Venture Capital: It Is A Pricing, Non A Value, Game!

Venture capitalists (VCs) don’t value companies, they cost them! Before y'all explode, implode or response with righteous indignation, this is non a critique of what venture capitalists do, but a recognition of reality. In fact, non exclusively is pricing just what y'all should human face from VCs but it lies at the pump of what separates the elite from the average venture capitalist. I was reminded of this when I read a response from Scott Kupor of Andreessen Horowitz, to a Wall Street Journal article about Andreessen, that suggested that the returns earned past times the theatre on its funds were non equally skilful equally those earned at other elite funds. While Scott’s intent was to demo that the Wall Street Journal reporter erred inwards trusting total returns equally a mensurate of VC performance, I holler upwards that he, mayhap unintentionally, opened a Pandora’s box when he talked almost how VCs attach numbers to companies in addition to how these numbers acquire updated, in addition to how nosotros (investors, founders in addition to VCs) should read them, equally a consequence.

The WSJ versus the VC: Influenza A virus subtype H5N1 Recap

Let’s start with the Wall Street Journal article that triggered the Kupor response. With the provocative championship of “Andreessen Horowitz’s returns trail venture uppercase elite”, it had all the ingredients for click bait, since a large cite (Andreessen Horowitz) failing (“trail venture uppercase elite”) is ever going to attract attention. I must confess that I brutal for the bait in addition to read the article in addition to walked away unimpressed. In effect, Rolfe Winkler, the Journal reporter, took the 3 VC funds run past times Andreessen in addition to computed an IRR based upon the realized in addition to unrealized gains at these funds. I receive got reproduced his graph below:

While the championship of the storey is technically correct, I am non certain that in that location is much of a storey here. Even if y'all receive got the Journal’s estimates of returns at confront value, if I were an investor inwards whatever of the 3 Andreessen funds, I would non endure complaining almost annual returns of 25%-42%, depending on the fund that I invested in. Arguing that I could receive got done improve past times investing inwards a fund inwards the travel past times 5% of the VC universe would endure the equivalent of claiming that Kevin Durant did non having a skilful NBA flavor finally year, because Lebron James in addition to Stephen Curry had improve seasons.

In the hyper-competitive occupation organisation of venture capital, though, the article must receive got drawn blood, since it drew Scott Kupor's attending in addition to a response. Scott focused attending specifically on what he believed was the weakest link inwards the Journal article, the combining of realized in addition to unrealized gains to approximate an internal charge per unit of measurement of return. Unlike investments inwards world equities, where the unrealized returns are based upon observed marketplace prices for traded stocks in addition to tin flaming endure converted to realized returns relatively painlessly, Scott noted that unrealized returns at venture uppercase funds are based upon estimates in addition to that these estimates are themselves based upon opaque VC investments inwards other companies inwards the infinite in addition to non easily monetized. Implicitly, he seemed to endure maxim that non exclusively are unrealized returns at VC funds land of study to estimation error, but also to bias, in addition to should thus endure viewed equally softer than realized returns. I agree, though I holler upwards it is disingenuous to proceed to fighting that unrealized returns should non endure considered when evaluating venture uppercase performance, since VCs seem to receive got qualms almost using them inwards sales pitches when they serve their purpose.

The VC Game

The Kupor response has been picked inwards the VC space, with some commenters augmenting legitimate points almost supply standard but many to a greater extent than using the WSJ article to restate their sentiment that non-VC people should halt opining almost the VC business, because they don’t sympathise how it works. Having been on the receiving halt of this critique at times inwards the past, y'all would holler upwards I would know improve than to butt in, but I simply can’t aid myself. I may non endure qualified to beak almost the inner workings of the venture uppercase business, but I do believe that I am on firmer dry ground on the specific topic of how VCs attach numbers to the companies that they invest in.

VCs cost businesses, non value them!

I receive got made the distinction betwixt value in addition to price so many times before that I audio similar a broken record, but I volition travel far again. You tin flaming value an asset, based upon its fundamentals (cash flows, increment in addition to risk) or cost it, based upon what others are paying for similar assets, in addition to the 2 tin flaming yield different numbers.

