A Guide to VC Valuations and Tech IPOs
With the recent tech IPOs suggesting the possibility of a bubble (and AirBnB now getting an investment valuing it at $1.3B), it may be useful to look back at how they got there. Most tech startups go through the venture capital system. The model is for the entrepreneur to:
- Start off doing a little bit of work or market research themselves
- Get investment from friends and family to buy 3-12 months
- Get angel investors to pitch in just enough to cover another year or so to build something that’s real but not ready
- Get anywhere from 1 – 10 rounds of VC investment, each time giving themselves 12-18 months of cash
- After 5-7 years (ideally), have an IPO or sell to a large corporation (the entrepreneurs may own 5-20% at this point)
One of the big things investors look for along this process is increasing valuations; if a company ever takes an investment that’s not at a higher valuation than the last one, they’re in the penalty box and they’ll find it harder to keep playing. To make things easier some early angel investors use a structure that doesn’t assign a specific valuation but otherwise the game is to push the valuation up each time.
In the early stages nothing is standard; small investors will do things differently and take big risks. Once you get into the VC stage it’s a well-defined process that is openly talked about now. It’s estimated that only 10-20% of VCs really get good returns, but they all follow very similar models. One of the key parts is betting on big wins. The general idea is that for 10 investments, 1 will make great returns, 3 will break even, and the rest will be a partial or complete loss. Out of this, the VCs are trying to create a fund that earns 15-20%+ over 7-10 years and pay themselves well along the way.
If you think about it, that means VCs value investments in a completely different way from most investors. While you or I might hope that an asset class won’t underperform for more than 10 years before coming back (or a stock 2-3 years), they are prepared to outright lose 60% of their money! So they don’t value an investment on the probability that it will return 10% per year; instead they value it as if it will change the world.
Back to AirBnB above, just a few days ago I read this interview 18 months ago where the founders talk about how they started it in October 2007 to pay rent for a month. Now there’s nothing wrong with coming out of nowhere and earning a $1B valuation in 4 years (never mind all the companies that took 50+ years to earn it). But one of the interesting things is that the interview shows their revenue at the time came from a 10% cut of booking fees. Let’s take that $1.3B valuation and assume the investors want it to be 10X the company’s earnings in 3 years to get their value (which means that an IPO at 15X P/E at that time would give them a 50% return, with a valuation of $2B). That means that in 3 years it will have to be selling $1.3B of bookings a year. Given that it’s supposed to be cheaper than hotels, that might be 14.4m nights sold at $90/night average or 26m nights sold at $50/night. The FT article above mentioned the site has sold 2m nights in the first 4 years. Assuming rapid growth, that might be 1m/year at this point. The recent valuation appears to be based on something like 14-26x growth in 3 years.
It’s certainly not impossible for the company to grow that fast, but it’s a hint that most investments of this type do not work out. Now the VCs want to earn their big return by the time of the IPO and then get out, but you have to wonder if the principle of ever-rising valuations carries a similar breakdown of returns into the post-IPO market. Would you buy 10 IPO stocks in the hope that one will make the portfolio? Do even the brightest stars have to exceed all expectations or just live up to the promise to do that? I have a feeling that many IPO buyers may get a worse risk profile than the VCs unless they learn to think the same way. And even then, they might end up like the 80%+ of VCs who don’t create significant value. I’ll just keep using IPOs as entertainment :)