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So far, 2022 is off to a rocky start. Fears of inflation and signals that the rate environment is about to shift have driven the markets down with high growth tech stocks leading the charge.
What does this mean for #VC backed private companies? A few thoughts:
What does this mean for #VC backed private companies? A few thoughts:
Answering this question is easier if put in the context of a valuation framework.
My simple framework:
A business is “worth” a combination of the intrinsic value of what it can produce and the option value of what it might be able to produce in the future.
My simple framework:
A business is “worth” a combination of the intrinsic value of what it can produce and the option value of what it might be able to produce in the future.
Intrinsic Value
Once a company has learned how to turn a dollar of investment into a multiple of the dollar in the future it’s earned the right to be called a money-making machine. Until then, it might have salvage value, but true enterprise value is questionable.
Once a company has learned how to turn a dollar of investment into a multiple of the dollar in the future it’s earned the right to be called a money-making machine. Until then, it might have salvage value, but true enterprise value is questionable.
Every money-making machine has some intrinsic value. The value is a function of the return profile of the future cash flows, the certainty of the cash flows, and the amount of money the machine can effectively put to work.
Option Value
In contrast to the intrinsic value of a company, the option value of a company is a function of unknowns vs. knowns. It’s about belief and assumptions vs. proof and results. The narrative around a company’s future can describe significant option value.
In contrast to the intrinsic value of a company, the option value of a company is a function of unknowns vs. knowns. It’s about belief and assumptions vs. proof and results. The narrative around a company’s future can describe significant option value.
The public markets have historically been good at valuing money-making machines especially when they’re in mature ecosystems with easy to analyze competitive landscapes.
The public markets have historically been poor at valuing the option value of companies, especially when there are many necessary leaps of faith and a company is still burning cash.
But in the last few years, there was no yield to be had anywhere and it was forecasted that low rates were here to stay. Chasing yield required taking on incremental risk and Investors did this by planting money with high growth “next generation” companies.
Multiples and valuations took off for these companies and Investors justified their investment decisions by lowering their hurdle rate (i.e. – their discount rate). This change ascribed less value to today (intrinsic value) and more value to tomorrow (option value).
If you've never calculated the valuation impact of discount rates to a high growth company burning cash then you should!
Homework: Pick your favorite high growth tech stock and run the math. DO IT!
But guess what? This phenomenon works in both directions!
Homework: Pick your favorite high growth tech stock and run the math. DO IT!
But guess what? This phenomenon works in both directions!
The Fed has signaled that it wants to focus on stabilizing prices (i.e. – battling inflation) by increasing rates 2-3 times this year and reducing the Fed’s balance sheet (i.e. – subtracting liquidity from the economy).
Boom! As an oversimplification of what happened next, Investors raised their discount rates and enterprise valuations of high growth public companies fell.
Does this matter to the VC landscape? It undeniably should.
But I chose the word “should” carefully because it might not.
Does this matter to the VC landscape? It undeniably should.
But I chose the word “should” carefully because it might not.
Just like public markets Investors, VC Investors have to determine how much they’re willing to pay for the intrinsic value and how much they’re willing to pay for the option value of a company.
Over the past few years, VCs recalibrated their valuation math to reflect the public markets trends, and with healthy multiples being attached to high growth public tech companies, VCs began to completely look past today (intrinsic value) if tomorrow looked bright (option value).
While VCs have always had to ascribe value an uncertain future, they typically priced a company based on its current results. But multiples jumped to heretofore unseen levels (100X+ ARR in many cases) which effectively valued companies based solely on their option value.
So, one would think that a downward correction in what a “right hand tail outcome” looks like would impact what a VC is willing to pay for that outcome.
The truth: Later stage startups should take a hit, but it’s possible that early stage startups might not be impacted at all.
The truth: Later stage startups should take a hit, but it’s possible that early stage startups might not be impacted at all.
There are many “Why Not” reasons that include:
Why Not Reason 1: Right hand tail outcomes are still quite good and the right hand tail of the right hand tail is still unbounded
Why Not Reason 2: Building blocks are in place that make shipping code easier and faster
Why Not Reason 1: Right hand tail outcomes are still quite good and the right hand tail of the right hand tail is still unbounded
Why Not Reason 2: Building blocks are in place that make shipping code easier and faster
Why Not Reason 3: Incumbents are saddled with legacy infrastructure that makes it increasingly difficult for them to innovate
Why Not Reason 4: Talent is flowing away from incumbents and into the startup ecosystem which decreases the odds that incumbents will be able to innovate
Why Not Reason 4: Talent is flowing away from incumbents and into the startup ecosystem which decreases the odds that incumbents will be able to innovate
Why Not Reason 5: Capital availability is a de-risking factor and capital is flowing freely into startups
Why Not Reason 6: VCs are incented to put money to work and price helps win deals
Why Not Reason 6: VCs are incented to put money to work and price helps win deals
There are other forces at play when it comes to how a VC values a company, but the reality is that in a many-to-many matching environment changes take time to ripple through the system (if at all).
My belief is that VCs are overvaluing many companies given today’s market conditions because the alternative is sitting the market out which they won’t do. It might take a liquidity crunch/consolidation wave within the VC ecosystem to trigger a real course correction.
The returns for the best VC firms should remain exceptionally good because the Power Law still drives VC returns. But it’s highly likely that the entire distribution of outcomes has moved significantly left which means average performers are going to be hit hard.
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Sahil Bloom @SahilBloom
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Jan 11, 2022
Great thread!