In world investing, I receive got argued that this plays out inwards whether y'all pick out to play the value game (invest inwards assets where the cost < value in addition to promise that the marketplace corrects) or the pricing game (where y'all merchandise assets, buying at a lower cost in addition to hoping to sell at a higher).  I would endure glad to endure offered evidence to the opposite but based upon the many VC "valuations" that I receive got seen, VCs almost ever play the pricing game, when attaching numbers to companies, in addition to in that location are 4 ways inwards which they seem to do it:

1. Recent pricing of the same company: In the most express version of this game, a prospective or existing investor inwards a mortal occupation organisation looks at what investors inwards the most recent prior circular receive got priced the society to gauge whether they are getting a reasonable price. Thus, for an Uber, this would imply that a pricing unopen to the $62.5 billion that the Saudi Sovereign fund priced the society at, when it invested 16z.com.5 billion inwards June 2016, volition travel your benchmark for a reasonable price, if y'all are investing unopen to that date. The dangers inwards doing this are numerous in addition to include non exclusively the possibility of a pricing fault (a novel investor who over or nether prices the company) spiraling upwards in addition to downward the chain, but also the problems with extrapolating to the value of a society from a VC investment inwards it.
2. Pricing of “similar” mortal companies: In a slightly to a greater extent than expanded version of this process, y'all would human face at what investors are paying for similar companies inwards the “same space” (with all of the subjective judgments of what comprises “similar” in addition to “same space”), scale this cost to revenues, or lacking that, a mutual metric for that space, in addition to cost your company. Staying inwards the ride sharing space, y'all could cost Lyft, based upon the most recent Uber transaction, past times scaling the pricing of the society to its revenues (relative to Uber) or to rides or number of cities served.
3. Pricing of world companies, with post-value adjustments: In the rare cases where a mortal occupation organisation has plenty operating essence today, inwards the shape of revenues or fifty-fifty earnings, inwards a infinite where in that location are world companies, y'all could utilization the pricing of world companies equally your footing for pricing mortal businesses. Thus, if your mortal occupation organisation is inwards the gaming occupation organisation in addition to has $100 i one m thousand inwards revenues in addition to publicly traded companies inwards that occupation organisation merchandise at 2.5 times revenues, your estimated value would endure $250 million. That value, though, assumes that y'all are liquid (as publicly companies tend to be) in addition to held past times investors who tin flaming spread their risks (across portfolios). Consequently, a discount for lack of liquidity in addition to mayhap diversification is applied, though the magnitude (20%, 30% or more) is i of the tougher numbers to approximate in addition to justify inwards practice.
4. Forward pricing: The occupation with immature start-ups is that operating metrics (even raw ones similar riders, users or downloads) are often either non-existent or besides small-scale to endure base of operations a pricing. To acquire numbers of whatever substance, y'all often receive got to forecast out the metrics two, 3 or v years out in addition to so apply a pricing multiple to these numbers. The forecasted metric tin flaming endure earnings, or if that even so is ephermal, it tin flaming endure revenues, in addition to the pricing multiple tin flaming endure obtained non simply from mortal transactions but from Earth marketplace (by looking at companies that receive got gone public). That forwards value has to endure brought dorsum to today in addition to to do so, venture capitalists utilization a target charge per unit of measurement of return. While this target charge per unit of measurement of supply plays the same mechanical role that a discount charge per unit of measurement inwards a DCF does, that is where the resemblance ends. Unlike a discount rate, a number designed to contain the jeopardy inwards the expected cash flows for a going concern, a target charge per unit of measurement of supply incorporates non simply conventional going-concern jeopardy but also survival jeopardy (since many immature companies don’t brand it) in addition to the fearfulness of dilution (a logical outcome of the cash burn downward at immature companies), patch also playing role equally a negotiating tool. Even the occasional VC intrinsic value (taking the shape of a DCF) is a forwards pricing inwards disguise, with the terminal value beingness estimated using a multiple on that year's earnings or revenues.
   
   
   

At the fourth dimension of a VC investment, the VC wants to force today’s pricing for the society lower, so that he or she tin flaming acquire a greater portion of the equity for a given investment inwards the company. Subsequent to the investment, the VC volition desire the pricing to travel higher for 2 reasons. First, it makes the unrealized returns on the VC portfolio a much to a greater extent than attractive number. Second, it also agency that whatever subsequent equity uppercase raised volition dilute the VC’s ownership stake less. If y'all reading this equally a criticism of how venture capitalists attach numbers to companies, y'all are misreading it because I holler upwards that this is just what venture capitalists should endure doing, given how success is measured inwards the business. This is a occupation organisation where success is measured less on the character of the companies that y'all create (in terms of the cash flows in addition to profits they generate) in addition to to a greater extent than on the cost y'all paid to acquire into the occupation organisation in addition to the cost at which y'all leave of absence this business, with that leave of absence coming from either an IPO or a sale. Consequently, how much y'all are willing to pay for something becomes a procedure of judging what y'all volition acquire when y'all leave of absence in addition to working backwards.

