If It Was Easy, We’d All Be Rich

A couple of articles in the Wall Street Journal last week highlighted challenges of managing and investing in early-stage companies.

• The first noted the difficulty some startups are facing.  Having raised large rounds at high valuations, some companies like Beepi discovered that when the cash runs out, investors may not be eager to re-stock the cash register absent compelling evidence that profitability is in sight.
• The second chronicles the imbalance between the supply of venture capital to be invested and the demand for funding from promising companies.  In short, available capital seems to outweigh attractive opportunities.

Of course, there’s really nothing new in either of these news items.  Market sentiment seems to oscillate between a preference for growth (with the confidence that profits will dutifully follow later) and a desire for profitability now (or at least a discernable path leading there).  Woe to the company pitching a growth story when investors desire profitability.  Entrepreneurs can never take the availability of the next round of financing for granted.

Despite the occasional wave of irrational exuberance, economic truths tend to be stubborn and unyielding.  Investors are ultimately rewarded for independent thinking, not following the herd.  The stampede of investors putting money into bike-sharing startups in China has virtually ensured that returns will be anemic.  Excess returns follow risk (and pricing discipline), not mimicry of one’s peers.

From a valuation standpoint, the articles are timely reminders of the importance of cash burn rates, dilution factors, and exit probabilities in measuring the fair value of startups.  While the magnitude of the potential exit often garners the most attention in a valuation, these other inputs are just as important in assuring a reasonable result that reflects current market conditions.

Related Links:

• Corporate Venture Capital Trends
• Updated: Valuation Best Practices for Venture Capital and Private Equity Funds
• How to Value Venture Capital Portfolio Investments
• Consequences of Calcified Cap Charts: A Few Thoughts on Startup Equity-Based Compensation