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Mulling The Magic Of Startups' Made-Up Metrics
In “Surprise: Tech Company Valuations Are Completely Made Up,” we outlined the process by which tech startup founders and their multi-billionaire VC backers determine valuations.
In short, it’s a highly scientific affair that includes entirely objective factors such as how much the founder thinks his or her company is worth. “A founder often starts off with a number in mind, based on the startup's last valuation, the valuations of competitors, and, for good measure, the valuation of the company's neighbor down the street,” Bloomberg noted earlier this year. As a refresher, here is our summary of how companies like Snapchat end up with higher valuations than Clorox and Campbell’s Soup:
Now that everyone is jumping on the “there’s no way that app is worth $50 billion” bandwagon, Bloomberg is out with a startling revelation: “Snapchat, the photo-messaging app raising cash at a $15 billion valuation, probably isn't actually worth more than Clorox.”
No, probably not, but it sure is more fun than doing laundry, which is why it absolutely makes sense that the number VCs are putting on the app makes absolutely no sense.
It’s all completely made up, which is what we suspected, but as Bloomberg discovered when they spoke to some of the billionaires involved in funding early stage tech companies, the term “valuation” doesn’t actually mean what sane people think it means.
In fact, having to equate the amount of money one throws at something with an assessment of how much the business is actually worth turns out to be really inconvenient which is why VCs would rather just not talk about it, but when pressed, here’s what they’ll say:
“Some VCs defend the practice by saying valuations are just a placeholder number, part of an equation fueled by other, more important factors. Those can include market share, growth projections, and a founder's ego.”
If those are the “more important factors,” what are the less important factors?
“A tech startup's cash flow is less important than you might think. It's something investors look at for a sense of how quickly a startup is growing its revenue, if the company has any.”
So just as the term “valuation” does not, as we mistakenly thought, indicate what something is worth, a business’s ability to generate cash flow is “less important” than we might have suspected, and it’s a good thing, because a lot of these business don’t make any money at all:
Financiers also look to find the number of people using the product, regardless of whether they pay for it.
Another mistake the market often makes when thinking about valuing these companies revolves around the bad habit of factoring in costs, and especially operating costs, which, like cash flow, actually don’t matter:
Costs, especially operations costs, are largely ignored for fast-growing companies.
Essentially, no conventional measures of corporate health apply when you're a tech startup with "hockey stick" growth on some metric that your founder has arbitrarily decided is the best approximation of your company's prospects going forward.
VCs buy into this despite likely realizing that it's complete nonsense because after all, what counts is getting portfolio companies to the liquidity event finish line (i.e. an IPO or a buyout) at which point it no longer matters what the long-term outlook is because everyone cashes out and moves on to the next Ivy League dropout with a flashy app.
WSJ has more on tech startups and made-up metrics:
Hortonworks Inc. Chief Executive Rob Bearden forecast in March 2014 that the software firm would have a “strong $100 million run rate” by year-end. But the number looked a lot smaller after Hortonworks went public and then reported financial results: just $46 million in revenue last year.
It turns out that Mr. Bearden wasn’t talking about revenue, though he didn’t say so at the time. The Santa Clara, Calif., company now says the $100 million target was for “billings,” a gauge of future business that isn’t part of generally accepted accounting principles. Mr. Bearden declines to comment.
As young technology companies jostle for investors who will pour money into the firms as they try to make it big and strike it rich, some companies are using unconventional financial terms.
Instead of revenue, these privately held firms tout “bookings,” “annual recurring revenue” or other numbers that often far exceed actual revenue.
The practice is perfectly legal and doesn’t violate securities rules because the companies haven’t sold shares in an initial public offering. Public companies can use “non-GAAP” financial terms but must explain them and disclose how they differ from measurements that follow strict accounting rules.
When Mr. Bearden made his forecast last year, Hortonworks had just raised $100 million that valued the company at more than $1 billion. It went public in December, now has a stock-market value of about $1.1 billion and is required to abide by accounting rules that include disclosing the company’s actual revenue.
Up-and-coming companies that see themselves through rose-colored glasses are of little concern to many venture capitalists and other investors as long as growth remains strong. Many tech-company executives say nontraditional numbers often are a better barometer of a firm’s progress at luring customers, outrunning competitors and pushing the company’s value higher.
In other words, find a metric that makes your startup look good when you're trying to close a funding round and if you can't find such a metric, make one up, but whatever you do, don't even think about using net income because i) you're probably nowhere close to profitable, and ii) no one cares about profitability anyway:
Investors keep lining up even though just two of the 13 tech companies that went public so far this year through June 4 made a profit in the 12 months before their IPO, according to Jay Ritter, a finance professor at the University of Florida.
Last year’s rate of 17% was the lowest for a full year since 2000. In 2010, about two-thirds of tech companies were profitable before going public.
Executives at young companies have lots of opportunities to do “whatever they need to do to generate magic metrics, whether they are relevant in the long run or not” says Lise Buyer, an adviser to Silicon Valley companies and former technology investment banker who worked at Google Inc. when it went public in 2004.
Of course, as Prem Watsa recently noted, all of this will end badly for someone, if not for the founders and VCs who will have long since cashed out with their fortunes in tow by the time reality comes calling and everyone suddenly realizes that valuing companies that have no hope of monetizing their product at infinty-times-daily-direct-eyeballs was probably not a great idea.
In the mean time, Andreessen Horowitz has the following words of wisdom for anyone who thinks bland, old school metrics like revenue and net income still matter:
"We have trained the world to judge company performance based on revenue and earnings per share... Such simplicity can lead to bad investment decisions."
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always chasing that 1000% ROI? greedy losers
KRAP! You are beat Boris to first post! Now Boris is must commandeer you thread, is feel bad like forum troll!
