In this episode of the Equidam podcast, Dan Gray and Daniel Faloppa delve into the complexities of startup valuation and early-stage fundraising. They explore the fundamental drivers of valuation from a venture capital perspective, discussing how market trends, investor behavior, and the use of multiples impact the valuation process. The conversation highlights the challenges of relying on multiples, the importance of understanding market dynamics, and the future of startup valuation in a rapidly changing economic landscape.
Listen on Spotify
Listen on Apple Podcasts
Listen on SoundCloud
Takeaways
Valuation is often based on a mix of market trends and company specifics.
Investors typically rely on multiples to justify valuations, but this can be misleading.
The quantity of capital in the market influences valuation trends significantly.
Understanding the portfolio approach is crucial for investors.
Multiples can be a crude measure and may not reflect the true value of early-stage startups.
Market dynamics, such as interest rates, can drastically affect valuations.
Valuation should consider both current market conditions and future potential.
There is a need for more sophisticated valuation methods in the startup ecosystem.
Investors should focus on risk-adjusted returns rather than just high-growth potential.
The future of valuation may involve a more nuanced understanding of different types of startups.
Chapters
00:00 Understanding Startup Valuation Fundamentals
03:09 Investor Perspectives on Valuation
05:55 Market Trends and Valuation Dynamics
09:07 The Role of Interest Rates in Valuation
12:00 The Limitations of Revenue Multiples
15:10 The Crude Nature of Comparables
18:03 The Impact of Market Sentiment on Valuation
20:56 Rethinking Valuation Methods
24:04 The Consequences of Overvaluation
26:57 Future of Startup Valuation
28:19 The Unintended Consequences of Market Innovations
29:58 Understanding Market Dynamics and Valuation Trends
32:17 The Role of Specialization in Economic Growth
36:34 Valuation Practices and Their Impact on Startups
39:01 The Spectrum of Company Valuations
42:00 Risk-Adjusted Returns and Investment Strategies
46:27 The Challenge of Systematization in Valuation
49:43 Market vs. Company: The Valuation Dilemma
Transcript
Dan Gray (00:01)
Welcome to episode three of the Equidam podcast, where we talk about startup valuation and early stage fundraising, a fascinating subject area for about seven people. I’m Dan Gray, Equidam’s head of marketing, and I’m here once again with Daniel Faloppa, our founder and CEO. Hi, Daniel.
Daniel Faloppa (00:17)
I do think that is interesting to more than seven people, but a very specific set of people for sure.
Dan Gray (00:26)
Yeah, absolutely. So I think this time, I think it would be interesting to talk about some of the fundamental drivers of valuation for venture capital, you know, particularly for startups and early stage companies. So we can at least for me, so I can better understand what it means for founders and obviously for any founders listening to this as well. And it’s going to mean, as with the previous episodes, you know, me asking some pretty basic questions and maybe playing devil’s advocate a bit.
If that sounds good.
Daniel Faloppa (00:58)
Awesome. Yeah, I mean, we can start on the general side on what do founders encounter, at least in terms of thinking from the VC side when talking about valuation, because there is… What we found out is that there is everything. The whole spectrum is there, right? From valuation doesn’t count and we just take in the…
like average of market values or like a complete random number or like the same valuation for everybody or to the extreme opposite, which is extremely detailed analysis and very scientific process and those things, right? I think like when you talk about, so the research that has been done actually says that like,
The majority of investors are not very scientific in their thinking and well, in their methods, but maybe they are scientific in their thinking, meaning that they do care about the right things. They do apply a premium and a discount, you know, according to like founder experience, the industry, like the usual things that people think about when thinking about valuation.
but they don’t express this in a scientific process where they conduct an actual evaluation or things like that. Again, that is the whole case is under the sun, so we’re talking about maybe like 40%, because then everybody else is very specific on either side of this spectrum. So that’s, think, the starting point.
And also it’s interesting because some of this research was done with our data as well. So it was super nice to see that there is a correlation between like important metrics for valuation and like this mental process that investors go through, but it’s not expressed a lot of the times it’s not expressed on paper.
Dan Gray (03:09)
Interesting. Yeah, that leads pretty nicely into the first question, which is basically, you know, before they get to that process of calibration, of, know, tweaking and tuning the valuation up and up or down, what is the primary kind of what’s what is it that they’re looking at most? Is it some objective value of the business that they then tune? Or are they looking primarily at like
comparable deals and you know, what’s the like market price for a company like that and then tuning that from there? Now, which one do they start with?