But Venture Capitalists receive got a information problem

It is non simply venture capitalists who play the pricing game. As I receive got argued before, most investors inwards world markets (including many who telephone telephone themselves value investors) are also inwards the pricing game, though they utilization pricing metrics of longer standing (from PE to EV/EBITDA) in addition to receive got larger samples of world traded firms equally comparable firms. The challenges with adapting this pricing game to venture uppercase investments are primarily statistical:

1. Small Samples: If your pricing is based upon other mortal society investments, your sample sizes volition tend to endure much smaller, if y'all are a VC than if y'all a world society investor. Thus, equally an investor inwards a publicly traded petroleum company, I tin flaming depict on 351 publicly traded firms inwards the U.S. of A. or fifty-fifty the 1029 publicly traded companies globally, when making relative value or pricing judgments. Influenza A virus subtype H5N1 VC investor pricing a ride sharing society is drawing on a sample of less than 10 ride sharing firms globally.
2. With Infrequent Updating: The small-scale sample occupation is exacerbated past times the fact that dissimilar world companies, where trading is frequent in addition to prices acquire updated for most of the companies inwards my sample almost continuously, mortal society transactions are few in addition to far between. In many ways, the VC pricing occupation is closer to the existent estate pricing than conventional stock pricing, where y'all receive got to cost a belongings based upon similar properties that receive got sold inwards the recent past.
3. And Opaque transactions: There is a 3rd occupation that makes VC pricing complicated. Unlike world equities, where a portion of stock is (for the most part) similar whatever other portion of stock in addition to the total marketplace value is the portion cost times number of shares outstanding, extrapolating from a VC investment for a portion inwards a society to the overall value of equity tin flaming endure in addition to often is complicated. Why? As I noted inwards an earlier shipping service on unicorn valuations, the VC investment at each phase of capital-raising is structured differently, with a myriad of options embedded inwards it, some designed for protection (against dilution in addition to futurity equity rounds) in addition to some for chance (allowing futurity investments at favorable prices). As I noted inwards that post, a start-up with a "true" value of $750 i one m thousand tin flaming construction an investment, where the VC pays $50 i one m thousand (instead of $37.5 million) for 5% of the company, past times adding plenty optionality to the investment. I may endure misreading Scott's department on using choice pricing to cost VC investments, but if I am reading it right, I holler upwards Scott is maxim that Andreessen uses choice pricing models to create clean upwards for the improver options inwards VC investments to acquire to the fair value. Put differently, Andreessen would position a value of $750 i one m thousand on this society rather than the $1 billion that y'all would acquire from extrapolating from the $50 i one m thousand for 5%.

I am certain that nix that I receive got said hither is novel to venture capitalists, founders in addition to those unopen to the VC process, but it is the subtle differences that throw off those whose master copy sense is inwards Earth markets. That is i ground that world investors should receive got the numbers that are often bandied almost equally valuations of mortal companies (like Palantir, Uber in addition to Airbnb) with a grain of salt.  It is also why I holler upwards that world investors similar mutual funds in addition to academy endowment funds should either tread lightly or non all inwards the space. Even inside the VC business, it is sometimes easy, specially inwards buoyant times to forget how much the entire pricing building rests equally much on momentum in addition to mood, equally it does on the underlying fundamentals.

With Predictable Consequences

So, let’s see. VCs cost companies in addition to that pricing is often based upon actually small-scale samples with infrequently updated in addition to tough-to-read data. The consequences are predictable.

1. The pricing estimates volition receive got to a greater extent than dissonance (error) attached to them. The pricing that I obtain for Lyft, based upon the pricing of Uber, Didi Chuxing in addition to GrabTaxi, volition receive got a larger band around the approximate in addition to in that location is a greater jeopardy that I volition endure wrong. 
2. The pricing volition endure to a greater extent than subjective, since y'all receive got the liberty to pick out your comparable firms in addition to often tin flaming utilization discretion to adjust for the infrequent information updating in addition to the complexity of equity investments. While that may seem to simply endure a restatement of the kickoff critique, in that location is also a much greater potential for bias to travel into into the process. Not surprisingly, therefore, non all VC returns are created equal, specially when it comes to the unrealized portion, with to a greater extent than aggressive VCs reporting “higher” returns than less aggressive VCs. That is mayhap the indicate beingness made past times Scott almost realized versus unrealized returns.
3. The pricing volition lag the market: It is a well-established fact that the uppercase coming into the VC occupation organisation ebbs in addition to flows across time, with the number of transactions increasing inwards upwards markets in addition to dropping inwards downward markets. When in that location is a severe correction (say, simply after the dot-com bust), transactions tin flaming come upwards to a standstill, making repricing difficult, if non impossible. If VCs handgrip off on total repricing until transactions pick upwards again, in that location tin flaming endure a pregnant lag betwixt when prices driblet at immature companies in addition to those cost drops getting reflected inwards returns at VC firms.
4. There is a cost feedback loop: Since VC pricing is based upon small-scale samples with infrequent transactions, it is susceptible to feedback loops, where i badly priced transaction (in either direction) tin flaming trigger many to a greater extent than badly priced transactions. 
5. And a fourth dimension horizon issue: The lack of liquidity in addition to small-scale samples that acquire inwards the way of pricing holdings also innovate a constraint into the pricing game. Unlike world marketplace investors, where the pricing game tin flaming endure played inwards minutes or fifty-fifty fractions of a infinitesimal on liquid stocks, mortal marketplace pricing requires patience in addition to to a greater extent than of it, the younger a society is. Put differently, winning at the VC pricing game may require that y'all receive got a seat inwards a immature start upwards in addition to bide your fourth dimension until y'all create it upwards in addition to uncovering someone who volition uncovering it attractive plenty to offering y'all a much higher cost for it. This is mayhap what Scott was talking about, inwards his response, when he talked almost this beingness VC investing beingness a "long" game.

