The time to eat the hors d’oeuvres is when they’re being passed

The efficient market hypothesis is a widely taught financial theory that states, roughly, that under certain generally-held conditions, asset prices are an accurate reflection of the information available at the time. The arguments underlying it are mathematically elegant and have been widely popularized. Its hardcore proponents argue that financial bubbles do not (indeed cannot) exist and that government intervention in financial markets is unnecessary. While efficient market theory is dominant in academic circles, it is very hard to find active participants in financial markets who believe in it. In financial markets – like most complex human systems – the closer you get, the more nuance you discover.

Venture capital markets are perhaps the most inefficient of mainstream financial markets. Complicating factors include: heavy reliance on comparables for valuations, desire of VCs to be associated with “hot” companies, tendency to overreact to macro changes, illiquidity of startup financings, illiquidity of financings for VCs themselves, perverse financial incentives of VCs, inability to short stocks, extreme uncertainty of startup financial projections, vagaries of the M&A market, dependency on moods of downstream investors, concentration of capital among a small group of VCs, the difficulty of developing accurate financial models, rapid shifts of supply and demand across sectors and stages, and non-uniform distribution of accurate market data.

The title of this post is an old venture capital adage (via Bill Gurley) that reflects a hard-earned truth about financing and M&A markets. For social consumer startups, the hors d’oeurves were being passed in the build up to the Facebook IPO. They are being passed now for B2B and e-commerce companies. In the M&A markets, the most extreme example is probably in adtech, where there were waves of acquisitions in ad exchanges (DoubleClick, RightMedia, Avenue A), then mobile ads (AdMob, Quattro), and then social advertising (Buddy Media, Wildfire). If you didn’t sell during these M&A waves, you’re suddenly stuck with lots of powerful competitors and few potential acquirers/partners.

It is common to hear entrepreneurs say things like “I am waiting 6 months to raise money/sell the company, when we’ve hit new milestones.” Of course milestones matter, and companies are ultimately valued based on fundamentals. But along the way you’ll likely need capital and sometimes need to exit, and for that you are dependent on highly inefficient markets.

Pricing to the demand curve

Many college microeconomics courses include the following exercise. The teacher offers the students an imaginary trip to Hawaii, and asks them to write down on notecards how much they are willing to pay for the trip. The teacher takes the notecards and graphs the bids. Here’s how the graph might look:

The y-axis is the students’ “willingness-to-pay” and the x-axis is the students sorted from highest to lowest bids. The line is known as the demand curve.

Now imagine you’re the company selling these trips. For simplicity, suppose you’ve already bought the trips, so your marginal cost is zero. What’s the optimal price you should charge? If you set the price at, say, $500, then the students who are willing to pay above $500 would buy the trip, and the rest wouldn’t:

Your total revenue and (assuming zero marginal cost) profit will be the area of the green square (revenue times quantity).

Notice the sections under the curve to the right and above the green box. To the right are students who were willing to pay but were priced out. Those are missed sales opportunities. Above the green box are students who were willing to pay more than you charged. That is lost revenue. (Since the underpricing benefits customers, the area above the green box is called the consumer surplus).

After you have chosen the right price, the only way to make the area under the curve greener is to charge different customers different prices. The theoretically optimal way to do this is to look at each notecard and offer to charge each student, say, 10% less than the prices he or she bid. In real life you can’t do this (although Priceline has gotten close by asking customers to enter their willingness to pay). Some companies – most famously Amazon – have attempted outright price discrimination, but this tends to anger customers and can even run afoul of the law.

So the goal of pricing is to capture as much area under the demand curve as possible. In practice, the best way to do this is to find proxies for willingness-to-pay that are easy to observe and that customers will accept.

For example, airlines know that business customers will pay more than vacation travelers. They therefore look for acceptable proxies to segment business and vacation travelers and capture more of the area under the demand curve.

This is why flights are cheaper when you book early, stay over on weekends etc. The airline pricing models assume you are a vacation traveller.

Book publishers would like to price their books according to customer enthusiasm. Hardcore fans will pay more for books when they are first published, and casual readers will wait. If publishers offer the same book at different prices at different times, their price discrimination will be too obvious (interestingly, time windowing for movies doesn’t provoke much outrage). So book publishers offer modestly better goods – hardcovers – to early buyers.

