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November 14, 2019
Back to Black: Thoughts on VC Valuation in the Wake of WeWork

Is it better to invest in a fast-growing company, or a profitable one? One innovating on existing technology products, or bringing a technology approach to a traditional market? While the past few years have broken new ground on these questions, lately investors have lost sight of what makes a company worth a particular sum in the first place. A string of recent stumbles from newly public or nearly-public companies should serve as a wake-up call to bring investors back to reality.

Let’s take WeWork’s postponed IPO as a prominent (but certainly not lone) example. In the lead-up to the planned public offering, the company’s valuation dropped from $47 billion to $15 billion, then even lower amid a Softbank bailout and a public mea culpa from Softbank chief Masayoshi Son. Why? Did investors have a sudden change of heart? Did the company report any material change to its business? Or was it simply scrutinized by much more pragmatic stock buyers who, after studying the company’s IPO prospectus, were not willing to sign up to the valuations implied by prior investors?

WeWork is a symptom of a broader phenomenon within the current startup landscape. Over the past few years, venture capital funding has become much more abundant and available to companies that may or may not be truly innovating in ways the VC funding model was designed to support. That’s not to say these are all bad businesses. To take WeWork again as an example, temporary office space has been around for decades, and there was certainly a welcome opportunity to refresh the old model for a new generation of customers. But just because a capital-intensive model, which has historically scaled gradually, can scale rapidly through immense funding, doesn’t mean it’s justified.

All this capital pouring into the innovation economy has also produced some amazing results. Startups are pursuing a record number of ideas. More and more talented people are leaving stable jobs to found new companies or join unproven ones. Yet, just as in past funding bubbles, companies are raising money at valuations that seem increasingly disconnected from fundamentals. As a venture community, now is an important time to revisit our model and ensure its long-term sustainability.

So what makes a company worth $100 million, $1 billion, or $100 billion? How do you tell a unicorn from a horse with a glued-on horn?

Company Valuation 101: Back to the Drawing Board

Any asset’s value is a function of the potential return it is likely to generate for its owners over some period of time. Therefore, company valuations should essentially be a summation of all future returns (both cumulative earnings and the value of its shares) a company can yield to its investors, adjusted for the amount of time until that return is realized. Mathematically, that summation can be described in two ways: either as (1) a range of multiples of a current or future profitability metric, such as sales or net income after tax; or (2) as a probability-weighted average of what an acquirer might pay for it.

Either way, VC valuation ultimately answers this question: “if I invest $X today, and need it to be worth at least $Y tomorrow for my own investors to continue giving me capital to invest, how much can I afford to pay right now?”. For any rational investor, there needs to be a clear path of how X becomes Y.

Why are some businesses valued more highly than others?

Remember the ‘90s? What were the arguments back then for why tech companies were worth so much more than their traditional counterparts?

Let’s take a shoe business as a simple example. A brick-and-mortar store can only sell shoes to customers in its neighborhood. Its unit margins are limited by the prices it can negotiate with manufacturers as a small business. Its company margins are limited by its overhead relative to total sales. If a national chain wanted to buy this store, they might look at its annual profits and multiply them by 8, 10, or 20. They might assume they could optimize some costs because they’re operating on a larger scale (for instance, they might have access to better prices on inventory). But they could expect to pay something roughly equal to that multiple of the store’s performance, depending on what alternatives they had at that point in time. This results in a fairly pragmatic and straightforward valuation.

Now – how much different is an online shoe store, and what might it be worth? Early on, an online shoe retailer actually faces certain disadvantages versus a brick-and-mortar location. It needs to hire expensive developers to build and maintain its infrastructure. It deals with more complicated logistics. Plus it must cope with a much higher rate of credit-card fraud.

However, all of this can be worthwhile given significant advantages. Once the online store’s infrastructure is in place, it can market to a customer across the country just as easily as one next door, without much additional effort or cost. Procurement, logistics, overhead, support, and brand all begin to benefit from economies of scale, improving margins.

Further, were it to reach a certain scale, national chains considering buying it would have fewer alternatives. Our online shoe store could be the dominant and only property on the market, and therefore have more negotiating power than its brick-and-mortar counterpart. As we’ve seen over the past two decades, a properly-run online business can scale much faster and larger than the brick-and-mortar business. That justifies its higher multiples: because it’s likely to be worth a lot more in the future.

The logic should be simple: when a company can leverage technology (or other enablers of scalability) to expand its business without requiring a similar investment to reach the next strata of sales, that justifies a higher valuation multiple.

Not all revenues are made equal

While growth is important, strong usage and even revenue don’t necessarily translate into value. To illustrate what I mean, imagine a venture-backed startup called Giftcard Co, which lets you buy gift cards from multiple retailers all in one place—and with discounts! Spend $95 today and get $100 in value—nice, right? What’s more, the company has grown from $1 million revenue last year to $10 million this year. Is this a unicorn in the making?

When we dig into the details, however, we realize that Giftcard Co purchases its gift cards for, at best, the same discount it offers to customers, leaving the company little or no margin. The vast majority of customers also purchased a gift card after clicking on an Instagram ad, which Giftcard Co pays for. Who’s ultimately winning here? Where’s the value going? The retailer distributes $10 million in gift cards, and Facebook/Instagram happily collects venture dollars in exchange for promoting gift cards. At the end of the day, Giftcard Co and its VCs are pouring money into an unsustainable business model.

This idea may sound overly simplistic, but is meant to illustrate a broader phenomenon I see daily. Too many investors today are ignoring the elements that make up value – the summation of actual sales and profits  – and leaning hard on continuing the momentum of prior rounds. That is to say, if the valuation in the last round was X, and the company’s sales grew in the interim by a multiple of Y, then the new valuation should be X times Y – without regard for the value generated by the business of the company itself.

This math can get dangerous. If a company’s revenue doesn’t yield ample margin, or if the original valuation was set in a way that had nothing to do with revenues, you’re in danger of wildly overpaying for a company that doesn’t have potential to create economic contribution to its shareholders. It’s true that early-stage investments may not have hard numbers upon which to base initial valuations. But once those hard numbers exist, VC investors should factor them into current and future valuations. Not only does this protect investors and founders in individual companies, it will also help ensure the sustainability of the venture investment model.

The VC community needs to go back to the basics. Look at the fundamental revenue-generating capacity and profitability potential of a company. Figure out if they have a sustainable, long-term path to scale efficiently. Don’t mistake a brick-and-mortar business with a shiny digital component (or brand) for a scalable and defensible technology venture.

If we want to keep the music playing, we need to pay the piper.

Battery Ventures provides investment advisory services solely to privately offered funds. Battery Ventures neither solicits nor makes its services available to the public or other advisory clients.  For more information about Battery Ventures’ potential financing capabilities for prospective portfolio companies, please refer to our website. No assumptions should be made that any investments identified above were or will be profitable. It should not be assumed that recommendations in the future will be profitable or equal the performance of the companies identified above.

Content obtained from third-party sources, although believed to be reliable, has not been independently verified as to its accuracy or completeness and cannot be guaranteed. Battery Ventures has no obligation to update, modify or amend the content of this post nor notify its readers in the event that any information, opinion, projection, forecast or estimate included, changes or subsequently becomes inaccurate.

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