There is i finally indicate that also needs to endure made. Much equally nosotros similar to beak almost the VC marketplace in addition to Earth marketplace equally separate, populated past times different species, they are linked at the hip. To the extent that a venture capitalist has to plot an exit, either inwards an initial world offering or past times selling to a publicity traded company, if Earth marketplace catches a cold, the venture uppercase marketplace volition acquire pneumonia, though the diagnosis may come upwards much later.

The VC Edge

If I were to summarize the entire shipping service inwards a distich of sentences, hither is what it would say. Venture capitalists cost the companies they invest in, base of operations that pricing on small-scale samples of opaque transactions in addition to the pricing is thence to a greater extent than probable to endure incorrect in addition to lag reality. That sounds pretty damning, but I holler upwards that these features operate to the wages of venture capitalists, or at to the lowest degree the real best alongside them. That may audio contradictory, but hither is my footing for making that statement.

1. The average VC does improve than the average world marketplace active investor: Both VC in addition to world marketplace investors play the pricing game, with the latter having the wages of to a greater extent than in addition to improve data, but over time, venture capitalists seem to deliver improve results than world marketplace investors, equally seen inwards the graph below. These are raw returns in addition to I do realize that y'all receive got to adjust for risk, but some of the biggest risks inwards venture uppercase (failure risk) receive got already been incorporated into long term returns. 

   

   Source: Cambridge Associates

2. The Elite: The most successful VCs non exclusively earn higher returns than the travel past times world marketplace investors but that in that location seems to endure to a greater extent than consistency inwards the VC business, insofar equally the best of the VCs are able to generate higher returns across longer fourth dimension periods. That would advise that venture capitalists convey to a greater extent than durable competitive advantages to the investing game than world marketplace investors.

How do I reconcile my declaration that the VC pricing game is inherently to a greater extent than error-prone in addition to noisy with the fact that VCs seem to brand coin at it? I holler upwards that the real factors that travel far so hard to cost in addition to turn a profit of a VC investment are what allow VCs collectively to earn excess returns in addition to the real best VCs to laid themselves apart from the rest. In particular, the best inwards the occupation organisation laid themselves apart from the balance on three dimensions:

1. They are improve pricers (relatively): As Scott notes inwards his piece, the cost that y'all tin flaming attach to a VC investment tin flaming vary widely across investors in addition to he uses the instance of how Andreessen's choice pricing approach tin flaming yield a lower pricing for the same society than an alternative approach. While all of these prices are undoubtedly incorrect (because they are estimates), some of them are less incorrect than others. Repeating a declaration that I receive got made before, y'all don't receive got to endure right to brand money, y'all simply receive got to endure less incorrect than everyone else in addition to the chances of y'all doing that are greater inwards the VC pricing game.  
2. They tin flaming influence the pricing game: Unlike world marketplace investors, who for the most business office tin flaming uncovering society metrics but non alter them, venture capitalists tin flaming receive got a to a greater extent than active role inwards the companies that they invest in, from informally advising managers to to a greater extent than formal roles equally board members, helping these companies create upwards one's hear what metrics to focus on, how to improve these metrics in addition to how (and when) to cash inwards on them (from an IPO or a sale).
3. They receive got improve timing: The pricing game is all almost timing, in addition to the VC pricing game is to a greater extent than emphatically so. To endure successful, y'all non exclusively receive got to fourth dimension your entry into a occupation organisation right but fifty-fifty to a greater extent than critically, fourth dimension your leave of absence from it. 

If y'all are an investor inwards a VC fund, therefore, y'all should of course of teaching human face at both realized returns in addition to unrealized returns, but y'all should also human face at how the fund measures its unrealized returns in addition to how it has generated its returns. Influenza A virus subtype H5N1 realized supply that comes primarily from i large striking is clearly less indicative of science than a supply that reflects multiple hits over longer fourth dimension periods. After all, if separating luck from science is hard inwards Earth marketplace, it tin flaming travel fifty-fifty to a greater extent than so inwards the venture uppercase business.

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