Daniel Faloppa (03:45)
It’s a good quest.
Dan Gray (03:46)
More often, I should say. We’re not treating it like
all VCs do the same thing.
Daniel Faloppa (03:50)
Yeah, so that’s the first thing, right? But the…
The way that it should be thought about is in a portfolio way for investors. They can only invest in startups that allow them a certain return. They already know that a certain percentage of the portfolio is going to fail. That means that they need to go after the companies that can drive those big returns. I also started to see investors that
Do think about this and do think about, maybe we position ourselves in a less risky way, so we have less companies failing, but then also we don’t need companies that go all the way to 100 billion IPO or something. We can invest in things that are more stable, less risky, and the portfolio return works out either way. So that’s how it should be done. I do feel like…
A lot of the times, the way that is thought about is more on their incentives. A VC fund, even if it’s a rolling fund, but let’s say a traditional VC fund raises capital, it needs to deploy it within two to four years in order for that capital to start gathering returns. Otherwise, the whole portfolio is not going to gather returns. Then what happens if those two to four years are at the top of the market and prices are…
and all companies are quote unquote, irrationally overvalued in the thought of that VC at the moment. They still have to deploy that capital to do their job. So I do feel a lot of… And the quantity of capital, we’ve been moving in the past 10 years to a point where the scarcity is on the ideas. So those ideas that are deemed to be…
deemed to be good make all investors become price takers more or less. then
So then the valuation approach is very much on multiples just because that’s something to justify to themselves, to the startup and to their investors that multiples is the wrong name, on comparables, on comparable deals on current market prices rather than on thinking about where the company can go and what kind of return can I make at this valuation.
Yeah, so I do feel that’s what actually ends up happening a lot of the time.
Dan Gray (06:41)
So how much of the price, like the valuation trends, know, the up in 2021 and the down right now, how much is that driven by simple kind of consensus of investors?
Daniel Faloppa (06:55)
That’s a good question. That’s a good question.
And also…
Dan Gray (07:03)
And maybe
if I can take that a little bit further, which maybe help you with an answer.
You know that I’ve asked a lot of people the simple question of like what drives this consensus? You know, what’s causing this because? Seeing the number of answers the most common is maybe like the the huge discrepancy between private company multiples and public market multiples And okay, I kind of understand that but if you’re looking at like a pre seed investment today that company’s not looking at
and not going to be exposed to public markets for six to 10 years or something before it potentially IPO. should there be pressure at that stage or why is there? It’s not clear to me.
Daniel Faloppa (07:49)
Yeah, exactly.
So what has changed? Right. So two things have changed. interest rates because of inflation and they’ve gone up and the future.
the future of the world, let’s say, right? Like the future potential of the world, like we’re all less optimistic, you know, because of everything that has happened and everything that is happening. And so that, you know, could decrease, let’s say, aggregated revenue and GDP and things like that. So the first thing is interest going up, right? So if interests go up, then basically the whole market adjusts because of arbitrage to
to match safe investments like state bonds and things like that, starts returning more capital, which means that everybody else also needs to return a higher percentage, to have a higher percentage of return. This translates for startups, if you cannot increase your future potential, which is generally relatively fixed because that’s the maximum that you can sustain as a story.
Then the only way to increase your return is to lower your valuation. So for an investor is kind of buy lower, sell at the same amount so that the return is higher. And so this has happened pretty much globally. And then a little bit of lack of optimism, lack of growth globally because of everything that has happened.
is happening, right? So those have brought down the value of like tech stocks by 50%, maximum 80 or so. I was actually reading yesterday, traditional companies are now back at an all time high. So it apparently hasn’t affected those as much. We’re coming out of COVID, which was definitely one in a lifetime, hopefully one in lifetime, but so far hasn’t happened. you know.
We don’t know what the consequences of that are. So for public stocks, how much of that change is hype versus non-hype versus actual physical differences of these companies is an interesting question. It’s a really interesting question. I mean, in my opinion, markets are fairly efficient.
And we, but again, we just came out of a very high inefficiency that very few people like predicted where everything was priced very highly. So yeah, so that’s already a question. And then the second step is how does that translate into prices of private companies, right? Because like what do interest rates and the global economy have to do with
the little startup that has 100 SMEs as customers of its new ERP little SaaS product. Does it affect its actual potential for an IPO or so? The IPO connection is the first one. It’s true that it’s expected to be six, seven years from now or 10 or whatever, but the best prediction of that multiple, of the price of that IPO…
Dan Gray (11:11)
much.
