The necessity of early stage valuations

A friend/contrarian Tweeted the following that I though was worth a discussion (the 140 character limit of Twitter quickly got too painful for me).

“What’s wrong with this world: Twitter is making $4mil per year yet is valued at $1bil. #newmath”

I think this is an important thing to talk about– it’s certainly something that would have resonated with me before I raised money from investors, but now falls pretty flat. I have two quick points to make about it, then I’ll wait for Marina to attack me in the comments.

1. Valuation does NOT equal market value for the company. Founders don’t like to give away a lot of equity when raising money (nor should they!). So, to bring the #s back to earth, let’s pretend that I have a seed stage idea with a little promise/traction that I’d like to raise $1m for. During the fundraising process, there is NO discussion about what the company is WORTH. Instead, the discussion is about how much equity I want to sell (say 25%) and how much I think I can get for it ($1m). This establishes a post money VALUATION of $4m (i.e. 25% of the company is worth $1m, so 100% is worth $4m). No one is saying that anyone who buys companies would even DREAM of buying it at a price of $4m… We just need a mechanism to decide how much equity the founders get to keep if we want to raise $1m. We could fix this offensive math by either selling stock in a company based on the market value (what someone would buy it for), but I think you’d find that good entrepreneurs are not interested in working for free/cheap when they own a tiny percentage of their “fairly” valued company. This model scales all the way up to Twitter. The conversation is more about how much founders and previous investors own after they raise their big rounds than “So, whaddya think we’re worth if we put this puppy on the auction block?”

2. Supply and demand. There are two markets here. One is the scarce (and not always rational) market of GOOD entrepreneurs/startups. If an investor wants a stake in startup that’s growing, they have precious few opportunities to do so. This market has VERY little to do with the current cash value/revenue of the company (at the early stage), but instead is based on the size of the market/opportunity, the entrepreneurs involved, growth patterns, long-term market trends, and how much competition there is for the deal. If Ev Williams punted Twitter tomorrow to start a new startup, he’d get huge valuations if all he had was a sketch on a post-it note, just because there are very few opportunities to work with a guy who has made VCs rich in the past (i.e. had an exit). And because the upside of a successful exit/IPO is so high it makes sense to buy the opportunity at that cost even if Ev’s post-it note probably wouldn’t sell for much on the open market.

Whether you think Twitter is or ever will be worth $1B is immaterial (I think it will, for what it’s worth). The real question is, should an an early stage investor buy stock in a company with a valuation that doesn’t reflect current market value of the company? I think the answer is a resounding yes– if it wasn’t, you’d have a lot fewer startups in the world.

I think the solution for the disconnect is to stop equating the phrase “valuation” (especially when talking about early stage startups) with market-value in your head. We back into those numbers in funding negotiations to make sure that entrepreneurs have the cash resources they need and enough equity to be motivated by the upside at the end of the rainbow.

And, remember: don’t be held back by common sense. There’s a great quote about an insane idea being a necessary but not sufficient requirement for startup success. Early stage investors have been in the business of funding companies without revenue forever, and the smart ones seem to make a lot of money doing it. Monetizing Twitter on a grand scale right now seems insanely hard. But a LOT of smart pundits were saying that the search market was a dead end when Google started spinning up. Markets change, smart people innovate, and magical things happen…

  • http://www.technotheory.com Jared Goralnick

    Amen, Tony, and good timing on this thought as I have to keep running it through my head. While a company with little revenue may not be valued particularly highly in some sense, there are other factors that can tie a stake in the business to a particular dollar value.

  • http://one-shore.com/aaron fijiaaron

    your argument essentially boils down to “I want to make money off of startups, so I want startup valuations to be high.”

    Some founders may not be thinking about valuation when they receive early stage investment, but investors are. If they take a 25% stake for $1 million, they're expecting it to sell for at least $4 million when they put their puppy up on the chopping block.

    The key word here is “early” stage. They expect growth (or at least hype) to increase valuation.

    Twitter is not an early stage startup. They've pretty much peaked. There may be sustained growth, but there will be no more exponential growth in users.

    While a revenue stream may eventually appear, no one is really optimistic. That's why you get the disbelief.

