This post was motivated by a few conversations I had with public market investors in which we explored whether value investing theory could be applied to venture / growth capital markets (forgive us for nerding out and ignoring the more practical indicators of what makes a good seed/growth deal). I have hand-picked a few of the more interesting questions we discussed.
As background, the efficient market hypothesis says that the price of every security (e.g. a stock on the NYSE) represents all available information (is 'efficient') and is 'fair' since all returns are related solely to risk. There is no free lunch since the market knows everything. However, for a variety of reasons (e.g. human psychology, poor analysis, etc.) the price of a security can deviate from its intrinsic value, thus creating opportunity. A value investor believes that he/she can only generate a return in excess of what is considered ‘fair’ if he/she has a view on intrinsic value that is differentiated from consensus (price). If less than the price, the company is overvalued (according to the investor), and if greater, than the company is trading at a bargain.
Does deviation from price vs. value thinking contribute to the high price environment / possible tech bubble?
Part of our conversation focused on the sources of high valuations today. One person argued that venture investors extend valuations to companies far in excess of their value, thereby contributing to tech bubbles. Perhaps it is semantics, but, absent strategic rationale, I don't think investors are participating in deals where price > their opinion of value (e.g. it is not worth $500MM, but let's invest anyway). I suppose all investors are technically 'value investors' if they formulate some personal view of what the company is worth and act rationally when comparing it to the price. Instead, I think prices are high partly due to 1) investors underestimating risk / believing a lot more and 2) investors underwriting lower returns. On the former, price will rise when investors underestimate risk, which is bound to happen in bullish times when risky investments have panned out. It is not sufficient to look at the 'unicorn' outcome of expensive deals and conclude that the decision to invest was correct. Either those investors were exceptionally bright or luck was in their favor. Impossible to say which is which without looking at long term track records. On the latter, investors may be willing to accept lower returns for a variety of reasons:
- Interest rates are low, so LPs may be willing to accept lower returns for all other asset classes
- There is greater competition among capital sources (everyone wants to invest in startups), and not all are smart. Momentum investing is common in bullish times (the company is growing, therefore it must continue to grow); these investors probably do not have any view of value and are investing just because a deal is 'hot' with the hopes that it continues to be hot. All of this money pushes up the price, and as a founder, why not take advantage of it?
- Access to hot deals is prized as the ultimate trophy in many ways by VCs and LPs alike. Whereas many investors in other asset classes are okay missing out on the home-runs just as long as they have no losers (i.e. downside protection is a priority), venture is in many ways the opposite. The penalty for a 0 is often less severe than the penalty for not being in a hot deal. LPs like to see that their funds were in Uber and Twitter. Additionally, VCs gain a lot of street-cred based on the logos they boast are in their portfolio. Access is king, and to the extent that it puts investors in the 'we need to get in at any cost' mindset, it can add to the pricey environment. Not a problem if the company lands up being a unicorn, but not all companies will.
Taking a step back, is price even important in venture and growth investing?
In theory, all else equal (e.g. cost of capital, synergies, value-add, etc.), the prices that two VC firms set should be the same unless their views on opportunity size or riskiness of the deal diverge. With such a wide range of possible outcomes (for example, anywhere from $0 to $100BN), it seems impossible to set a precise value for a startup. With the variance in outcome so large, the implied intrinsic value is likely to be a large range as well (the inability to actually determine value is why it is hard to really describe VCs as 'value investors', though in theory they are). With that, how do we explain this recent (true) example? A VC firm was willing to value a company at $45MM, but saw the $60MM offer from another VC firm as crazy and walked away from the deal. Do they really have so much insight that they can value a startup so precisely? Assuming they are targeting a 10x, do they have so much conviction that the deal will eventually be worth $450MM but not $600MM?
From my conversations, I think the decision to walk away ‘based on price’ has less to do with price vs. value, and more to do with desired exposure and ownership targets. A VC firm wants to have $10MM of exposure to a startup, and wants to have 20% ownership, therefore implying a post-money valuation of $50MM. If another firm comes along offering $20MM for 25% (implied post-money of $80MM), the first firm might walk away. Was it really because the first firm could not imagine a scenario where the company could be worth $800MM? Unlikely. But if it wanted to invest with the same ownership/governance goals, it would now require more exposure, which may not be something the VC firm has the appetite for. My simplistic example seems odd since the valuation is not dependent on any business fundamentals, but I'm assuming that is incorporated into exposure / ownership considerations.
To the VC folk, is this consistent with your experiences? What other reasons might you walk away from a deal 'based on price'?
It is only worth doing diligence on a company if you have a differentiated viewpoint.
Public market investors typically will only spend time analyzing a company if they believe they can develop a differentiated perspective. If they rely on consensus to inform their view, there will be no difference between their opinion and market price; therefore, no opportunity exists.
I don't think this statement carries to the venture / growth market. The requirement of a ‘differentiated view’ is predicated on the fact that the price is set by the market, is more or less efficient, and represents consensus view. In the venture/growth context, the price is often driven by non-market forces. For example, entrepreneurs regularly choose investors for non-economic reasons (better fit, the right connections, other terms, etc.). Access is another reason; 'extra' demand in the public markets will drive the price up, whereas excess demand in the private markets often means you are not getting into the round. For these reasons (and many more), the price may not represent supply and demand. Therefore, as a potential co-investor in a deal where the valuation is already set, I am of the mindset that unless you cannot understand what the company does, you should be open to doing diligence on the deal. The lack of a true market price, in other words, negates the aspect of value investing theory that requires a differentiated view. Note this is ignoring the practical limitations investors might have on ownership, governance goals, exposure, etc.