Daniel Faloppa (11:30)
is the current multiples unless you really think you know better than the market and you do a lot of your own research and stuff. So that’s why you have a little bit of a connection towards startups because startups are expected to do that IPO. That IPO is the exit value for VCs. The exit value for VCs determines today’s valuation, kind of. And in the middle of that, you also have…
the interest rate as well. So this idea that interest rates went up.
The problem that I have with this is how does this connect to multiples? Because multiples are calculated on today’s revenue, they’re calculated on today’s stock prices, and they are supposed to represent all this future 10 years discounted to today. Is there a rational explanation why the multiple was, let’s say 20…
six months ago and 10 today? I don’t think so. I think we shouldn’t have used multiples in either cases. then we would have a much more interesting view of what has actually happened. Has the hype gone down? Is the interest rate increase justifying this valuation decrease? Or are we speculating on the fact that this is the new norm for startup IPOs and it’s gonna be exactly the same as today in 10 years from now? So…
Yeah, I’m not giving many answers, I realize. It’s more like the basic theory behind this thing is this one. Finding out the practical percentage of what each factor contributes. Yeah, it’s not easy.
Dan Gray (13:07)
Yeah.
I have a little theory and you’ve been in the startup valuation world for more than 10 years. So you probably can shed a little bit of light on this or at least have a better understanding of it. My theory is multiples have like revenue multiples, especially have never made a lot of sense to me that they’re relied on so much because they seem to me to be very crude. So my kind of theory is that in the beginning,
They were used as a crude and quick way to compare similar companies’ valuations, like to benchmark valuations against each other, and particularly SaaS, know, like easy standard business models with subscription revenue, etc. Something like a revenue multiple, especially with software, because, you know, the costs are all going to be more or less the same. So it was like a way to compare valuations between similar companies.
But then at some point it became shorthand for valuation. Like people just started using revenue multiples to do valuation, which is probably not a good idea.
Daniel Faloppa (14:31)
Yeah, especially for private companies. So the multiple, right, is…
just a very crude comparative measure. So it basically, you base the value of what you are valuing on what other people have valued, whatever they were valuing. And that’s why it’s very quick. And in a lot of places, it has perfect usage. The pricing of a house per square meter, that’s a multiple.
pricing of, I don’t know, trained by the number of people that it can carry or something. That’s a multiple. So those things have a lot of sense because you can find good comparables. If you cannot find good comparables, then the multiple is completely useless and misleading. And the thing is that, as far as I know, in early stage startups, there aren’t
any good comparables because you don’t know the revenue that they’re doing or any other metric at an early stage. We’re talking pre-C to seed, maybe some series A, some series B. It’s very, very difficult to find companies that are similar of which you know the revenue or the EBDA or whatever you want to use for your multiple. And you know the valuation.
So if you look at, for example, Crunchbase, they have, I don’t know, half a million funding rounds in there. And then the ones with valuation are like 10,000 or something. So I’m not super sure about the exact numbers, but the percentage of rounds where valuation is known is very, very little. And even when it’s known, there were studies that the valuations are generally overstated, and they might not be the actual. Because I mean, this is all voluntary information.
It might not actually be true. And a study that people conducted in France with Chamber of Commerce data found out that the valuation, no, that the funding amount was overstated by 23 % on average. And that’s the number that we thought was certain. God knows about the valuation, right? Without thinking about like liquidation preferences, different conditions in the deal, all those types of things. you know, I think we, like we would…
Dan Gray (16:54)
Yeah.
Daniel Faloppa (17:06)
also make better usage of multiples and include the multiple method that everybody’s talking about if there was data enough to use it, right? So the best that you do, that people do right now with multiples, let’s say it’s for public companies, right? For public companies, you find like 10 to 12 really, really good comparables that are in the same industry that do roughly the same thing.
you then look into their financials, you remove stuff that is not the same, like differences in accounting, you try to remove departments that are not the same, you try to make the companies as similar as possible. Then you take their precise stock price and their stock conditions are all the same because they’re public companies, so if they are listed, they need to have common stock and the normal things. And that’s how you get to a multiple, and that generally has a range.
So that generally has a range which is 20%. So that’s also not a great indicator. So this is the best thing that you can do with multiples. You start removing the public company, the public data, the same in that accounting, the analysis that you do, and the availability of actual reliable anything, and you remove the whole utility of the multiple for me. That’s just the… And then…
You see it because you see this blog post that tries to reference a multipost. They say, yeah, a SaaS company active in healthcare has a multiple between 5 and 15, which is roughly true, but it’s not very useful. Yeah, again, 515 random numbers. I’m not sure about the multiples on that.
