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:
Stormtrooper: Let me see your identification.
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.