art or sorcery?
clues to .com valuations
page three of four |
the audience: q&a
We'll start with an email question. What is a down round?
Mr. Frederick: A
down round is any round of financing that you have to raise at a lower
price per share than the round before. Watch out for these because
there is an odd disconnect between the private and public markets in
this regard. In the public market, stocks go up and down all the time.
Cisco was down yesterday. You don't feel that it's a weaker company
because of that, but, in the private market, people expect the
exponential growth curve to go in only one direction. It can taint
your company if you are pushed into a down round scenario, so I urge
you to think about that when you establish your valuation
Please give your advice on the following scenario: an Internet
startup with no capital and no experience would like to bring in
five experts. Contribution and dollars invested in time is valued
at $10,000 each. Since the company's growth is a complete unknown,
how can a percentage of future profits or a vested ownership be
looked at fairly, and what are some scenarios?
Ms. Kim: Early on,
especially when we were trying to preserve cash, we thought of some of
these issues, whether it was with strategic advisors, outside
agencies, development firms or others. We gave some of them
convertible notes and said, "You are giving us $10,000 worth of
services. Here is a note that converts at the first VC round,"ómaybe
with some slight discount to itó"Thanks for letting us use your
money. You get to invest along with some pretty smart VCs who have
done pretty well, so you should do very well." Those are the
arguments we used and it seemed to work out.
That's the best way to do it. Unfortunately, we see people with broken
capitalization tables because they gave too much of their company away
too early, or they tried to get fancy and ended up with things like
revenue overhangs. I can't think of any subject matter expert who is
worth some sort of revenue share going forward. The best way by far is
these convertible deals where it converts as the same price at the
next round of financing. If the subject matter experts are going to
play an important role in securing that financing or creating value at
the time of that financing, give them a discount. We have absolutely
no problem with that. If it's just a little bit of value that they
created, give a 10% discount; if it's a lot, 20%.
Scott, you said that a "sure thing" with 2x return on
your money wasn't worth looking at. Would you be willing to look
at a company coming to you with less risk but much less return and
help them develop a more exponential growth model and a larger
Mr. Frederick: By
all means. If the seed of the idea is compelling enough, and it sounds
as though there is the opportunity for much greater than the 2x
return, then I'm not worried about that limited return opportunity.
That's what we do. We view ourselves as roll-up-our-sleeves types of
investors and are certainly willing to help a company develop a
strategic model that can give us the returns we are looking for.
The question I often get from people when I travel around the
country is, "How much longer is the Internet valuation craze
going to last? How much longer are you going see these huge
multiples of sales?" Jeff, does your firm have any standard
response to this question?
I don't think I can predict how long it's going to last, but one
interesting way of looking at it, perhaps, is that a lot of times we
get the question, "Is the market overvalued?" The market is
what it is. It's twice as big for these companies driven by the
capital markets at this time, and the values are tremendously high. As
I mentioned before, it's very difficult to justify these markets using
an income approach, but you still have to try to do it. One way of
using the income approach to determine whether the values are
reasonable or not is to back into it. For example, I was looking at TheStreet.com
recently. Earlier this week, they had an enterprise value of $275-$300
million. I wanted to see what kind of assumptions it would take to
justify that market value in today's dollars; what kind of targets
they would have to hit. Using a simple DCF model over a 10-year period
with a discount rate of 18%, the company would have to grow annual
revenues in excess of 150% for 10 years, achieve an operating profit
margin in year three and grow to 50% in year six. I assumed an exit
multiple of about 20x. This is not TheStreet.com's business plan. It
gives you a sense of the magnitude, the hyper rate at which these
companies have to grow in order to justify current values.
My name is Michael Finn with Powersim.
Our revenues are skewed more towards services than products, but
we want our investors to view us as a product company. What kind
of things do you look for in a business plan that help you
categorize a company as a product versus services firm?
The distinction is important because service companies are often
viewed as difficult to scale. A lot of entrepreneurs we talk to don't
quite realize that just because we make that distinction, it doesn't
mean that service businesses are not good businesses. We did very well
on our investment in Proxicom,
but the danger of a service company is that all your assets go home
and sleep in their own beds every night, which is a pretty scary
position as an investor. The reason why the product company gets a
higher multiple and tends to get higher valuations is that it's
eminently scalable. Once you make the product, you can enjoy repeat
sales. With services, in order to grow you need to get your body count
up, and that's going to be a function of the rate at which you hire
and retain people.
We see a lot of companies trying to
make that transition from being a services company to becoming a
product company. One of my biggest fears is that a services company
that wants to "productize" will never be able to firmly
delineate what the product is. It sounds simple, but it's tough
because you are going to be tempted in a lot of situations to do
anything to close a deal. Big customers will say, "I really like
the product. If you could just do this to it, then I'd buy it."
You are going to want that customer as a reference, but you have to be
careful not to become a one-off consulting shop that has to layer on
tons of services every time you sell a product. We wrestled with that
and they were very successful. They said, "Hey, this is our
product." After a while, you need a "take it or leave
it" aspect to hope that it sells.
I'm Edwin Grosvenor, CEO of KnowledgeMax.
Scott, I assume that most of the deals you are doing are $5-$15
million. Most of the New York investment banks won't act as
placement agents for raises that are much under $20 million. How
often do you work with placement agents for the size rounds that
you do? On the whole, do you find them to be helpful in the
process or would you rather see that percentage of your money
going into the operations?