Dan Gray (18:54)
Mm-hmm.
Daniel Faloppa (19:02)
So, yeah, so that’s the problem that I have with it. And a lot of the times it’s used as an excuse. That’s the other thing, like multiples, they increase as your perspective growth increases, right? Because if you have, let’s say, let’s take three companies that have a million in revenue right now, but the three of them have wildly different futures, right? One is going to be the next Amazon.
One is going to fail and one is going to remain the same, let’s say. The one that is growing the most has to have the highest multiple because it’s going to have the highest valuation and the multiple is valuation divided by whatever, revenue in this case. Then, what people don’t extrapolate from this is that the earlier the startup, the faster it grows.
Dan Gray (19:49)
Mm-hmm.
Daniel Faloppa (20:01)
Generally, that’s just because it’s easier to grow a smaller thing. So what it means is that the multiple changes according to the stage, you cannot apply the multiple of a public company that trades at 3X revenue to a startup that has… The public company has been growing 2 % a year inflation rate for the past 20 years, and the startup is forecasted to explode.
and you use the same multiple, right? So I think it’s also used a lot because it brings down valuations for early stage companies. Because there is no data on companies in the same stage, right? So then people refer to companies generally at a later stage because the later you go, the more data there is. So then you take data of…
Dan Gray (20:40)
Mm-hmm.
Daniel Faloppa (20:56)
larger companies, public companies, series B when you are valuing a seed. And that multiple is not the correct one, just by definition, is not the correct one because you’re not comparing companies with the same growth potential in the future. So yeah, that’s a long explanation on that.
Dan Gray (21:16)
And
you know all of that makes sense to me and it sounds Makes multiple sound, you know a lot sketchier than perhaps I’ve thought before But it’s still you know, they’re they’re relied on so much
Daniel Faloppa (21:32)
Yeah, and we use them as well. That’s the other thing, right? So you really cannot do without. They’re relied so much because every method is limited, and at least it gives you a different limitation compared to a discounted cash flow compared to, let’s say, a scorecard or checklist method. It gives you a different limitation, so it allows you hopefully to see…
Dan Gray (21:35)
Mm-hmm.
Daniel Faloppa (22:00)
So it’s more connected to the current public market or the current market in general. And that’s an angle that you don’t have, like let’s say, in a Berkuss or in a DCF. But it doesn’t have… The thing is, it shouldn’t have as much credit, maybe, as it has.
It shouldn’t be the only method for sure.
Dan Gray (22:31)
Yeah, the way I think about it personally is in the context of the way we do valuation. It’s the method that kind of adds that market perspective, which I think is important. And, know, it’s it’s one of one of a few perspectives you can use for valuation. It’s quite a valuable one. In our case, you know, it’s it’s used in two out of the five, I suppose. Whereas from a
Daniel Faloppa (22:51)
Yeah.
Dan Gray (23:00)
of traditional VC point of view, they seem to have much more reliance on what the market’s doing. That seems to be much more of a driver evaluation.
Daniel Faloppa (23:12)
Yeah, I mean, I do think, you know, like I spoke with a lot of investors that said like, we cannot do anything better than this. They would be interested, but like, of course, they don’t have a 20 people research department or, you know, so hopefully we can do something in that area as well to really try to get people to think about effective returns and like…
portfolio returns and those things in a better way.
Dan Gray (23:47)
Yeah, and that, you know, on the whole, maybe my slightly cynical take on all this is that a crude method like multiples basically means that the person doing the evaluation can kind of like, manipulate it a little bit up or down to their purposes, you know, possibly but but there’s there’s an interesting case I was reading about recently, which is where this kind of crude or you know, the way that
Daniel Faloppa (24:04)
Yeah.
Dan Gray (24:15)
rely on comparables, of compounds, trans and so on the way that actually starts to hurt investors, which is say you invested in a company in 2020 in like the seed round, and then say it had a series a in 2021 that you didn’t participate in. And because of the you know, the market at the time, the other you know, the new lead investor, whoever gave it a
crazy high valuation. And then that then collapses in 2022. And you have, know, you’ve had this this kind of reporting history with your LPs of saying we made this investment. And then the next year we say, Yay, it’s up, you know, however many percent it’s doing incredibly well. And then you have to go back to them afterwards the year after and say, Oh, it’s sorry, it’s collapsed, you know, it didn’t hold up. So like the kind of conversation there was whether there’s an argument for
early stage investors to use. Whether or not they rely on comparables when they make the deal is one question, but certainly for markups in the future, should they look at a method that’s kind of more of an objective individual perspective on the company itself?
