From Pieter Welten – Prime Ventures (@pieterwelten)
A few months ago I wrote a blog post about fair company valuations. I argued that a fair company valuation is in the best interest of the long-term success of any company. A relatively high (entry) valuation could create issues for the company going forward and will hit back when the company is not executing according to plan. I do realize, though, that when I try to convince an entrepreneur of my personal believes he or she might believe that I am simply squeezing every cent out of them. That’s not true, in my opinion it is investor & entrepreneur versus the world and NOT investors versus entrepreneur.
Anyhow, over the last couple of days we have seen a sharp decline in public tech stocks across the world. There are concerns that the tech industry is in a bubble. I personally don’t believe that’s the case. Compared to 2000, tech companies trade at lower multiples, have larger cash reserves and wait longer before going public. What does concern me is that the serious amounts of capital in the market push private company valuations to fresh highs as various players (e.g. VCs, PEs, family offices, HNWs, corporates, angels etc.) seek out investments in tech. Since there is a serious discrepancy between public and private multiples, I wonder whether private companies are overvalued OR public companies are undervalued?
Let me explain myself. I see start-ups valuing themselves in Series B or C rounds anywhere between 5 – 20x revenue. Yes, perhaps we (as investors) are willing to pay forward for future growth, but at the same time we shouldn’t underestimate the risks inherent in these businesses. Some argue that because of the risks, these fast-growing, risky start-ups deserve a discount and not a premium to average trading multiples (I tend to disagree with this, it should be a fair valuation, in line with peers).
Continuing, if we look to some of the tech leaders, i.e. Facebook, Amazon, Apple, Microsoft and Alphabet (or ‘FAAMG’ – please replace Alphabet by Google), we get to an average EV / revenue multiple of lets say 5.5x 2017 revenues. The likes of Apple an Amazon trade around 2.5-3.0x revenues and Facebook is an ‘outlier’ with a trading multiple of +10x revenues. We should realise that these FAAMG companies have strong gross profit margins, are profitable, have huge cash balances and steady free cash margins. The vast majority of start-ups I talk to fail to tick the majority of these boxes.
Top analysts and investors mentioned already months ago that tech stocks (both pubic and private) are due for correction since they are overvalued. That correction is currently taking place. If public companies are (slightly) overvalued than it is fair to say that private companies are like to be overvalued as well. As a result, I wonder why entrepreneurs believe they deserve (significant) premiums to their listed peers? I personally grow increasingly uneasy about the valuations expectations of certain start-ups. As I have stressed before, these potentially stretched valuations can hurt the business on the long-term and hence the investment. Fortunately, I don’t have such thing as FOMO and it definitely won’t affect my decision making process!