Mike's Case Against Venture Capital

Mike Simonsen, our fearless leader at Altos Research, wrote an article for FoundRead this weekend entitled "My Case Against Venture Capital."Interesting how he and I wrote our articles independently this weekend, but advocated similar positions - heeding caution with respect to venture capital's role in funding your start-up endeavor.

Maybe its the "Altos Research Cultural Bias" in play. Since the founding of Altos Research, the company has bootstrapped - paying for growth as cash comes in the door (no pressure on the sales guy here though....). I've been on the other side working with start-ups with considerable cash (Aplia, Inc. with $10+ mln) and my own firm that I operated for 2+ years on angel funding. Now that I'm on the side of the "pay as you go" model, I don't think I'd go back unless there was a viable reason. There's a certain feeling of autonomy at Altos Research that I didn't feel in my previous tenures, including my own company...

His article is chock full of great examples and outbound links that are guaranteed to get the gears grinding if you're considering venture capital for your business.

Venture Capital is not the end goal

It’s interesting when talking to start-up CEOs and entrepreneurs how often they are enamored with landing venture capital, as if receiving the funding itself is their main business objective. Venture capital is the beginning of any start-up's journey- a vehicle to speed product development, expand market reach, and grow the firm more rapidly than what would be possible through self-funding from revenues. Venture capital is never the destination.

Just remember the VC's rough equation:

10 investments = 7 failures + 2 breakevens + 1 successful exit

You're one of ten - there's a better chance that you're one of the future failures in this model than the successful exit.

Just as bankers provide small business loans to firms that meet their expected rate of return hurdles, venture capitalists invest in start-ups that offer the opportunity for them to meet their own capital growth goals. This is not philanthropy. One rarely hears an entrepreneur express delight for their pending small business loan from their banker, yet closing a round of venture capital is met with valedictory celebration.

In many ways, it would seem logical that the bank loan should be the capital event to spark celebration at a small business, since the bank only wishes to be compensated with interest payments, instead of preferred shares. Of course, most start-ups don't fit the lending criteria of most banks - this is illustration is meant to offer some perspective.

Certainly venture funding is vitally important to fill the investment gap between angel investors, private equity, and traditional lenders. The start-up entreneur should just remember that there are two sides to any transaction. If a VC is willing to invest $5, $10, $15+ million in your biotech, software, or patented technology, that money will come at a cost. Be sure to weigh the cost/benefit of the transaction before considering venture capital funding to be the end game.

(There's some solid reading and perspective on venture capital and angel investing at The Smart Startup).

Some Basics on Angel Capital

While doing some reading tonight, I came across a couple of very informative articles regarding angel capital and seed stage start-up financing.

• Jim Roberts provides his Top 10 Tips for Entrepreneurs Seeking Venture Capital - a nice list of practical examples that focuses on developing relationships and taking the long view when considering angel funding.
  

• An article from The Huntsville Times written by an angel investor offering the "blocking and tackling" basic advice that is always good to remember when approaching angel investors.

• Some cautionary advice from BusinessPundit.com.

The key factor that I read time and time again, is that angel investing is an option and an opportunity for entrepreneurs. But remember, angel capital doesn't mean "manna from heaven."

New Social Network - "Were You There?"

I met Jonathan Hull, founder of "Were You There?" at a recent SVASE event. I just set up a membership and started playing around.

"Were You There?" bases its social networks on events, times, and places. Couple of examples - there are groups around the Kennedy assassination, Elvis Presley, and Venice, Italy.

Cool stuff. Definitely worth checking out for an interesting perspective on developing a new social network.

Venture Capital Investment Competition & the University of San Francisco

The Venture Capital Investment Competition (VCIC) is a unique opportunity for university students to act as investors, instead of the standard competition where students present their business plans.

In an obvious attempt to be a homer, I'd like to congratulate the University of San Francisco Graduate Student Team for their outstanding performance at the February 8th event, finishing in 2nd place with universities like USC and UC-Irvine in the field.

Mark Cannice is the Executive Director and Founder of the USF Entrepreneurship Program. Over the past couple of years, Mark and his colleagues have quickly transformed the department from a great little secret to an outstanding program for developing entrepreneurs in the fertile Silicon Valley environment.

Mark compiles the Venture Capital Confidence Index, and reported his most recent findings here.

The Predictions Business...

The Industry Standard is back in the publishing business again. For those of you, okay, for those of us, that feel compelled to be right all the time, they have their "Predictions Board." Put your money where your mouth is - wager $100,000 in Standard Dollars on predictions in the tech industry.

If there's competition and a bit of gambling involved, count me in. I already see some predictions about FaceBook, Salesforce, and a few others that I like.