Great question. We have very rarely invested in deals that were
brought to us by placement agents. This is going to be a huge
generalization, but deals that come through placement agents tend to
be higher priced because a lot of the places they are going to are not
"smart money." I don't mean that in a detrimental sense, but
they are going to high net worth individuals who are going to be a
little bit less valuation-sensitive. That being said, private
placement agents can be very, very valuable, and we have used them in
some of our portfolio companies for follow-on financing. At that
point, we are already in the company and we are trying to get as high
a valuation as possible. There is a second reason as well. We want the
management team building a business, not on the street raising money.
Agents can be very, very valuable, and there are some people locally
who will do smaller rounds. Just make sure you ask for a list of
companies they successfully raised capital for.
Mr. Hooke: I would
add that a placement agent can be helpful in drafting a story for you
that is appealing to institutions, and they can give investors a
reality check that they are in the market zone.
Sometimes they can oversell. They will want to get your business and
they will say, "We can raise money for you at such-and-such a
valuation." They will go out on the street, then come back and
say, "Well, the market is actually telling us it's lower."
Mr. Hooke: The
common problem is that they try to bid as high as they can to get the
business. Six months later they say, "The market changed. Sorry,
I can't give you that valuation."
That's incredibly frustrating. In a deal we are trying to close now,
there was a private placement agent who was offering to raise money at
two to three times the valuation we gave, and we had to explain to the
entrepreneur that the placement agent's money wasn't guaranteed. I
would wire by Christmas.
Audience Member: Regarding
B2B transition, we are moving into industries that are not
commonly known to those who invest in Internet startups. What is
your best advice for trying to convey to the VC both the
opportunity on the Internet and in the industry itself without
losing them or putting them to sleep? In other words, how can we
best explain a complex business model in a short time?
Ms. Kim: We have
seen great receptivity to B2B. It's so hot right now. We got started
in May, when it was still not sexy, which was one of the reasons why
we entered the space. Now, it is so red hot that when we were doing
the fundraising, all it seemed we had to say was, "We are focused
on B2B in a really boring industry," and people would be all over
us. Getting the suppliers in the market to listen to you is something
of a different story, however, and we have used some public relations
things to say to people, "This is real. It is going to happen to
your market. Don't let what happened to some of the old consumer
companies happen to you."
Boring is good. I'd rather be rich and boring than famous and poor.
Especially in the B2B space, boring is hot.
Ms. Kim: Right
now, because it's so hot, you can be famous and rich. Maybe.
I'm John Shin with Web-On-Site.
We are involved in a second round of financing and getting a lot
of interest from individual and institutional investors. How much
money should you take at various stages, especially as you start
thinking about public offerings later? Additionally, at what point
do you want to introduce strategic investors, and how important is
that to you?
Mr. Hooke: Are you
giving the same valuation numbers to the individuals and institutions?
Mr. Simon: We were
trying to get some money in to shore up things. We are going to true
up the individuals if it winds up that the institutional money comes
in at different valuations.
Scott recommended, at least in earlier rounds, not to worry too much
about dilution, but, instead, to obtain a large amount of money up
front in order to get to a certain level. An alternative strategy is
to take a look at the minimum amount of money that you need to
get to a certain level, then revalue the company at that time once you
have a better track record for financial revenues, customers and so
forth. It might give you a little bit more flexibility and higher
valuation and dilution at that time if you are in a different stage.
Mr. Hooke: Individual
investors are nice because they are less sophisticated than VC firms
and you can get more dilution out of them. You can get more hand
holding as the company grows.
I have been told by a lot of VCs that the window of opportunity
for these valuations is closing to a certain extent, even to where
some securities lawyers have suggested that we have six months
left to get out. That just seems ridiculous to me, and I wondered
about your thoughts.
Mr. Hooke: Well,
if everybody promises to keep their answers to under 20 seconds, I
think we should all answer that. I thought it was going to end 20
months ago. I think this thing could keep going for a year, two years
easily until there is some severe downturn in the general market as a
whole. Jeffrey, what do you think, particularly about the non-earning
Mr. Anderson: I
personally think this may last a couple of years. It's really going to
be dependent upon how the funding continues for these companies to be
able to market and develop their enterprises before they start
generating revenues. As we mentioned before, these measures such as
subscribers and site visitors are just potential value. You have to
convert those measures into revenues, and, hopefully, one day,
operating profits. There is so much money going into these companies
now, and a lot is being spent on marketing promotion, so I think that
in a couple of years, if you are not turning things around pretty
quickly, that funding could dry up and you'll face real problems.
First of all, I want to say I'm a raging bull; otherwise I wouldn't be
in my profession, but I do think that in the end all markets have to
return to some sort of fundamental analysis. What you are speaking of
are proxies, and you use proxies such as eyeball counts when you don't
have earnings. My fear is that the Internet success will, to some
extent, actually take its own air out of the balloon. I don't think
it's a bubble that will burst; I think it will deflate a little bit,
but not burst. Let me give you some examples. People say these extreme
valuation multiples have never happened before, but that isn't the
case. I'll tell you a funny story about biotechs. There literally were
biotech companies whose stocks fell when the FDA announced approval of
their products. A Wall Street analyst explained that it was because
the companies could no longer garner biotech multiples because they
were now real drug companies.
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