A few weeks ago I was invited to speak to a graduate accounting class at the University of Washington. Although most of the students in the class had already accepted offers from one of the Big 5 accounting firms (which mostly work with larger companies), the professor wanted to give them a little exposure to early-stage finance before sending them on their way.
We covered a range of topics in the discussion, but the one that clearly generated the most interest — and puzzlement — was early-stage valuation. In a world of balance sheets and cash flow statements, the idea that financial investors would accept a valuation that wasn’t built from financial data was surprising, and even a little shocking, to this class of trained accountants.
As strange as it seems to investors in later-stage companies and public markets, there is a kind of logic to the valuation path for high-growth startups, but it often has more to do with where you are in the “valuation stack” than anything intrinsic to the company being valued.
How is a startup like a shirt?
The analogy I used with these accounting students — a useful (if overly simplified) way of describing how the system works — was to compare a private company to a consumer product sold at retail.
When a shopper picks a t-shirt off the shelf at Nordstrom, it has a price tag attached that reflects the manufacturer’s recommended selling price (or MSRP). But what that price tag doesn’t show is all the activities that went into making that shirt, the vendors and suppliers who participated in making it, and the layers of both cost and margin that have been applied to the product as it made its way through the value chain.
The entire startup financing ecosystem is like a retail value chain. The public markets (as well as late-stage / strategic M&A) are the equivalent of the retail shelf — the final sale that comes at the end of a long and winding journey through seed, Series A, B and C (and often deeper into the alphabet), growth equity, and mezzanine / “crossover” finance.
Because most high-growth companies consume capital (meaning they spend money faster than they make it in order to accelerate growth), fundraising success is the achievement that unlocks a company’s ability to progress to the next level in the value chain. Each step up the capital markets “stack” reflects a judgment by investors that your company stands a good chance of making it all the way to the retail shelf. Conversely, a company that isn’t able to raise is implicitly being judged by investors to be unlikely to progress far enough in the stack to allow them a risk-adjusted return on their investment.
Most venture returns are driven by the companies that make it very high in the stack, and especially the ones that make it all the way to retail (IPO). But since most early-stage companies fail, and only a small number are acquired for a significant gain, investors also build a risk premium (or markup) into their valuation assumptions for the next raise as compensation for the risk of failure.
In early stage finance, valuation is driven much more by your relative position in the valuation stack than any measure of “intrinsic” value.
In a previous post I argued that venture fundraises “come in twos” — meaning that every current raise contains a set of embedded information about the expected terms of the next raise. The most fundamental information about any given venture raise — and the one that has the biggest impact on valuation — is *not* the actual merits of the company’s founders or market, but rather the current position of the company in the valuation stack relative to the expected “retail price” the company will be able to command when it finally makes it to the public markets.
Investors and founders who try to over-optimize on any given fundraising event — pushing valuation too high or too low relative to norms for that stage — can effectively kill their chances of getting to the next one (thereby halting their progress up the stack). Dilute the founders too much and you undermine their incentive to deliver the superhuman effort required to carry the company forward. Price a deal too high and you leave no risk premium for investors between the current round and the next one, killing their incentive to make the bet. Every fundraise must strike the right balance between the needs of new investors and existing shareholders for the game to continue.
Unsurprisingly, the mechanistic logic behind this system is jarring to the human beings actually participating in it. Every company is a unique and every founder is extraordinary, not just raw material stuck at an intermediate stage in some abstract retail supply chain. But if you’re ever wondering why some companies progress through the venture financing ladder and others don’t, the answer can often be found in the logic of the t-shirt: no matter how many steps there are in the value chain, it has to make sense for every participant, at every stage of the process, to help get it to the retail shelf.