Enterprise software companies price using proxies for the customer’s budget. Oracle databases are priced by the number of processors. Salesforce is priced by the number of end users (“seats”). Many enterprise software companies obfuscate the highest tier of pricing, telling sales prospects at that level to “call us.” What this really means is: “Call us, so our sales people can attempt to estimate your budget and price discriminate accordingly.”

Sometimes, the search for pricing proxies can lead to absurdity. I once heard someone from a prominent hardware company tell a story about how his company had offered two versions of a printer. The cheaper model was identical to the more expensive one, except the cheaper one printed fewer pages per minute. To accomplish this, the cheaper printer had the same hardware as the expensive one, except the cheaper one had an additional chip that forced it to slow down. This made the cheaper printer more expensive to produce. Situations where cost and price have zero or negative correlation are far more common than most people assume.

Equity value

Warren Buffet once said:

Buy into a business that’s doing so well an idiot could run it, because sooner or later, one will.

This is a useful way to understand the meaning of “equity value”. You learn in finance that equity value is the overall value of a the stock (i.e. equity) of a business, which in turn is the present value of all future profits. Of course with startups the future is extremely uncertain, leading to a huge variance in valuations.

In perfectly competitive markets, all profit margins tend toward zero. So equity value is a function of the degree to which you can make your market inefficient by making your business hard to copy (so called “defensibility”). If your defensibility depends solely on having superior people, you have what VCs call a “service business.” In a competitve labor market, service businesses tend to have low margins and therefore low equity value. A popular saying about service businesses is “the equity value walks out of the building every night.”

Different types of tech businesses exhibit different relationships between capital, revenue, profits, and equity value. Enterprise software companies tend to require lots of capital to get to scale but command high equity values once they do, partly because enterprises are risk averse and like to adopt the most popular technology, leading to winner-take-all dynamics. Adtech companies tend to be quick to revenue but slower to equity value, and sometimes risk becoming service businesses. The equity value of consumer internet companies vary widely, depending on their defensibility (usually networks effects and brand) and business models (e.g. transactional vs ad supported). Biotech companies require boatloads of capital for R&D and regulatory approval but then can generate lots of equity value, with the defensibility coming primarily from patents. (Patents introduce market innefficiencies, but, proponents argue, are necessary to create sufficient incentives for entrepreneurs and investors). E-commerce companies generally require a lot of capital as well, since their defensibility comes mostly through brand and economies of scale.

Some thoughts on when to raise money, and the current financing environment

A key question for founders is when they should try to raise money. More specifically, they often wonder whether to raise money now or wait, say, 6 months when their startup has made more progress. Here are some thoughts on this question generally along with some thoughts on today’s venture financing market.

– In the private markets, macro tends to dominate micro. Venture valuations have swung by roughly a factor of 4 over the last decade. In finance speak, venture tends to be high beta, moving as a multiple of the public markets, which themselves tend to move more dramatically than economic fundamentals. Hence, it is easy to imagine scenarios where the same private company will command 1/2 the valuation in 6 months due to macro events, but it’s rare for a company to increase their valuation 2x through operations alone in 6 months.

– Therefore, when it seems to be the top of a venture cycle, it’s almost always better to raise money sooner rather than later, unless you have a plausible story about how waiting will dramatically improve your company’s fundamentals.

– Prior to the Facebook IPO, the consensus seemed to be that private valuations were near the top of the cycle. Today, FB is valued at up to 50% below what private investors expected. Moreover, the financial crisis in Europe seems to have worsened, and unemployment numbers in the US suggest the possibility of a double dip recession.

– It takes many months to understand how macroeconomic and public market shifts affect private company valuations since (with the exception of secondary markets) private transactions happen slowly. So we don’t know yet what these recent events mean for private markets. According to a basic rule of finance, however, it is safe to assume that companies “comparable” to Facebook are worth up to 50% less than private investors thought they were worth a few weeks ago.

– The question then is what companies are comparable to Facebook. Clearly, other social media companies with business models that rely on display or feed based advertising are comparables. Internet companies that have other business models (freemium, marketplaces, commerce, hardware, enterprise software, direct response advertising, etc) are probably not comparables. The public markets seems to agree with this. Defensible companies with non-display-ad business models have maintained healthy public market valuations.