Last time I had an encounter with the Industry Standard was one of their roof top parties back in 1999 or so... Wonder if they'll be throwing galas like that again...

The Facebook Multiplier: Economic vs. Market Valuation

I get the social part of it. I just found a friend of mine from high school, spent 10 minutes with my wife perusing pictures to put on my profile, and even reviewed 20 results for “Sambucci” including two in London, one in Glasgow, and one in Ecuador. I don’t get the 100x revenues to determine its $15 billion valuation.

Facebook’s foray into tracking member purchases went awry. Advertising dollars reach their ceiling quickly unless you’re Google.

The Facebook marketplace is less than overwhelming. There are 2598 items for sale in Silicon Valley, CA at the time of this posting. When I click “For Sale", the first page results include a 5"x5" cheese cake for $50, Oracle SQL/DBA Training for $360, and a 2007 Hybrid Ford Escape 4WD for $26,000.

Huh?

A marketplace is a place of aggregation where economic activity transpires. On the Internet, eBay is the typical example - an established marketplace with buyers and sellers. Defining the market more loosely, the same occurs when someone uses Google or another search engine to find a product that they eventually purchase. Members join Facebook for social networking, not to directly engage in economic activity.

With no indications that Facebook’s revenues are rising exponentially, it’s likely that direct revenues Facebook will generate for itself will remain relatively low compared to the true online marketplaces like eBay (~ $7 bln in 2007) and Google (~$15+ bln in 2007).

If this is indeed true, they why use Facebook’s revenues as the metric for valuing the company (currently at 100x revenues according to Microsoft’s recent investment)? Maybe there’s a more accurate way…

Let’s assume that because I’m a Facebook member, I meet up with a long lost high school friend in New York City and have dinner. It’s fair to assume that this happens frequently with many Facebook members – connecting with friends either directly or in part because of Facebook – which results in economic activity of some sort taking place (a $100 dinner in this case).

By taking this approach, we can then begin to connect a certain amount of economic activity attributable to Facebook. Some members are “power” users and others are more cursory like me. But overall, there is likely some average amount of economic activity per member that can be measured. Economists use “mulipliers” to calculate these “down line effects” of some event or activity. (In fact, the consumption multiplier is the rationale for the recent tax cuts approved by Congress and President Bush.)

If we can quantify these economic activities per Facebook member, then why not use a “Facebook Multiplier” to determine the firm’s value? This multiplier is not related to the revenues of Facebook. Instead, the newly-created revenues of other market participants as a result of Facebook existing become the determining factor to establish Facebook’s economic value to the market. Using the multiplier establishes a true intrinsic value for the firm, not an arbitrary market value as was done with Microsoft’s investment in Facebook.

This proposed multiplier may indeed show that Facebook’s firm value is indeed 100x revenues, but not because we use Facebook’s revenues as a basis for arriving at the valuation. Instead, Facebook is valued based on its contribution of total economic activity. This multiplier can be justified going forward because of the lock-in effect of Facebook, and possibly the growth of the multiplier as Facebook members utilize Facebook more frequently.

This creates a clear divide between Facebook’s economic value (its contribution to the economy as a whole) and its shareholder value (market value). To the displeasure to future Facebook shareholders, the multiplier approach values Facebook on the total revenues that it creates in the general economic, not revenues that it collects as a participant in the market.

The result? Facebook’s economic value is different than its market value. In fact, its economic value is greater than its market value. We assume that shareholders value a firm based on future earnings due to them as a part owner of the company. Shareholders that purchase shares of Facebook based on the market valuation of $15 billion established by Microsoft will be sorely disappointed if the firm’s personal revenue growth of Facebook remains at its current level.

In the end, I’m not contesting that Facebook is worth $15 billion. It could be even more than that. I just disagree that Facebook’s market value is $15 billion. The firm may hold an economic value of $15 billion with the resulting multiplier effect, with the market value falling far short of this number.

(Also consider that perhaps Microsoft established a $15 billion market valuation for Facebook to artificially inflate the market price to other would-be suitors…)

Caveat emptor.

Funding 2.0 - SVASE

Last Thursday, I attended an SVASE event - "Funding 2.0 – How To Build A High Growth Startup Fast And Cheap." It's always interesting to check out the mindset of the Valley's newest entrepreneurs and hear what its successful members have to say.

Panel members were:

Mike Cassidy, Entrepreneur in Residence, Benchmark Capital
Matt Mullenweg, Founder, WordPress
Naval Ravikant, Partner, The Hit Forge
Peter Yared, Founder & CEO, wdgtbldr

Here are a few memorable one-liners (might be slightly paraphrased, but I think I'm close....):

Mike Cassidy on developing a strong Web 2.0 company:
"Find the lock-in effect; the network effect. That makes it hard for users to switch."

