The Price is Right

by Stuart Ellman

VC's have trouble figuring out price. You cannot base it on a multiple of anything because there usually isn't much of a company, at least in the early stage. Public comparables are also relatively useless because comparables are much later stage companies. You cannot discount cash flows because the cash flow numbers depend entirely on your revenue and earning assumptions. You can look at private comparables (at what price have similar venture deals taken place) but you have no idea if those companies will be successes or failures. So, you look at basic parameters for stage and quality of management. But, what do you do if a company seems great but you know the price is high. Do you chase it, or wait for a "bargain".

VC's don't want to be seen as just chasing high priced deals because if the deals don't work out the VC looks foolish. Back in the last bubble, VC's who paid eight and nine figure prices for Kozmo.com, Webvan, Idealab and many others certainly took heat from their limited partners for making such "crazy" investments. But here is the issue: If you are a bargain hunter and only pay single digit valuations for companies, you still lose 100% of your money if those deals fail. On the upside, if you get one of those occurrences where a very low priced deal turns out to be a big win, it seems like you have won the lottery. Those are few and far between.

These are the issues I struggle with every day. A great startup comes in the door. Great team, a superb market and early traction. All companies like this have the attention of many VC's. Management wouldn't be that great if they can't generate significant VC interest. But instead of a normal early startup valuation in the single digits, this company wants (and will be able) to command significantly higher. It is tempting to say, "Oh, just let it go. There are many deals which are almost as good that I can get at far more reasonable valuations".

Then I remember Priceline, CommerceOne and WebMD. All three deals came into RRE. Priceline at $400mm, WebMD at $200mm and CommerceOne at $85mm. We scoffed, so did most of the venture community. "Way overpriced" was heard from the rafters. I am sure we put that money into other much cheaper deals that probably didn't work nearly as well as if we had done those three high priced deals.

Some investors, particularly a good friend up in Boston, go by what I call the "pay any price" theory. He believes that 90% of the money made in a fund are from 10% of the deals. So, if it costs twice as much as other deals, it is worth it if it works. It is called taking the big swing. I have to say, I agree. I do not believe you should chase mediocre or even good deals to high valuations. But, if you believe this deal is the moonshot, take the swing. Babe Ruth was not only the home run champion in the 1920's, he also led the league in being struck out. If you really believe, take the swing. But also be prepared to take the heat if it doesn't work.