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.
- See how publicly traded comparables were doing,
- See how other similar venture deals were priced,
- Look at how similar companies were being acquired,
- Find out how other VC firms would value this company, and finally
- 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.