The Watney Rule for Startups and the Return to the ‘Old Normal’

... When the public stock price of marketplace lenders (like LendingClub and OnDeck Capital) dropped, it somehow (magically) had little effect on the valuations of private marketplace lenders. This was a new — and scary phenomenon. It was as if promising baseball players in the minor leagues were suddenly able to earn a higher salary than veteran all-star players in the major leagues. Perhaps this was partially driven by the limited supply of promising high growth companies — which created an auction-type dynamic in which Greater Fool Theory drove prices. Or perhaps it was due to the fact that public companies trade every day (on good news and bad news), whereas private companies control when they trade (so they were able to have far more control of their valuation by only trading on good news).

This piece irritates me. The author (who clearly should know what's going on) is acting surprised, as if they did not see this coming. I can't believe he or she is not just stating the true reason that public and private market valuations have drifted apart:

It's that private market investments are on much different terms than public market investments. Usually private market investors are given liquidation preferences and more, none of which a public market investor can ask for. When a public company goes down, the investors lose money right away. When a private company goes down the investors lose money only if the company is worth less than the invested money (the company value including what's left of the invested money!)).

I would not even call private market valuations "valuations". They are more like a valuation cap. Investors make money if the company sells for more than the cap.

The venture market has been running on the "greater fool" approach, assuming that stage N investors will be bailed out by stage N+1 investors. Instead, the last private equity stage is left holding the bag. Look at Twitter's numbers.[1] Twitter still isn't profitable, which is incredible considering the simplicity of the business.

From the startup perspective, the trouble with becoming profitable is that you're then evaluated as an operating company. Investors look at GAAP earnings, not growth or EBITDA ("earnings before all the bad stuff") numbers. Operating companies are usually valued around 10x earnings. (Apple is around 11 right now). On that basis, many of the "unicorns" have negative valuations. If you're stable and profitable but not hugely profitable, you can't get another round of funding.

[1] http://financials.morningstar.com/ratios/r.html?t=TWTR

[1] https://news.ycombinator.com/item?id=11111753

[2] http://heidiroizen.tumblr.com/post/139377970205/dear-startup...