
The Valuation Trap - asanwal
http://avc.com/2014/05/the-valuation-trap/
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malanj
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.

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robg
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_

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marcus_holmes
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?

~~~
graeme
What about the third option: be sole owner of a (hopefully profitable) private
company?

~~~
fsk
But that isn't VC. When you have outside investors, you have an obligation to
give them an opportunity to cash out. If you can bootstrap and own 100%, then
you have maximum flexibility.

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lisper
> When you have outside investors, you have an obligation to give them an
> opportunity to cash out.

A moral obligation perhaps, but no legal obligation. As long as you control
the board, nothing prevents you from taking investors money and essentially
pocketing it as long as you can find enough suckers. In fact, one could view
the public market as the suckers of last resort, particularly for companies
that don't pay dividends and have two-tiered stock structures (e.g. Google and
Facebook).

~~~
newhouseb
In a world where you could get a VC to sign any deal, sure, but realistically
any VC investing on a large enough scale will require provisions for a trigger
they can pull to get their money back out if their investment survives long
enough without liquidity. I'm sure someone can provide more detail but if I
recall correctly they tend to be about 10 years out and require that the
companies go public or allow the VCs to sell there shares (possibly back to
the company) at some certain value.

~~~
Retric
Profitable company's can just get a loan to buy those shares based on a
reasonable valuation of the companies value. IPO's are only nessisarily if you
_need_ to rase money or are overvalued. Bonds, private equity, institional
investors, and plenty of other options exist when you don't need a greater
fool.

~~~
001sky
Debt for equity swaps are only of use up to a point. The issue is the ration
of one to the other. Which will be proportionate to cash flow and not to paid-
in capital (or a multiple therof).

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davidu
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.

~~~
fredwilson
Good criticism. I saw an opportunity to make a point I've been wanting to make
and jumped on it

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jacquesm
If there was an 'ethical VC' award I'd be happy to nominate you, there are
several occasions now that you've managed to make me note you in this respect.
Off the top of my head: caring about where LPs get their cash, listing your
conflicts of interest up front and admitting mistakes gracefully. Upvote
gladly given, I wished I could give more of them.

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joshfraser
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.

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asanwal
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.

~~~
richardwhiuk
It's possible you could argue that the pre IPO markets are or were in a bubble
phase and the postponement of the IPO is being caused by the broader market
rejecting the hyped valuation as the broader economy isn't in a bubble (unlike
dotcom bubble where companies were IPOing at hyper valuation). I'm not
convinced I buy that, but it is one way of reading the numbers.

~~~
carlosrt
TL;DR In the broader economy: "Almost every asset is overvalued,"

For those of you that followed the hashtag #2014GC last week you saw this:

"The quantitative easing and the excess money and the low interest rates have
driven pricing up of almost all financial assets to beyond what their
intrinsic value might be," Joshua Harris, co-founder and chief investment
officer of $161 billion private equity firm Apollo Global Management, said
Monday at the Milken Institute's Global Conference in Los Angeles.

"So even though we can all chat about the benevolent growth environment that
exists in the U.S. and to a lesser extent globally, the ability to make money
and invest wisely on that is very, very challenging right now because you're
starting at a point in the valuation cycle that is very, very aggressive."
Harris added that it's a "time to be cautious" and that Apollo is still
looking for investments in sectors that are still relatively depressed.
"Almost every asset is overvalued," he said.

Source: [http://www.cnbc.com/id/101620735](http://www.cnbc.com/id/101620735)

Tweet:
[https://twitter.com/ldelevingne/statuses/460800459972681728](https://twitter.com/ldelevingne/statuses/460800459972681728)

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johnrob
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.

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Codhisattva
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.

~~~
larrys
True but in business that is still a model. The idea in business is to make
money. Just like in sports the idea is to win the game. Which is not the same
as saying "at all possible costs" but nothing really inherently wrong with
playing the game this way. Imo of course.

For all the stories that you read about business success you never know what
happens behind the scenes. But you also don't know about those that played,
say, a fairer game, didn't make it (a lot of money that is) and that you've
never heard of either.

~~~
Codhisattva
I agree it's a business model. Unfortunately I don't think many of the startup
participants are aware they are the product.

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rokhayakebe
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.

~~~
quanticle
But, on the other hand, Amazon lost money for _years_ after it went public.

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stevenj
TIL Facebook had a down round:

[http://avc.com/2014/05/the-valuation-
trap/#comment-136902035...](http://avc.com/2014/05/the-valuation-
trap/#comment-1369020357)

~~~
prayag
This was mostly due to macro-economics and the fact that the down round was
after the Microsoft investment which valued Facebook at 15 Billion.

[http://www.businessinsider.com/2008/12/facebook-get-ready-
fo...](http://www.businessinsider.com/2008/12/facebook-get-ready-for-a-down-
round#!IkZMf)

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applecore
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.

~~~
kanamekun
Companies are usually reluctant to raise a down round due to anti-dilution
provisions:

[http://www.businessweek.com/smallbiz/content/jan2009/sb20090...](http://www.businessweek.com/smallbiz/content/jan2009/sb20090123_008974.htm)

~~~
taylorwc
Even if there are not anti dilutive preferences, both management and existing
investors are likely to leave a down round as their last resort, simply
because of the dilutive impact it would have.

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jgalt212
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.

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orky56
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.

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arbuge
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.

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gyardley
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.