– One counterargument to the “all social media companies are now worth less” argument is the discrepency between how the smart Wall Street money and smart internet money views Facebook and social media companies generally. The smart Wall Street money thinks like Mary Meeker’s charts. They draw lines through dots and extrapoloate. This method would have worked very poorly in the past for trying to value tech companies at key inflection points (and tech investors know that what matters are exactly those inflection points). In Facebook’s case, Wall Street types look at revenue and margin growth and the trend toward mobile where monetization is considerably worse (for now). Smart internet investors, by contrast, look at Facebook in terms of its power and capabilities. They see a company that is rivaled only by Google and Apple in terms of their control of where users go and what they do on the internet. Smart internet investors are far more bullish than smart Wall Street investors on Facebook. Thus if you believe the internet perspective over the Wall Street perspective, you’d likely believe that Facebook and social media in general is undervalued by the public markets.

 

Is it a tech bubble?

Every week a “we are in a tech bubble” article seems to come out in a major newspaper or blog. People who argue we aren’t in a bubble are casually dismissed as promoting their own interests. I’d argue the situation is far more nuanced and that people who engage in this debate should consider the following:

1) Public tech companies: Anyone with a basic understanding of finance would have trouble arguing many large public tech companies are trading at “bubble valuations” – e.g. Apple (14 P/E), Google (18 P/E), eBay (16 P/E), Yahoo (17 P/E). You could certainly debate other public tech stock valuations (there are a number of companies that recently IPOd that many reasonable people think are overvalued), but on a market-cap weighted average the tech sector is trading at a very reasonable 17 P/E.

2) Instagram seems to be the case study du jour for people arguing we are in a bubble. Reasonable people could disagree about Instagram’s exit price but in order to argue the price was too high you need to argue that either: 1) Facebook is overvalued at its expected IPO valuation of roughly $100B, 2) it was irrational for Facebook to spend 1% of its market cap to own what many people considered one of Facebook’s biggest threats (including Mark Zuckerberg – who I tend to think knows what is good for Facebook better than pundits).

3) Certain stages of venture valuations do seem on average over-valued, in particular seed-stage valuations and (less obviously) later-stage “momentum valuations.” The high seed-stage valuations are driven by an influx of angel/seed investors (successful entrepreneurs/tech company employees, VC’s with seed funds, non-tech people who are chasing trends). The momentum-stage valuations are driven by a variety of things, including VC’s who want to be associated with marquee startup names, the desire to catch the next Facebook before it gets too big, and the desire of mega-sized VC funds to “put more money to work”.

4) Certain stages – most notably the Series A – seem under valued. Many good companies are having trouble raising Series As and the valuations I’ve seen for the ones who do have been pretty reasonable. Unfortunately, since the financials and valuations of these companies aren’t disclosed, it is very difficult to have a public debate on this topic. But many investors I know are moving from seed to Series A precisely because they agree with this claim.

5) No one can predict macro trends. The bear case includes: something bad happens to the economy (Euro collapses, US enters double dip recession). The warning sign here will be a drop in profits by marquee tech companies.  The bull case includes: economy is ok or improves, and tech continues to eat into other industries (the “software is eating the world” argument). Anyone who claims to know what will happen over the next 3 years at the macro level is blowing hot air. That’s why smart investors continue investing at a regular pace through ups and downs.

6) The argument that sometimes startups get better valuations without revenue is somewhat true. As Josh Koppelman said “There’s nothing like numbers to screw up a good story.” This is driven by the psychology of venture investors who are sometimes able to justify a higher price to “buy the dream” than the same price to “buy the numbers.” This doesn’t mean the investors think they will invest and then get some greater fool to invest in the company again. For instance, at the seed stage, intelligent investors are quite aware that they are buying the dream but will need to have numbers to raise a Series A.

7) No good venture investors invest in companies with the primary strategy being to flip them. This isn’t because they are altruistic – it is because it is a bad strategy. You are much better off investing in companies that have a good chance to build a big business. This creates many more options including the option to sell the company. Acquisitions depend heavily on the whims of acquirers and no good venture investors bet on that.