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."