The Trap of Relative Value

Yesterday, at The Calloway Way event at MIT, I ran into Joe Caruso. I’ve known Joe for a while – we met through Techstars Boston, where he’s been a great mentor and very active angel investor.

He had just read my post on being uncomfortable with the phase of the current cycle and told me an anecdote from the great Internet bubble of 2001 that I hadn’t heard.

A guy came up to me and said “I just sold my dog for $12 million.”

I responded, “WTF – who would ever buy a dog for $12 million? That dog must have gold plated teeth!”

The guy responded, “Nope – but it’s a normal dog. But I was able to get two $6 million cats for it.”

When I got back to my room last night, I noticed Fred Wilson’s post from yesterday Averaging In And Averaging Out. In it, he talks about how he handles public company stocks that he ends up with either via an IPO or a sale of a company he’s involved in to a public company. We have somewhat different strategies, but we each have a strategy, which is key.

This morning I woke up to an email thread from a founder of a company I’m an investor in. He’d gotten a random note asking about his valuation when we invested relative to another financing that was just announced. When we made our investment, the company got about 3.5x ARR. The other company, which was much smaller at the point of investment, got an 11x ARR valuation.

My response to the specific situation was:

Valuations have increased on a relative basis.

They raised relatively little so probably had supply / demand on their side – which drove competition and enabled a higher price.

VCs are currently living in FOMO land so they’ll overpay for aspirational value in the future if they see growth.

There’s a lot of inefficiencies at these price levels. 

A “good price” is when you have a willing buyer and a willing seller, both happy, and willing to work together on whatever path you are on!

Each of these examples got me thinking about the relative valuation trap.

In the first case, we’ve got a dog and two cats. Who knows what they are worth – you can get a dog for free at the pound and as far as I can tell cats believe they belong to themselves and do whatever they want. But trading one dog for two cats, where the person owning the cats values them at $6 million each, means you can “mark your dog to market” which is currently $12 million. Now, if you can find someone to give you $12 million in cash for the dog, you have a $12 million dog. But you can carry it at a value of $12 million for as long as you want if you don’t want to sell it. Granted Rule 157 says that you need to mark it to market every quarter, but that’s a different messed up issue.

In Fred’s example, he does a great job distinguishing between optimizing and satisficing. Two weeks ago Twitter stock hit $54 / share. Today it is trading at $42 / share. Should you have sold it at $54? How about $52? How about $49? Or, now that it’s fallen to $42, maybe it’s time to sell it at $42. If you have it at $42 and believe you should hold it because it was recently worth $54, you are falling into the relative value trap. You should hold it because you think it will be worth more, but not because it was recently worth $54. It could be worth more or it could be worth less – making your decision on what it used to be relative to what it is today is a trap.

In the financing discussion, it’s easy to look back in time and say “wow – we got too low a valuation.” It’s just as easy to look at valuation in current terms and say “that’s not high enough” because you heard of someone else, relative to you, that got a higher valuation. Or it’s easy to feel smug because you got a higher valuation than someone. Unless we are talking about the final exit of the company for cash or public company stock that is fully tradable, this is a trap. It’s like the $6 million cat and the $12 million dog. How did someone come up with the valuation?

A simple answer is “well – public SaaS companies are currently trading at 6x average multiples so we should get a 6x ARR valuation.” There are so many things wrong with this statement (including what’s the median valuation, how do it index against growth rates or market segment?, what is your liquidity discount for being able to trade in and out of the stock), but the really interesting dynamic is the relative value trap. What happens when public SaaS companies go up to an 8x average valuation? Or what happens when they go down to a 3x valuation? And, is multiple of revenue really the correct long term metric?

As I said in my email this morning, A “good price” is when you have a willing buyer and a willing seller, both happy, and willing to work together on whatever path you are on! I deeply believe this – my goal is not to get the best price, but a fair price. I don’t subscribe to the philosophy that both parties should feel slightly bad about the terms of the deal, meaning that each had to compromise on things they didn’t want to in order to get the deal done. Instead I’m a deep believer that both parties should feel great about the deal – the terms, the participants, and the dynamics.

Ultimately, whatever stage you are in, you should be focusing on building long term value. It’s always a mistake to optimize for the short term, and when you do, you’ll often confuse relative value as justification for specific behavior.

  • The best and longest lasting deals are win-win. It all depends if you are looking at the short term or long term. I prefer long term, and am co-opting your definition of a “good price” if that’s ok with you!