Matt Mullenweg referring to start-ups that are beginning to turn the corner:
"When you're in the green, the best times are ahead of you."

Peter Yared about outsourcing hardware:
"There should be no IT people in a software company."
"Why buy the elephant when you can ride the elephant?"

Naval Ravikant on making money on the web:
"Most money on the web comes from search mistakes."

I spoke to Peter for a couple of moments before the Panel began. Unfortunately, I didn't know of his success as an entrepreneur - our conversation was rather light. Had I known, I would have pressed him for some advice about Altos Research and our AltosCharts application...

SVASE continues to impress with their abundance and quality of events. I recommend their events to any enterpreneur that wants to get out, practice their pitch to strangers, meet people like you, and learn more about what to expect in getting your ideas from concept to realization. Must have been 150 people there.

Using Salesforce

I'm in process of migrating to Salesforce.com for our company's CRM. Here's what I know so far:

1. Salespeople there are meticulous during the sales process. I'm hoping this is because they're using Salesforce for their CRM.

2. You can get a user "seat" for about $65/month, and set up billing quarterly, semi-annually, annually, or bi-annually. Bi-annual prepayment gets you a discount.

3. I posted a "user case" on my profile, and received a call from a tech guy within a couple of days. He left me a voicemail because I couldn't take his call. I called him back and left him a voicemail. Another tech guy called me back about an hour later and walked me through the answer to my question. He was clear and thorough.

4. If you are using a contant/registration form on your website and you want to fully integrate Salesforce into your sales processes, you'll need to pull out the contact/webform on your website that exists and replace it with the Salesforce "web-to-lead" form.

That's all for now. Still haven't migrated our contact data over because of the day-t0-day fires, but I'm cautiously optimistic. Would be nice to be able to employ a consultant to handle the migration for us. But seeing that we're paying less that $1500/year, I'm not about to pay $2-3K to have someone come in and do this for us. (Though maybe I should, but cash flow is always the challenge in start-up land...)

No Revenue, Profit or Free Cash Flow? Now what?

In my recent post, I discussed how a firm's value could be determined simply by discounting the total revenue of the firm over a reasonable time period using an appropriate discount rate - the "Discounted Revenue Valuation Model" (DRVM)- because a firm's revenue represents the total benefit received by its customers.

DVRM focuses more on the economic, or intrinsic, value of a firm, not the market value of a firm. Financial markets and investors have shown a propensity to ignore economic valuations, instead valuing firms at artifically higher levels, creating a "market value" that exceeds true "economic value." This is the fundamental issue that I am addressing in these series of posts.

While I think DVRM a good starting point to begin to alter the way we think about firm valuation, practical challenges emerge with using this approach.

From a financial and accounting standpoint, it is possible for a firm's expenses to exceed its revenues. If a firm under evaluation has this condition, then the firm would not be a sustainable enterprise over the long run (assuming no change in the growth rates of revenues relative to expenses over time). So it seems that revenue alone cannot serve as the only indicator or proxy for determining firm value.

Arguably, it would be more responsible to take into account what's left from a firm's revenue after deducting all expenses. This is commonly known as "income" or "profit." Instead of using revenue, one could project a firm's annual income over a reasonable time horizon, determine a discount rate that fairly represents the risk level or opporunity cost of capital for the firm, and reach a new value for the firm. Using this method, there is the implicit correction for expenses incurred by the firm to achieve their revenue.

Even so, there are still problems with using a "Discounted Income Valuation Model." Primarily, accounting rules allow for a firm to claim expenses and revenues that are non-cash events, such as Depreciaton and Amortization on the expense side of things and Accounts Receivable on the revenue side. Therefore, accounting rules show that a firm may show an accounting profit, but may not have positive cash flows.

Cash is king, and anyone who's every been without money when they need will certainly attest to this. This leads us to using annual Free Cash Flows (FCF) to determine a firm's value. Just as we did with our Revenue Valuation Model and Income Valuation Model, we just forecast FCFs through a reasonable time period, discount them back using an appropriate discount rate, and now we have the true "value" of a firm.

Every textbook in basic finance espouses this method for properly determining a firm's value. This line of reasoning - starting with revenues, then using profits, and then using FCF to determine a firm's value - is exactly why textbooks and academics argue that the Discounted FCF Method is the proper technique to value an asset (or firm in this case).

