Beauty Contests and Venture Valuations

After all, we don't exist in a vacuum, and we don't live off the dividends of the companies we invest in. By the nature of venture investing (which basically returns the money to investors within a fixed period of time), we need to exit the investments.

When we exit, we are at the mercy of the people who buy the company from us. This means it is not worth what a fundamental net present value calculation would indicate. A company is only worth what somebody will pay us for it.

Since companies require multiple financing rounds, we even need to be right in interim valuations. After all, if the next financing is done at a step down in valuation, it's just an indication that we shouldn't have participated in the earlier round -- we should have waited.

This leads to a situation where everybody is looking at each other to guess valuations. In a situation like that, we can't guess the fancy equations every single potential later investor is using - so we simplify, using measures based on agreed upon benchmarks. We can also be sure the other guys are doing the same thing, so we all end up using the exact same methods.

In other words, VCs aren't being lazy or stupid when they use multiples and comparables to quickly set valuations - they are being completely rational, knowing that later buyers are doing the exact same thing.

There is no benefit to any individual player improving their valuation metrics. Let's say that I decided that I should use fundamental analysis (and overcame the uncertainty issues involved). If my calculations came out lower than the simple metrics everybody else was using, I would get shut out of the deal. Since the buyers are also using those metrics when buying, I would be shut out of a potential profit as well.

If my calculations came out higher and I actually offered that valuation, I would overpay - and would lose money compared to other investors, since the buyers wouldn't offer me higher amounts for my shares in future rounds of financing.

Price-setting events

So how do prices get set in such a market? There is theoretically some semblance of fundamentals that gets priced in - the Internet bubble did eventually burst after all.

These come about through price setting events - major transactions where a very large player with huge resources makes a purchase. Microsoft's acquisition of Hotmail for $400 million falls into this category.

Additionally, public market swings (driven by who-knows-what -- a completely different topic that academics are still arguing about) will change the public market comparables and affect private market transactions.

In both of these cases, the ultimate buyers do a more detailed analysis that likely will include more fundamental factors. At that point, there is a new benchmark set that will guide future transactions.

Arbitrary, but necessarily so

That characteristic leads to the biggest complaint I've seen about valuations. Entrepreneurs want to focus (as they should) on what makes their company different and more valuable than the others. In the meantime, venture investors are busy fitting companies into boxes so that they can use existing valuation metrics (as they must).

The results can often seem arbitrary since companies that at first blush look very different are measured by the same ruler. Without this consensus on valuation, however, the deals would not get done at all.

(For a good overview on the types of metrics used for valuations, see Ion Equity's presentation on fundraising and valuations. The specific metrics used for a particular deal type can change frequently and/or be very specific. If you're looking for current metrics, you'll have to do some checking around with people who know the financial angle in the industry. Investment bankers are often a good source, since they track recent transactions very carefully.)