  • 100% agree about both parties feeling happy. In fact sucking every ounce from the deal may leave the other party feeling cheated/disillusioned later on (if not at the table) leading to eventual breakup of your partnership. Of course its another story if you do not care about the other side.

  • I have beat this drum forever. I even use a physical example. Unless somebody hands you a one hundred dollar bill and you hand them a signed stock certificate, the “valuation” is just a relative term, with no monetary meaning.

    Since I have never seen a deal-book less than 50 pages long (not counting seed) what you are really saying is somebody gave me X amount of money for Y terms.

    Years from now when we get to the point of exchanging $100 bills for stock certificates, if everything went absolutely right we can look back say the valuation was worth X pre-money. And I hope that works out.

    In every bubble cycle and I have seen three you watch entrepreneurs, employees, and VC’s calculate the post money valuation and their “ownership percentage” and see how much they are worth. Ownership percentage is in quotes because those 50 pages??? You know what they are all about?? Changing ownership percentages and control if things don’t go absolutely right.

    At the end of every cycle you hear all three WAIL as “somebody” tries to “steal” their company. People hate “losing” money. Losing is in quotes because you never really made it.

    So be happy, build your company, don’t count money while you are still sitting at the table.

    • RBC

      thanks for the added analogy

  • I suggest you include the content of this post in a future book so it is immortalized. There’s a lot to be reflected on here. I particularily like the definition of “good price”. I saved it to my Evernote. BTW, I own a pet rabbit that’s worth $20MM to me, as he’s so special — looks like I’m going to have to hold onto it.

    • RBC

      Can I sell you another rabbit?

  • Rick

    “Ultimately, whatever stage you are in, you should be focusing on
    building long term value. It’s always a mistake to optimize for the
    short term, and when you do, you’ll often confuse relative value as
    justification for specific behavior.”
    .
    If your objective is to sell for the highest price. Does optimizing for short term value help to drive up that selling price?

    • Richard Leavitt

      Temporal market windows aside, I think that very few financings are a “final” sell, so valuations tends to work itself out. If I get a “great price” in my A round, by the time I seek my B round there will be more track record to judge me against my peers and so it goes.

    • Rarely in my experience.

    • RBC

      I’d say you have a better change of slashing costs, to make your company look more profitable, than juicing revenue – which is often by shipping product that people don’t want and letting the Acc’ts Receivable build up. Neither one are great in the long term, and the second one is potentially illegal!

  • Brian Allman

    this is the reason I follow @bfeld: “A “good price” is when you have a willing buyer and a willing seller, both happy, and willing to work together on whatever path you are on! I deeply believe this – my goal is not to get the best price, but a fair price. I don’t subscribe to the philosophy that both parties should feel slightly bad about the terms of the deal, meaning that each had to compromise on things they didn’t want to in order to get the deal done. Instead I’m a deep believer that both parties should feel great about the deal – the terms, the participants, and the dynamics.” The whole scenario brings to mind the idea that as an early investor trying to demand the absolute best deal possible in the early stage is in reality often times working against the company’s best interests in the long term as well as perhaps their own. So many factors come into play from those initial valuations and if you’re in early trying to squeeze everything out of the deal that early in the game, I’m not sure you’re the right partner for the Founders or the business. There are always good deals to be had without taking everything, including goodwill, off the table early in the process.

  • This is totally off topic but – Tim Cook 🙂

    • Yup. Pretty awesome.

  • I have another way of justifying the relative value of valuations.

    Over time the pendulum always swing back to the “right valuation”. An entrepreneur finds out later if they were over-valued, under-valued or right-valued. If they were under-valued, the upside is easier to achieve. If they were over-valued, the expectations are tougher, and they need to live-up to that valuation, and if they don’t, the next valuation will self-correct.

    So you really never know until after, whether you were rightfully valued or not.

    • Well said.

    • Rick

      “So you really never know until after, whether you were rightfully valued or not.”
      .
      In that case there is never a correct value.

      • I think what matters more is where you’re going, not where you are. A valuation is a snapshot in time. Get it, then move on. At least in the pre-liquidity stages, it’s just a paper thing, really. A means to an end.

    • William as always great way of putting it. I am all for Entrepreneurs getting maximum value. But what you eloquently said is really important. You can fix being undervalued. It is really hard to fix being overvalued.

      • Exactly. You completed my point well.
        The gap between fair or unfair valuations is really the actual performance that happens after.

  • Henry Glover

    I just use my time machine… hits the best price every time 🙂