But, here's the big problem -

Most start-ups generally have no FCF, Revenue, or Profit. And if this is the case with Facebook (which does have some revenue, though very little relatively speaking), how can you logically use some variation of the Revenue or FCF Valuation Models to accurately determine the true intrinsic or economic value of a firm?

I would argue that you can't. Throwing out valuations such as 10x revenues or 100x revenues to determine a firm's valuation is an economically unsound practice. There must be a better way to calculate firm valuation outside of some variation from the Revenue or FCF Models.

Company Value = Benefit to Customers

A common way to value a company is to look at the company’s total revenues and then take a some multiple such as “1x” or “2x” in conservative industries, with “10x” as an acceptable standard in the technology industry, and an incredible “100x” as witnessed in Microsoft’s valuation of Facebook. We’ll call this the “Revenue Multiple Approach” (RMA).

What’s interesting to me is that you never read about why we use "revenue" (or a multiple of revenue) to establish a firm’s valuation.

I was considering company valuations last week from an economic perspective - thinking more about how and why companies are valuable and how they fit into the broader economy and less about the plug-and-chug, back-of-the-envelope modeling that is common in finance. It made sense that a firm’s value solely should be based on the benefit that its customers receive from purchasing the firm’s products and services.

The outcome of this explanation is to show how we can generate the value of a firm (“Supplier") based on its sales to its customer(s) (“Purchasing Firm”)

In general economic theory, we know that consumers will consume a good as long as price of good is less than (or equal to) the benefit received by the firm. Consumers consume based on personal utility and firms consume production inputs to minimize cost (or maximize profit). It is possible to calculate the contribution of consuming this input to total profit.

Mathematically, this is means that a transaction to purchase a good or service will occur only if:

Price of a Good ≤ Value

So, if the value of a good is expressed in its price, then the value of a product is equal to the maximum price that the good’s consumer is willing and able to pay.

Total Value of a Good = Max Price Paid by Purchaser

(This sort of reinforces what we said above about a transaction taking place only if the price of a good is less than or equal to its value to the consumer.)

In a perfectly competitive market, firms produce to a point where their marginal cost of producing a product is equal to the marginal benefit gained from its sale. This is represented by the marginal cost/marginal benefit curves, also more commonly known as “Supply” (marginal cost curve) and “Demand” (marginal benefit curve).

If a firm produces to the point where MC = MB, then the costs to the Purchasing Firm for the good will be equal to the revenue of the Supplier. Conversely, the revenue of the Supplier will be equal to the marginal costs of the Purchasing Firm, which happens to be equal to the marginal benefit received by the purchasing firm.

So if we want to determine the Supplier’s value, then we can assume that its value is equal to the total marginal benefit experienced by all Purchasing Firms, which we’ve said happens to be equal to our Supplier firm's revenue.

Simply put:

Value of a Firm = Total Marginal Benefit Received by its customers = Total Revenue of Firm

Instead of using the Revenue Multiple Approach, we could call our company valuation model method the “Marginal Benefit Valuation” (MBV) because when we’re using revenues to determine a firm’s value, we’re really just calculating the firm’s total marginal benefit to its customers.

Finally, the last step in this process would be to take some reasonable time period, project revenues each year over that time horizon, use a discount rate that correctly assumes risk level or opportunity cost, and calculate a firm's value based on the discounted revenue streams during this time. And there's the basis for firm valuation using revenues to make the determination.

As an extension to the discussion ---

Which multiple to use (1x, 2x, 10x, 100x…)?

Much of that decision is subjective based on brand recognition, future company growth, the industry, and pure subjectivity. (We all remember the dotcoms where business valuations were based on which venture capital firm was willing to bid the highest.) This is another article in itself….

Why use multiples of revenues?

Well, as a part-time academic (I teach Finance at the University of San Francisco), I’ve personally never been able to get my head around using the RMA. If revenues are the choice for determining a company’s value (because they represent the Marginal Benefit received by their customers), it seems that it is far more logical to calculate the present value of future revenues. If one is particularly bullish on a company’s future prospects and would like to reflect this attitude in a company’s value, just adjust the discount rate downward and adjust the growth rate upward to yield higher present value (or higher company value). But of course, then you’re infusing significant subjectivity to the equation, but this approach offers a more sound theoretical modeling technique.

Market Value vs. Intrinsic Value

I'd like to tackle the issue of firm valuation. Determining a firm's value is especially important for start-up firms under consideration for venture funding. Establishing, maintaining, and increasing a start-up's value is central to the reason the firm was founded and for utilizing venture capital and investment provided to it.

This introduces an item that requires further clarification - the definition of "value." Value can be generally defined as "a fair price" or as "utility" or "worth" (courtesy of the American Heritage Dictionary...).

