A VC friend emailed me the following question(s) a few weeks ago:
The rumor this week regarding Yahoo acquiring Digg for $30M sparked a discussion here around company valuation. The discussions revolved around the key factors in valuing an early stage web technology business and how these factors are being evaluated by investors today. For example, would Yahoo or other companies be buying the technology? Are they buying subscribers? Are they buying a brand or is it a weighting of a number of these factors? Based on what you are hearing, how would Digg, Technorati, livemarks or another consumer internet business be both evaluated and valued today?
Remember the Jedi Mind Trick that goes as follows:
: Let me see your identification.Stormtrooper
Obi-Wan: [influencing the stormtrooper's mind] You don't need to see his identification.
Stormtrooper: We don't need to see his identification.
Obi-Wan: These aren't the droids you're looking for.
Stormtrooper: These aren't the droids we're looking for.
Obi-Wan: He can go about his business.
Stormtrooper: You can go about your business.
Obi-Wan: Move along.
Stormtrooper: Move along... move along.
I recommend my VC friend meditate on it. There’s been plenty said in the blogosphere about Web 2.0 companies, the notion of “build-to-flip”, the AGILEAMY gang looking to buy early stage technologies / features to plug into their platforms, and the need to transform / reform / change venture capital to accommodate these companies. I won’t retread those discussions here. However, I will add two things.
This is not the real VC game: While there is a category of VC firms that is deliberately looking for companies that are planning on raising a small amount of money (< $2m) and then selling quickly to AGILEAMY, this is a game best left to angel investors. The ratios are bad (1000 companies created for every one acquisition), the upside is too small (even 10x a $2m investment – which is probably the best you could imagine – is not worth the risk / reward ratio), and ultimately there becomes fundamental tension between the VC (who wants to build) and the entrepreneur (who wants to flip).
This is a dangerous long term approach for any VC investor: Repeat after me - “there is a very limited amount of easy money.” There’s some – but VC firms (and successful VC investments) are not made on easy money. It’s definitely like candy – it tastes good in the moment, but isn’t particularly filling or long lasting. Taking a great new idea with an entrepreneurial team that wants to create something significant and trying to build a real company is what is interesting. Unfortunately, VCs will habitually over invest in new, trendy areas. As a result, companies that have a clever product idea but don’t have a long term vision for a business will end up with $5m to $10m in the bank and the pressure to “grow.” However, they’ll have no where to grow to – they should be small, scrappy, underfunded companies focused on trying to beat the 1000:1 odds and end up with a flip. Once they’ve raised $5m+, they are on a different trajectory and – if in 12 months they haven’t turned their nifty product into a business - life can get really unpleasant for everyone involved.
Fundamentally, if you are a VC, these aren’t the droids you are looking for. The same is true for the entrepreneur – be wary of the droid you pick.
Posted in: Venture CapitalCOMMENTS (7)
Thanks for the rant on "build to flip". Especially fleshing out the non-economics of such deals.
I like the comment that is attributed to Larry Ellison back in the boom: "That's a *feature*, not a business."
Alas, I can just hear the response from these "flippers" now: Brad is just *jealous* that we get to have all the *fun*.
Maybe it's just a battle between the sprinters and you marathon types.
-- Jack Krupansky
Unfortunately, the VC math calculation for funding (i.e. despite the capital raised in a Series A, they own about 50% of the company) incents the entrepreneur to raise as much as possible (3 on 3, 4 on 4, 5 on 5) as this is the most reliable way to increase valuations (something entrepreneurs seem to always be focused on).
Once the money is in the bank (i.e. you've raised $3 million), you're effectively playing a different game. And, in many cases, its not the game you wanted to play nor should be playing.
I usually comment when I disagree with you :) But this time I think you are so right that I had to say so. As an entrepeneur I bristle anytime people ask "who would want to buy you"? I don't want to be bought! I want to build an awesome business. And I think that's the way most entrepeneurs feel, and the way their investors feel, too. The idea that a company would be founded just to build a feature for a bigger company is just weird.
So Digg is now on the block for around 30 Million after raising 2.8 late last year. I seriously doubt they sold 50% of the company for that much given their growth so you can say somewhere between 5-7X ROI. That's not bad for a short term investment (less than 1 year), but obviously not a game a lot of VCs want to play.
The question is why aren't these companies being more ambitious? Digg has awesome growth and some good ideas. Why didn't they raise 4-5 million and try to do something really unique? Why not try to disrupt the news industry? Maybe the entrepreneurs didn't have it in them to take it to the next level? Or maybe the consumer web VCs aren't holding up their end of the bargain and funding early companies for the long run? Digg should not sell to Yahoo now. With their growth, why not just wait another year and sell for 5X as much?
Awesome post, Brad. You hit the nail on the head for this whole Web 2.0 mania, which is that the number of exits to date is actually quite small, as is the average size of exit.
This is survivorship bias with a vengeance! There are thousands of failed ventures for every one that succeeds.
As an entrepreneur, I too don't want to be bought. I have had my business since 2002, and have had a hell of a time trying to find a VC that is interested in what we are doing. I don't want to make a quick buck. I want my company to be the standard with which independent artists distribute their music on the web.
It's an untapped market, sites like CD Baby and Garageband don't even come close to what we offer...
It is not true that you have to leave 50% of the company on the table upon the Series A, and therefore you do not need to raise a ton of money at that stage - unless you need to.
Investors will have minimum targets for their ownership in mind, but that does not mean that they will not do less.
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