The Trap of Relative Value
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.