In the financial world, it's common to differentiate among types of "value." Specifically, there is a difference between an asset's "market value" and its "intrinsic value." Market value is the value that someone else places on an asset - what that asset is worth to some other market participant. Intrinsic value is the actual value or worth of a firm.

This fundamental difference in values supports the argument that the true value of a company is not necessarily reflected in the market valuations given to them by other market participants. The case I referred to was Microsoft's $15 billion valuation of Facebook. Valuations generated by venture capitalists or other related suitors nearly always tend to be market values, and not a reflection of a firm's intrinsic value.

If a VC values a company at $100 mln, and makes a $10 mln investment, that means that they have purchased 10% of the company. That initial $10 mln investment may be (or at least should be) entirely necessary for the target company to propel itself for product development, sales, and eventually profit. However, given that VCs are wrong on their company valuations 90% of the time, the $100 mln valuation is solely based on the market value - what the VCs are willing and able to pay for some asset.

In this case, they are willing and able to pay $10 mln for 10% of the company. Surely they would be willing to pay less that $10 mlm for 10% of the company, and alternately, the company owner would surely be willing to sell less than 10% of the company for $10 mln. But assuming that the VC and the company operate in a competitive market, this $10 mln investment for 10% of the company represents the market equilibrium price for the asset (the asset being 10% of the start-up).

This market price doesn't necessarily mean, and in most cases, does not mean that the intrinsic value of the start-up is $100 mln, only that the market value of the start-up is $100 mln. In fact, with the 90% failure rate of the VC industry, it stands to reason that the market valuation of the company is quite overpriced, but because there is a willing buyer and seller, a market for the 10% of the company is created.

With a couple of fundamentals definitions, we can begin to see how the market valuations for start-ups and new media companies may be incorrect a high percentage of the time, with these errors tending to overvalue a firm rather than undervalue a firm.

It's a point of frustration to see artificially high market values placed on firms (whether they be start-ups or publicly-traded) when it is clear the economic or intrinsic value of a firm can be clearly argued to be much lower.

Free Information for sale...

Working with Altos Research over the past six months, it's been fascinating to not just have a front row seat in the theater, but be up on stage as one of the main cast members. Sales and subscribers and growing every month, and the use cases of the residential real estate market data that we collect and provide to our subscribers are becoming more and more diverse.

The Altos Market Reports and AltosCharts compose the crux of our product line for real estate professionals (agents, mortgage lenders, title reps, etc.). The reports are updated weekly, providing our subscribers with local market information to share with their clients about the constantly changing real market dynamics.

Our CEO, Mike Simonsen, passed along a link to a blog post by Kevin Kelly from Wired Magazine titled "Better Than Free" that discusses how free data on the Internet is valuable and can be sold if packaged correctly. It's a striking post and motivated me to do a quick analysis of the Altos Market Reports and AltosCharts to see if we meet the criteria in Kevin's article. Turned out to be a remarkably pleasant experience. Seems we're doing things pretty well here at Altos Research....

Immediacy - Check! The Altos Market Reports are updated every week and available for download on Monday of each week, reflecting market data collected from the Friday before.

Personalization - Check! Market Reports include the contact information, photo, and logo of each subscriber. This enables our clients to utilize the reports for outbound marketing and impress the heck out of their clients and potential clients in listing and update meetings.

Interpretation - Check! Subscribers receive a training session over the phone regarding the market stats in our reports and how to use them effectively with their clients. In addition, we're launching a User Forum this week where subscribers will be able to collaborate on use cases.

Authenticity - Check! There is a branding aspect to the Altos Market Report and the AltosCharts. The reports are copyrighted to Altos Research, and our clients like that we're a third-party, objective source data. Being able to rely on our data collection reliability and accuracy enables clients to support their argument with their clients.

Accessibility - Check! All subscriber reports are hosted at Altos Research - just log in, download the report(s) needed, and off you go. Additionally, we're launching a CRM application that enables real estate professionals to auto-send copies of the market reports directly to their clients are part of their drip marketing campaigns.

Embodiment - Check! All of the market data/stats published in the Market Reports is available for display using AltosCharts - a "widget" that is posted to a website, updates itself automatically every week with new data, and can be utilized as a web conversion tool.

Patronage - Check! From the early days of availability, our clients have been enthusiastic subsribers. With a retention rate over 90%, there's no doubt the Altos Research clients see the value for their subscription fee.

Findability - Check! Clients continuously share stories about how our Market Reports and specific data within has helped them with their clients and getting the next listing. This is often the same data found in alternative sources, but not with the clear packaging and presentation necessary to communicate the key ideas.

Fun stuff - sometimes its okay to give yourself a little pat on the back....