The “art” of VC startup reviews is a forgery – TechCrunch


Venture capitalists often say that valuing startups is “more art than science”. If this is true then it is absurd art because most early stage businesses are of no value.

In fact, early stage startups – companies that have yet to launch a product, no matter how many rounds they’ve raised – are probably worth less than zero using rational valuation methodology. The only certainty at this point is that the startup will continue to lose more money until a product is released, in which case it is. possible that income can be generated. The chances of going bankrupt are high.

It’s not much better for start-ups, which, again, aren’t defined by cycles like Series A or Series B, but by how many company progress they did. Once a start-up business has launched a working product, the startup has reduced one of the two major risks the business faces: going to market. At this point, a business must now prove that the new product or service can be turned into a scalable business.

Like early stage startups, early stage companies are still very fragile, with little predictability of revenue or cash flow. By definition, once the business has become predictable, the business is in a phase of growth or expansion. Without predictability, traditional valuation tools like Discounted Cash Flow (DCF) are almost useless.

Venture capitalists therefore lie to entrepreneurs and claim that start-ups and start-ups have intrinsic value.

Why would investors agree to place value on assets that have no objective present economic value?

I’ve heard many business executives ask this specific question, wondering if it might not be better to just acquire startups instead of funding them, usually in the hope that rational valuation techniques can be applied.

The best answer, based on my experience as a venture capitalist and entrepreneur for three decades, has nothing to do with valuation methodology and everything to do with teamwork, conviction and commitment. Investors must be part of the same team as the entrepreneurs they finance. And that means that each party needs an opportunity to win and must demonstrate that they believe in common goals. In venture capital, where investors are betting on high growth rates, a “win-win” concept of compensation is much more important than a “technically correct” assessment.

At the seed stage, where the value is arguably zero, investors would own the entire startup with an investment of any amount. Obviously, no entrepreneur would readily agree to such an arrangement.

So, to be fair to the entrepreneur, a lie was born. We claim that the startup is of value so that the startup team is motivated and everyone involved has a chance to win. The VC will also not take the majority of the startup in most cases, as a controlling position means the entrepreneur “works for” the investors. The philosophy of venture capital is that the entrepreneur runs the business and the investor provides the capital and support in exchange for a minority stake and a non-operational role.

I learned this from Bill Draper, who was one of the first West Coast venture capitalists in the 1960s. He said at that time the goal was just to keep it simple, unlike to the “financial engineering” that characterized the growth phase investment on the east coast.

His mantra at the time was “half for the entrepreneur and half for the investors”. When investors realized that employees needed motivation too, it became a third for the entrepreneur, a third for the investors and a third for the employees. It is not drastically different today.

So, if this is true, is there a role for the early or early stage evaluation discipline?

The answer is yes, because the investor should always evaluate the transaction as a potential source of return over other alternative investment opportunities, as long as the resulting valuation is fair to the entrepreneurs.

In fact, a good analogy for how it works can come from real estate. Before becoming a venture capitalist in 1992, I worked as a real estate appraiser. Appraisers use three main methodologies to assess a property: intrinsic value, income generating value and market value.

Embedded value is often referred to as “replacement cost” in real estate. This is what it would cost to buy a similar piece of land and rebuild the same house from scratch, estimating the cost of labor and materials. In real estate appraisal, this method has almost no weight, just like in venture capital.

The income in real estate method applies to properties that produce predictable cash flows, such as apartment buildings or established rental properties. For obvious reasons, this method is impossible to apply to start-ups and start-ups where there is no profit and nothing is predictable except expenses. This is why DCF is not used to valuing startups.

The dominant valuation technique used in real estate appraisals is the third methodology, market value. This approach seeks to understand how the market values ​​similar assets, as defined by the location, style, size and recency of the transaction. In other words, what have other buyers shown they would pay for similar homes in the same neighborhood over the past six months?

Real estate appraisers use comparable sales to determine an adjusted price per square foot as the primary basis for calculating appraisals when applying the market value method.

Venture capitalists do something very similar. There are clear valuation ranges for stage and round startups, which represent established market value. These numbers are even published by PitchBook, CB Insights and other organizations that track the investment activity of startups.

VCs then look for comparable sales in the exit stocks of startups with similar business models in the same industry, measuring the price / income ratio for mergers and acquisitions and IPOs. We then apply these multiples to future income projections to determine whether we can achieve a “risk-adjusted” multiple at today’s market price.

For a venture capitalist, it doesn’t matter that a startup has an intrinsic value of zero today if there is a reasonable chance of making 10 times our money or better. It’s the potential multiple that matters, not if we can apply traditional financial metrics to a startup.

This is completely different from how valuations are typically calculated in an acquisition, creating potential confusion for business development staff who have added venture capital investing as a new responsibility.

When a company makes acquisitions, every transaction should have an independent financial meaning. Venture capitalists, however, can accept the risk of early-stage and early-stage startups – including a rational expectation of some setbacks – by taking a portfolio approach. Venture capitalists don’t need a fixed or predictable return, but look for a combined return on a pool of capital invested in multiple startups. According to PitchBook, the average VC fund has 18.4 portfolio companies and the performance of the top quartile is typically a return of around 2 times the overall committed capital over the past few decades.

All that is necessary to justify a seed or start-up investment is to believe that the potential multiple of the investment outweighs the risk that the principal will not be repaid. This is based on the premise that the most VCs can lose is 1x their money – and the more they can earn is unlimited. Of course, investors need to be rational about whether the potential multiple is realistic and worth the risk, noted investor Fred Wilson.

And that means venture capitalists are free to participate in the fiction about what early-stage and early-stage startups are worth today. The real purpose of evaluations at this stage is to find a fair and motivating distribution for all involved.

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