Simon Bartmann

"I heard stories that last year, end of 2022, when the auditors were getting involved, they were telling GPs to talk to each other to try to figure out how to value things." (source: Beezer Clarkson of Sapphire Partners) 2022 was the year that pissed-off LPs put a spotlight on poor valuation practices, with different VCs holding the same company at radically different marks. This is not a simple issue, and nor is it just a question of correctly setting marks or entry price. The failure of venture capital to properly address valuation has cascaded into a number of other problems. The majority of "venture capital wisdom" today was hastily assembled during the SaaS bull run from 2011 to 2021 and is designed to cram money into high growth companies. In this transition, the concept of "valuation" was slowly squeezed out by "pricing". Few managers can now really claim to understand the former. Instead of looking to understand the intrinsic value of an idea, investors began to simply follow the market. Were others investing in similar companies? How were they priced? In this environment, multiples (mostly multiples on ARR) seemed like a practical tool. Historically, multiples were a tool for price comparison after a valuation had been completed: "We often pursue this kind of rationalization as a spot check, generally after going through the valuation process. When the multiple is implied, investors will then compare it to others seen in the public and private markets to get more comfortable. Think of it like a gut check, a way to determine if the valuation feels 'reasonable'." (source: "When Entry Multiples Don’t Matter" - @a16z) In the rush to accelerate capital velocity in the low interest rate environment, multiples became the defacto approach for quickly pricing rounds. Four major problems stem from this: 1. The fundamentally procyclical nature of comparative pricing has weakened returns and concentrated risk for venture capital. 2. The herding of capital into SaaS means it is now far less likely that exits will appear on a scale to produce the required returns in this sector. 3. Founders build in sectors where VCs more easily understand value. The habitual use of multiples has shifted activity to SaaS, away from (e.g.) deep tech. 4. Focusing solely on revenue has incentivised founders to sacrifice financial health, often resorting to cheap accounting tricks or fraud in some cases. The focus on revenue multiples has incentivised capital intensive business models that spend every dollar on creating more revenue growth, to drive up value and raise more capital to fuel more growth. The outcome is companies that have poor unit economics, little in the way of a competitive moat, and weak financial health. These are not attractive targets for IPO or acquisition, which is why venture capital has a huge liquidity problem today. It has turned venture capital into an engine that burns a lot of cash to produce huge excess heat and relatively little kinetic energy. "There are two ways to come up with a value for a financial asset. The first is to calculate an intrinsic value by discounting future cash flows. If the stock market is efficient, price and value will be the same. The second is to compare investments that are similar and buy the relatively undervalued one and sell the overvalued one. If a sufficient number of investors are doing this, few will outperform the market" (source: "Everything Is a DCF Model" - @MorganStanley) Fundamentally, using multiples to price a company is a delegation of responsibility to the market. In public markets, where there is more price tension and shares are more liquid, this can make sense. This is why it's so difficult to outperform index funds. In private markets, this is very different. The whole ballgame for venture capital firms is finding outlier companies and novel concepts. The idea that they could be appropriately priced by the market is obviously silly, although it probably explains recent underperformance. In conclusion, after a decade of sneering at "excel jockeys" and financial engineering, venture capital needs a rennaisance of financial literacy. Investors don't need to start building detailed DCFs for each investment they make, but they should at least understand the main drivers of value and how to measure them in the context of a unique scenario. It means learning how to read and understand financial forecasts, and build logical connections with business models, strategies and markets. It means looking for sustainable competitive advantage, not just rapid scalability. Mostly, it means questioning all of the dogma that has appeared in venture since 2011.