The Valuation Trap

I've talked to many founders who seem to forget the basic "economic laws of the universe". You have to create more value (if you're feeling pessimistic, more perceived value) than you take to get something out. It's crazy how many founders get excited about how much they've raised, or at what valuation, while forgetting that basic fact. Every dollar you raise is one you need to put to work more effectively than the general market. A high valuation is basically a "discount" applied to any value you create, the higher the discount the more value you need to create to make the equation balance. It's scary to see founders that have significant exits (>$100m) walk away with very little, because they didn't manage to make that fundamental equation balance.

Hard not to respect someone who you starting reading and are saying "Yeah, but you are conflicted..." then hit:

Epilogue: I am a VC. I am talking my book here. I don’t like to pay sky high valuations. And I like to argue against them. So understand this post in that context. But I am also an investor in companies that have found, and may or will find themselves in the valuation trap. I have lived it, felt it, and suffered from it. It is a real issue

I saw Orion Henry (Heroku) talk about this last year: they got so big they had to make a choice to IPO or accept Salesforce's offer as maybe the last chance to get bought out. Once they got past a certain size suddenly the options shrank.

Seems like a sensible thing to talk about in advance: do you want to become the CEO of a public company, or do you want to get bought out and walk away?

I'm generally a fan of Fred's posts, but this one is odd. At least he calls it out at the bottom.

For starters, he's neither an investor in Square nor Box. There is zero evidence that Square was even prepping their IPO. As far as I'm aware, and I keep my ear to the ground, Square hasn't selected any bankers. They are far from even getting ready.

And Box will have no trouble attracting capital. Their valuation is a fraction of Dropbox's.

I'm not sure Fred is really in an authoritative position to write this post. He lacks facts about the two examples he cites. Linking to other news stories that are talking about rumors isn't helping tell a realistic story, it just perpetuates the echo chamber, which is not something he generally does.

If you ever negotiate with a VC on valuation, you'll hear some variation of this story. It's one of their favorite ones to tell. They all love to warn of the risks of taking too high a valuation. There's some truth to it of course, but what you won't hear are the stories of founders who give away too much of their companies and ended up with a tiny share of their company when they exited. Sure, sometimes you can get hurt by having too high of a valuation, but I know a lot more entrepreneurs who worked their asses off only to walk away with a token amount when they sold their company.

I'm skeptical Box can course-correct.

They are in a hyper-competitive space with margin pressure and also seem to have pretty poor SaaS fundamentals (high Customer acquisition costs and illusory LTV)

Fred felt they could slash their cash burn to put the company on better footing but that kills the growth story that they were pitching to public market investors.

The good news in all of this is that it counters to some degree the notion of a bubble as companies with crappy fundamentals are not able to IPO.

If your company is losing money every month, then any valuation can present a valuation trap. Founders and investors are both speculating that there will be profits down the road. Sometimes they are right. Sometimes they aren't.

The trap exposes the dirty little secret: you're not building a product to sell to customers, you're building a product to sell to investors.

The exit is the massage.

It is interesting to see that both Google and Microsoft were profitable before going public.

The ratio from cash raised/revenue at IPO is something investors should look at before buying stock.

A company should not go public while loosing money, that is what venture capital exists for.

TIL Facebook had a down round:

http://avc.com/2014/05/the-valuation-trap/#comment-136902035...

When a company is the size of Square and Box, why not just raise a down round—a round of financing that values the company at less than the previous round?

Valuations are lower than they were three months ago. Companies that were once worth billions of dollars now find themselves with lower valuations.

Prices will always fluctuate as a result of market forces.

My view on this is only take on a crazy sky high valuation if it leaves you with tons of cash on hand so that you then have years for runway left. The converse is don't take tons of money, if you then immediately turn around and start spending at an even crazier rate than before.

The positive example that immediately comes to mind is Github's $100M investment from Andreesen Horowitz. Of course, perhaps all that money led to some other problems down the road (that are now only coming to light.)

To troll, Mr. Horowitz a bit: "Mo Money Mo Problems" --Notorious B.I.G.

When you raise money, you are taking a gamble on the future. You expect that your current situation will be improved with an inflow of cash that allows you to pursue an opportunity higher hurdle rate. If any of those assumptions were wrong at any point including general macroeconomic issues (like beta), then you are stuck. If an investor has faith that those false assumptions could be reversed or are irrelevant, then you get additional funding. Valuations are just what everyone is willing to cope with.

Downrounds are not a tragedy though. If you can take the money without giving up too much equity (which a high valuation is tantamount to), I would think carefully before considering any other option.

Yes, although founders and early employees of companies at this stage can often exit by selling on the secondary market. For individuals the trap is somewhat porous.