Are Startups Over-Valued?

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The market has had a strong run, far outpacing GDP growth

To Answer This Question, Start With the Public Markets

To answer that question, we need to start at the top of the market and flow down the food chain. For the tech sector, two of the biggest market gorillas out there are Google and Amazon, each of whom conveniently announced their 2020 earnings today. Both companies, not unexpectedly, crushed it:

  • Google generated $183 billion in revenue, $41 billion in operating income, and generated $65 billion in cash flow through their operating activities.
  • Amazon generated $386 billion in revenue, $21 billion in operating income, and generated $66 billion in cash flow through their operating activities.

Google is now worth $1.3 trillion while Amazon is worth $1.7 trillion — each one a 2x increase from “peak pandemic panic” in March. What drove those valuation increases? Not sales growth: Google grew revenue by only 13% year over year while Amazon grew by 38%. Those growth rates are strong for such mature companies but don’t explain 100% valuation growth. How about cash flow growth? Google grew operating cash flow by 19%. Amazon grew operating cash flow by 71%. OK, that’s better, but still doesn’t fully justify a 100% growth in valuation.

Valuing mature companies like Amazon and Google, in theory, is a straightforward exercise (we teach it in the first semester of the first year at Harvard Business School!). The value of a company (similar to any asset) should be the current value of all future cash flows, discounted back to the present. So when the market values Google at roughly 20x their operating cash flow, they’re assuming that Google’s 2020 results can be replicated at least 20 more times — or at least the equivalent of that if you discount all of Google’s future cash flows to the present. I know that’s a gross oversimplification, but hang in there with me.

There are two wicked big assumptions that you make when you try to value a company: how big will their future earnings be and what is the discount rate that you use to discount future cash flows to the present. Future earnings are a guessing game based on past operating results and your belief about the future. The first “aha” about why valuations of tech stocks are soaring is that the market believes that the pandemic has improved the odds that tech companies like Amazon and Google are going to generate larger earnings and more free cash flow in the future.

Regarding the discount rate: what rate do you choose? The discount rate is based on an assumption about interest rates or cost of capital: if interest rates are high, then cash coming in 20 years is a lot less valuable than cash coming next year. If interest rates are low, then cash coming in future years looks a lot more valuable.

Because tech companies are all about the future and the promise of future cash flows, most valuation models of tech companies are very sensitive to changes in the interest rate. To see what’s been happening to interest rates, here is the 10-year treasury rate over the last 150 years:

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Interest rates are sharply down in recent years — and dramatically down since the pandemic began

Hard to miss that trend line! A year ago, the 10-year treasury rate was 1.9%. Today, it’s nearly half that figure. That means all the financial valuation models that everyone applies to future earnings have been recalibrated, making future cash flows more valuable. And that’s the second “aha” about tech valuations: lower interest rates are making the net present value of tech company cash flows even more valuable — simply because the discount rate applied to their future earnings has gone down.

Moving beyond Amazon and Google and looking at smaller public companies, you can see the impact of these two forces. I don’t want to analyze our portfolio company, MongoDB, whose valuation has increased 4x from the low days of March 2020 to a $24 billion market cap today. But a similar story can be seen across many other, similarly-sized software companies. Hubspot, for example, has seen a 3x increase in its valuation since March 2020 to $18 billion. Yet, non-GAAP operating income grew only 35% and revenue grew 32% in the first nine months of 2020 as compared to 2019. Strong growth, for sure, but does it justify a 3x valuation gain? Again, a more optimistic belief in future earnings growth and a sharp drop in interest rates, resulting in an increase in the value of those future earnings, makes the valuation model soar.

Public Valuations Drive Startup Valuations

Today, the public SaaS comps for the fast-growing, industry-leading companies are more like 20x revenue. Bill Gurley’s well-written post a number of years ago about the keys to the 10x revenue club is still on point in terms of characterizing the varying quality of different business models, but the title needs to be revised to “the keys to the 20x revenue club”. Why? Because of a macro belief that digitization has accelerated in a post-pandemic world (as Satya Nadella famously said, “we saw 2 years of digital transformation in 2 months”), which will lead to faster growth in future earnings. And at the same time, a drop in interest rates has meant those future earnings — which had been 10–20 years out and so highly sensitive to interest rate drops were less heavily discounted and so now more valuable.

If the public comps are 20x revenue — roughly 2x what they were a year or two ago — then the private comps follow. In our work at Flybridge, the new rule of thumb is that a $10 million revenue SaaS startup growing fast and well-positioned can raise additional capital at a $200 million valuation or 20x revenue. The valuations compress a bit when growth-stage companies get closer to becoming public companies — e.g., a $50 million revenue SaaS startup might achieve a 15x revenue multiple or $750 million in value — because the M&A air is thinner at that scale (i.e., fewer buyers) and private investors want to be rewarded for selecting those companies that can get through the grueling IPO process (less grueling now with SPACs, but that’s a whole ‘nother story). Looking at Pitchbook’s valuation trends data (the latest is their Q3 report), the sector-wide data supports my subjective market observation: valuation in later-stage deals grew 70% year over year.

Early Stage Valuations Not Affected by Increase in Public Market Valuations

Again, a look at the Pitchbook data supports this observation. They report that the median angel (i.e., pre-seed) pre-money valuation in 2020 (again, through Q3) was $5 million (so call that $6–7 million post-money), and the median seed pre-money valuation was $7.5 million. Both figures flat in 2020 as compared to 2019.

Early Stage Valuations: Cap Table Math vs. Comparables Math

Conclusion

Former entrepreneur turned VC @Flybridge, teach @HBS, author of Entering StartUpLand and Mastering the VC Game

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