009

Binary Pricing

Filed under: Uncategorized — fiveyearstoolate @ 11:09 am

Eric Wiesen

Stuart Ellman

When I (Stuart) just started in business, I worked with cash flowing entities, both buying them and selling them. Pricing methodology for these businesses was well-established and easily-understood: Project out the cash flows of the business, discount those cash flows at the appropriate discount rate and arrive at a present-value number. All I needed was Brealey and Myers Principles of Corporate Finance and my HP 12-C.

When I started in venture capital, I realized that the extreme variations in cash flows (and the highly speculative nature of them) prohibited DCFs from being useful. Comparables were the way to go.

  1. See how publicly traded comparables were doing,
  2. See how other similar venture deals were priced,
  3. Look at how similar companies were being acquired,
  4. Find out how other VC firms would value this company, and finally
  5. See how low the insiders were willing to take until they did it inside (in effect, find the market clearing price).

The problem most VCs eventually discover is that for the big winners (like Ciena, Priceline, Cerent, WebMD and Google, most of which I looked at at one time or another), it actually doesn’t matter how seemingly overpriced the deal is. These winners created fantastic returns almost irrespective of what you paid. The primary reasons? Traction and momentum. The problem was, it usually took until a Series C or at least Series B was completed until investors could see the traction. Series A funded the idea, Series B built the product and beta tested it, and Series C rode the momentum.

An oft-cited (but poorly understood) dramatic shift in the world of technology, particularly internet technology, is the enormous decrease in the cost of starting a company, building a product and distributing it via social or viral channels. Cloud infrastructure compounds this compression in terms of capital and time to market and reduces the fixed cost associated with getting a product launched. All of this rolls up to allow a company to generate traction with only Series A money and sometimes just the seed money.

The consequence of this is that for consumer-facing companies (and even some that address businesses, particularly SMBs) pricing is now binary. If a deal has early traction, (like Foursquare), VCs will kill to get into the deal and price it up as it looks to be a future winner. It doesn’t have a hockey stick projection, it is following the hockey stick upwards. On the other hand, if a deal is forecasting great traction (and all deals do) but doesn’t yet have it, there is no floor to the price. It is worth barely more than a person and an idea. Why? Because if it doesn’t cost much to generate the traction, if the product is great, why fund it until you know? From the VCs perspective, pay up for the ones with traction, wait on the ones that could get traction unless you are getting a rock bottom price.

This is rational because risk is in the traction and the momentum. Companies will come in and tell us at RRE that we should look at deals like Facebook or Twitter as comparables because their great idea WILL have momentum like that. What they don’t want to hear is that, UNTIL they have the momentum, they are worth very little. Why? Because if it doesn’t cost very much to get to market and there aren’t any real technical barriers to entry, then what does a tractionless startup actually HAVE? Unless the team is amazing or the product is actually quite technically distinctive (e.g. Dropbox), it’s hard to perceive a ton of enterprise value in a consumer-facing web service with no uptake. It’s also rational because the companies with runaway momentum are the ones that acquirers pay big money to pick up. Look at AdMob relative to other mobile ad plays. Where was the distinctiveness – runaway growth.

In my view, the best possible deals from a pricing perspective are deals like the one we just did with Justin Shaffer called Hot Potato. We funded Justin at a seed round price because we believed in Justin and thought that traction would occur. But the price reflected the lack of traction (and even a launched product) at that point. Fortunately, Justin realized this was the right price and took in the capital from ourselves, Josh Kopelman and many great Angels, and now has a company with real traction. And the next round will reflect the traction improvement. The critical point here is that Justin knew what his company was worth. He did not look at others with traction and demand a price discounted from those lofty levels. He waited until he actually had the traction to be able to demand such a price. He played it smart and VCs know that and want to fund him.

One piece of advice for entrepreneurs: everyone forecasts huge upside. Right now, either you have the growth and traction or you have excuses why you do not. If you do not, and you want to get funded, you are going to end up with a low price, if funding comes at all. One piece of advice for venture capitalists: there are no bargain prices on companies with great momentum. Any entrepreneur who is smart enough to call a few VCs and has the traction is going to get term sheets with lofty valuations. If that entrepreneur takes your bargain price, you have to ask yourself why. Pricing is no longer linear, it is binary. Welcome to 2010.