    Twitter's valuation is now based not on the auction block, but the chopping block. There are existing revenue generating organizations who depend on monopolizing eyeballs. To the extend that Twitter competes with eyeballs, controlling (or eliminating/assimilating) Twitter has value to them.

    Online rivals include Facebook (obviously) but also Google and Yahoo. All of which are in a similar situation themselves — being worth more to their revenue generating competitors, who are primarily traditional media. It was no accident that Time-Warner bought AOL or that NewsCorp bought MySpace. Microsoft is the major non-media major player in the game that is also revenue generating, and they have been trying to get into the media business for a long time.

  • http://www.rescuetime.com webwright

    Yeah, investors certainly want to see a big bump– in your scenario, they
    generally want to see a minimum of a 5x but hope for a 10x or greater.
    Given that they've taken $155m in funding, that ALMOST eliminates the
    “chopping block' scenario you describe. Hard to guess the post money
    valuation, but let's say they'e sold 50% of their company for all that
    cash. That's a valuation of $310m, which means a 5x exit would be $1.5B -
    $3.1B – that would seem like they are angling for IPO (which means finding a
    revenue model).

    Whether Twitter is an early stage startup is an interesting question. Maybe
    they have peaked– there are certainly some sites that indicate their growth
    has flattened (though that might just be a migration from the web to Twitter
    clients). To say that there will be no dramatic growth in their future
    (when they had dramatic growth as recently as a few months ago) is probably
    premature. Clearly a lot of people are betting that there is more magic
    that's going to happen there, whether it's growth or monetizing their
    existing traffic.

    I agree with a lot of what you're saying– if Twitter doesn't change. With
    the war chest they have and the talent they've grabbed, my guess is that
    they'll be trying a lot of ambitious things in the next 24 months.

  • http://one-shore.com/aaron fijiaaron

    your argument essentially boils down to “I want to make money off of startups, so I want startup valuations to be high.”

    Some founders may not be thinking about valuation when they receive early stage investment, but investors are. If they take a 25% stake for $1 million, they're expecting it to sell for at least $4 million when they put their puppy up on the chopping block.

    The key word here is “early” stage. They expect growth (or at least hype) to increase valuation.

    Twitter is not an early stage startup. They've pretty much peaked. There may be sustained growth, but there will be no more exponential growth in users.

    While a revenue stream may eventually appear, no one is really optimistic. That's why you get the disbelief.

    Twitter's valuation is now based not on the auction block, but the chopping block. There are existing revenue generating organizations who depend on monopolizing eyeballs. To the extend that Twitter competes with eyeballs, controlling (or eliminating/assimilating) Twitter has value to them.

    Online rivals include Facebook (obviously) but also Google and Yahoo. All of which are in a similar situation themselves — being worth more to their revenue generating competitors, who are primarily traditional media. It was no accident that Time-Warner bought AOL or that NewsCorp bought MySpace.

    Microsoft is the major non-media major player in the game that is also revenue generating, and they have been trying to get into the media business for a long time. And that is why they are so obsessed with controlling the delivery mechanism.

  • http://www.rescuetime.com webwright

    Yeah, investors certainly want to see a big bump– in your scenario, they
    generally want to see a minimum of a 5x but hope for a 10x or greater.
    Given that they've taken $155m in funding, that ALMOST eliminates the
    “chopping block' scenario you describe. Hard to guess the post money
    valuation, but let's say they'e sold 50% of their company for all that
    cash. That's a valuation of $310m, which means a 5x exit would be $1.5B -
    $3.1B – that would seem like they are angling for IPO (which means finding a
    revenue model).

    Whether Twitter is an early stage startup is an interesting question. Maybe
    they have peaked– there are certainly some sites that indicate their growth
    has flattened (though that might just be a migration from the web to Twitter
    clients). To say that there will be no dramatic growth in their future
    (when they had dramatic growth as recently as a few months ago) is probably
    premature. Clearly a lot of people are betting that there is more magic
    that's going to happen there, whether it's growth or monetizing their
    existing traffic.

    I agree with a lot of what you're saying– if Twitter doesn't change. With
    the war chest they have and the talent they've grabbed, my guess is that
    they'll be trying a lot of ambitious things in the next 24 months.