When is considering of crazy-eye startup of Internet 2.0, Boris' high grade copper ore urban extraction venture is much more to sure thing. You are come work for Boris!
(* Please you are to bring thick leather glove and rubber boot.)
What fuck happen to Boris? No many posts this year. Glad Boris back.
Boris back is now covering of hair, is save for Russia Wax (not is so different as Brazil Wax). You are check out Boris web cam at www.nudeapartment.ru
Mark To Unicorn accounting is the new GAAP.
Not just is unicorn, but is rainbow color skittle unicorn!
Fvck these web 'startups'... fake ass mvthrfvkrs. Worship that money, you fools, and sell your soul to the highest bidder for catered lunches and 'free perks'. It will come back to bit you in the ass eventually.
Free money does strange things to any market, even the morning dew may be priced.
It sure didn't take long for the magic metrics of the NASDAQ era to fade from memory. Humans must love to be re-conned...!
Snatchclap.com
Take my idea and become rich.
It should be an online dating site for people that have STDs or just like rubber.
Is $100 million enough to get the ball rolling? If not I can make a few calls and triple that at a minimum.
One onion article a day, please.
wait, what?
These are the same fuckers, that after an EMP event, will be riding around in their covered wagons selling "snake oil" 19th century style.
Used Iwatches.
I spend a lot time in this space, dealing with business valuations on almost a daily basis (but generally with smaller companies and not the next lotto tech superstar company) and I can tell you that it is completely and totally out of control right now. Not only are valuations unsupportable and based on nothing more than BOTE information (i.e., back of the envelope) or maybe some "Sizzle" PPT Deck that presents another too the moon, disruptive, and innovative idea, but what is absolutely mind blowing is the lack of due diligence being completed or in some cases, none at all.
I had dinner with my sister last night and we discussed a deal the company she works for (large public healthcare company) was pursuing. The entire assessment and initial evaluation of the opportunity was based on nothing more than a PPT deck produced by a bunch of SFBs at D&T or E&Y (can't recall which consulting firm it was) that valued a small medical professional group at $30 million. They were moving right to an LOI/TS without even looking at any business operating information. No financial statements, no business plan, no forecasts, to KPIs, no critical operating data, what management team?, no nothing. Here's a so-called prudent business comitting valuable corporate resources on an opportunity that wasn't even worth $5 million (if that) with no strategic value present. I then shared with her a deal I helped close with 3D Systems that basically went down the same path (and you wonder why DDD's shares have decreased from roughly $100 to now trading just a little above $21).
I could go on and on about what I'm seeing in today's economy ranging from the worst accounting and financial inforamtion I've ever come across (in 30 years of experience) to business plans that don't have a chance in hell of ever succeeding to completely incompetent management teams but my main point I would like to emphasize is this as it relates to valuing businesses (and the utterly insane quote from AH). The blame for this mess squarelly falls on the world's CBs and primarily the Fed.
When money is as easy, cheap, and undiciplined as it is today and the spigot is fully opened, then nobody gives a shit about real revenue, gross margins, operating expenses, net income and most importantly "CASH FLOW". Why, well that's simple as there's always one more source of funding to take out the prior funding source whether it be an exit to PE that has raised junk debt, an IPO to a bunch of fucktards that have never had to manage capital in a bear market, to the FED itself (think MBSs and very soon corporate junk debt as when this market goes, the only party capable of handling the exit flow will be the FED), or even to Governments that buy up worthless assets or invest in dead companies (think GM).
Undiciplined money and capital markets lead to direct statements like the one made by AH as why worry about these small inconviences (who needs cash flow) when there's always another sucker inline to cash you out. Nothing else matters but the story, the sizzle, and the spin. Period! End of Story!
So we're coming to the great infliction point which I suspect will be this fall. That point in time when either the FED sticks to its words, raises rates, begins to exit and actually instill some level of diciplin back into the market and require valuations to be based on real economics and actual financial results (as liquidity continues to be drained and the greater fool theory evaporates like a fart in the wind). Or will the FED fold again, find another excuse to provide liquidity, defer raising rates, and turn a deaf ear on the travisty of modern day VDA&F (i.e., VooDoo Accounting & Finance) and allow this farce to continue and kill off any assemblence of real economic value creation.
My hope is that the FED will act in a prudent manner much like the House did today with the TPP and if so, companies are going to get a very quick and painful less in understanding cash flow and capital management. But my experience paints a different picture, one based in pretend and extend and deny and lie. I'm hopeful but not naive as I suspect the FED will fold like a cheap coat again and in the spirit of Starwars "Let the Farce Be With You"!
Flawless post. Thank you! The reason I read the comment section of ZH.
me too .
Appreciate the feedback and I apologize for the length in the comment but what generally happens is that I start with the best intention of keeping the post short but then all of my thoughts and ideas start to flow and just like that, my post turns into a chapter or novel. Oh well, when I get fired up and identify a subject that really boils my skin, this is often the result, a combination of a rant and providing an opinion/information which I hope others will find of value.
BTW, my 30 plus years of direct experience has not only enabled me to experience just about every business condition possible (from seeing brilliant fraud first hand and painfully to working with some of the most well-intended, hard working, smart, and resliant business owners) but also has provided endless material and a window to co-authoring a number of books with my father on the subject of finance, accounting, cash flow, reading & evaluating financial reports, etc. My intent is not to self promote but rather to spread the word and help keep the faith on just how important it is to stay focused on proper business fundamentals and how real economic value is created (not paper wealth). God knows we've been force fed and crammed down a thousand lifetime's full of paper promise bullshit that has engulfed the world with the worst promises being made from some of the most immoral, corrupt, and unethical individuals that have ever walke the face of the earth.