9 Comments »

  1. wow, great post Stu! and a wake up call for us entrepreneurs in this environment. the days of funding 2 guys and a dog are far behind

    Comment by Vic Singh — December 15, 2009 @ 4:38 pm

  2. Yes Stuart, your post is very much in-line with current dynamics, especially for services with limited IP.

    However, every rule has its exceptions. Not all business can be launched on a shoestring (it cost AMZN $2bn to create AWS). This is especially true of infrastructure businesses – providing a buggy, if innovative, first release can mortally damage how you’re perceived.

    In these cases, ie where the company brings a substantial amount of proprietary IP to the table, and aims to take away clearly appreciable pain, then there is strong case for a decent tractionless valuation. It’s almost as if the investment becomes a self-fulfilling prophecy, because should traction occur – and this goes back to the conviction over how much pain will be removed – then the company will have a defensible competitive advantage for quite some time.

    Comment by David Semeria — December 16, 2009 @ 12:10 pm

    • Yes David, I totally agree. I was talking about real time data and web based deals. IP intensive and especially hardware deals take a lot more money and a longer gestation period.

      Comment by Stuart Ellman — December 16, 2009 @ 4:23 pm

  3. Stuart, great post. With this argument, you’re effectively taking a position on venture capital as an asset class (vs a cottage industry) debate. The skillset that VCs (at least in internet as you note in previous comment) need is competing to get into the top deals. Thus, perhaps only the best firms can make money and limits the scalability of the asset class.

    Comment by johnr — December 16, 2009 @ 10:05 pm

    • John – this is Eric, but as a co-author of this post I’ll try to respond.

      In the larger sense no, we’re not taking a position on VC as an asset class with this post. The reason we’re not is because the binary pricing phenomenon that exists today is driven largely by the collapse in fixed costs required to build a certain type of startup. More specifically, consumer (or SMB-facing) web startups built primarily on open-source “tech lite” stacks (LAMP, etc…). For these startups the binary pricing emerges because only a minimal asset is generated by initial product development efforts. These are essentially engines for either consumer engagement or transaction monetization – in either case there is no equity value generated until good early evidence of uptake is present. Once a true ramp has begun, it is easy to understand and see the power of habit, network effects and brand-building take place and high value generated as a result. This is why binary deal pricing takes place – if we (and by we I mean investors generally) believe you have found a real vein of consumer engagement or the ability to monetize a particular time of transaction, we get very excited, but until that happens it’s unclear that a tractionless startup has anything of value.

      This isn’t a position on VC as an asset class because despite the popularity of this type of startup within the social media world, they represent a relatively small portion of overall startup activity (and a much smaller portion of overall startup revenue and ultimate exit success). Most other categories of startup (software, bio-sciences, clean-tech, hardware, etc…) don’t follow these rules, require much more capital and creation of value prior to uptake, and so binary pricing doesn’t take place.

      In the smaller sense, we agree with your statement as it pertains to the consumer web. There will be a few big winners and it will be competitive to get into those deals. As VCs fund numerous no-traction competitors to these winners, you’ll see evidence of venture’s inability to scale in this way.

      Comment by fiveyearstoolate — December 17, 2009 @ 9:28 am

  4. […] via Binary Pricing « Five Years Too Late. […]

    Pingback by Binary Pricing « Five Years Too Late | techspill blog — December 17, 2009 @ 6:16 am

  5. A very thoughtful and well articulated post on the investor dynamics with respect to consumer/SMB facing web app businesses. Totally agree.

    Chris

    Comment by Chris Sheehan — December 18, 2009 @ 8:32 pm

  6. […] Building a destination makes sysiphisus’ task look easy. Stu Ellman had a good post about how this is a largely binary value equation and before having desti… […]

    Pingback by The Post Destination Era | Jon Steinberg — January 12, 2010 @ 8:58 am

  7. Great post, and I certainly agree across the board. And, additionally, your post had an unintended consequence: I ordered a used copy of Brealey and Myers’s book off amazon. I’m sure it will be almost completely irrelevant to my gig at USV, but I’ve always wanted to learn more traditional large company valuation methodology, and all my finance knowledge is self-taught so this looks like a good way to dive in. Thanks.

    Comment by Andrew Parker — January 12, 2010 @ 10:30 am


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