In the world of startups, there is a schism between real value creation and the irrational funding market. Strange as it is, these two things can co-exist without much correction for a sustained period of time.
What is this schism?
On one hand, there is an ecosystem of startups hard at work, disrupting incompetent, traditional models of business, whilst making markets more efficient and creating real economic value. This faction works for the long-term and is completely rational.
On the other hand lies the venture capital industry. It thrives on opacity and is driven by egos and primal instincts. It is fearful during bad times and greedy during good times. It is an almost dysfunctional utopia where valuations could shift by the billions in a day, even when the needle hasn’t moved on value creation. This faction is emotional and largely irrational.
What is the truth that everyone knows?
The fundamental value of a company is based on its current and expected earnings. It’s normal for it to evolve rather slowly. A company’s valuation, however, is quite simply the result of supply and demand on any given funding round. The demand for a company’s stock, like the demand for fish in a market at any given day, and like our moods and emotions, is contingent on many variables that have pretty much nothing to do with a company’s fundamental ability to create value, and hence, earnings.
FOMO is at a high. So much inexperienced money is flooding into tech. It’s human nature to not want to miss out before it’s too late. As a result, startups can raise money easily and cheaply. But any market where the players have a huge disparity in valuation expectations is a warped one. It’s a market that favours startups, but only in the short term.
It’s extremely difficult to estimate a startup’s worth with precision. The key is to focus on long-term value instead of short-term price fluctuations. It seems obvious, yet it’s surprising how often people confuse the two.
It’s short-sighted to raise funds at a price which the public market can’t swallow. This is a prime example of moral hazard. It obscures the meaning of “valuation” and becomes perilous down the line because private investors aren’t taking the same risks as public shareholders. If and when a company goes public, the valuation attached to it by VCs might not align with its balance sheet. Look at what happened to Box.
Beware of competitors with big money…
Tolerance for burn is an essence of the venture model. Startups are pressurised to maintain growth at high costs. Venture-backed tech startups exist in a cyclicality driven by reinforcing dynamics of burn and valuation. High-growth companies attract high valuations, which allow them to raise money, which would then be spent on more growth, before eventually raising valuation again. This stimulates a cycle of high burn, higher growth and higher valuations with an entrenched feedback loop.
Look out for competitors who raise a ridiculous amount of funds. They could kill your startup by burning money. This is an unfortunate reality of company-building: well-funded competitors could spend a silly amount of marketing money to buy non-sticky audience and grab your market share. Ctrip gobbling up significant strategic stakes in both eLong and Qunar is a prime case in point.
…but continue to place your bets on long-term value creation
The best investors will not fall into the vicious cycle of trends, biases and herd-like instincts that drive valuations up pointlessly. The best investors like businesses that address huge market opportunities and create long-term economic value through a differentiated and defensible approach. The best investors understand that less money in the system will not result in less innovative technology being built.
Every product creates “value”. A company absorbs some of that value back as revenue. Abstracting for nuances, a startup should aim for either of the following:
- Generate a huge amount of long-term value, but capture a small amount
- Generate a moderate amount of long-term value, but monopolise the economics
Our point is simple: The only way to make money is to delight lots of people, and then extract some of that value you created for them. Focus on creating long-term sustainable value and you’ll have a long-term sustainable business that transcends insanity in the funding markets.