Daniel Faloppa (25:31)
That’s a good question. Yeah, because the thing is, for me, startups are going to raise at the highest valuation that they can. It’s less dilution for everybody involved. have almost all the incentives to do that. Yeah, of course, you have the problems of pinning stock options and things at the higher valuation that could lower morale afterwards. You have, if you look at research, you also have…
moral hazard, like startups that raise a lot of money without the need for it, end up burning it and burning themselves in the process. But for investors, the question is, if you don’t do that well, then your portfolio is not going to have the return that it needs to have. then, yeah, 10 years from now, you’re going to be out of a job.
the… I don’t know, mean, on the reporting, you know? Like, yeah, I think it should be more rational throughout, not necessarily only for the reporting, mostly for their own returns. You know, for the rest, like, the overvaluation and, people buying on overvaluation is… Until it becomes a scam, right? You have some theories, like, on the art market and…
some places where, for example, criminality brought up the price of housing so much. then it becomes, first, it becomes a Ponzi scheme. Like you just invest to raise more afterwards and use that money to attract more investment. So that’s not good. And second, you might have real world consequences of like, yeah, fraud or even just people not…
in the case of housing, people that cannot afford housing just because there’s, you know, criminals speculating on the price of apartments. And this is a real, like, well, not with criminals, but in general, like, I think if you see the vast majority of apartments in the super expensive high-rises in New York is empty.
Dan Gray (27:33)
You
Daniel Faloppa (27:49)
because it’s just bought by investment funds that are just looking to resell it in a few years. So that’s a real issue. don’t The same thing on startups. mean, it’s definitely that we’re going to burn capital on the wrong things and waste a lot of energy and time and returns and talent on the wrong things.
Dan Gray (27:53)
Mm-hmm.
Daniel Faloppa (28:19)
if we don’t try to consider these things in the better way.
Dan Gray (28:25)
A bit of a strange tangent, but that the apartments in New York reminded me of something I saw the other day. Someone came up with a mock up for what’s the restaurant booking app? It’s like open table or something. But basically they created a mock up where it allowed it allowed people to sell their bookings like a secondary market for bookings. And I thought, you know, OK, clever idea. But do you have any idea what you’re going to do to to restaurant bookings like
Daniel Faloppa (28:39)
Yeah.
Uh-huh.
Dan Gray (28:55)
when you create this financial market for them, it’s going to have a lot of weird unintended consequences.
Daniel Faloppa (29:01)
Yeah, it’s like that person that was buying futures on cows and then they forgot to sell them and then they got the cows at home. like a hundred cows delivered at home because they bought futures. then, yeah, like it creates a detachment from the actual consequences. then, OK, but you see this happening. I mean, it’s a market, right? The nice thing is that.
Dan Gray (29:07)
Hahaha
You
Daniel Faloppa (29:28)
Like a lot of people think about finance and economics and economic theory as sort of like applied business sense or applied intuition or something like that. But there are some behaviors that apply to all markets that lower the benefits for everybody, for everyone involved, including the person making the market. it’s very interesting. There is the…
economy of Eve online is super interesting. they do actual wars between corporations to conquer control of assets. you know, I mean, that’s it’s not that far from what would happen in the actual market if there wasn’t law preventing it,
Dan Gray (30:22)
That’s true. I know a
couple of academics who have done studies in like solely on the economy of Eve online. And yeah, it’s it’s fascinating. I could read about it endlessly and the politics as well. It’s a funny world. I got one more question on kind of valuation trends. And it connects a little bit with what you were saying before about how, you know, maybe VCs have like a scientifically minded, but not so much in their practices.
And it relates to like, why markets go up when they do and why they go down when they do. So like the up is kind of easy to explain, I think. More competition for deals, you know, more capital, the competition for deals drives prices up like it’s pretty straightforward. But on the downside, okay, so like maybe this this little downturn was triggered by the interest rates and so on. But like at some point, venture capitalists
some weird monolithic group which doesn’t exist but at some point like they had to all start agreeing that prices were coming down or you know, there must have been some trigger because if they all if they Primarily or commonly look at comparable deals for pricing You know, it’s only going to start to move when there’s some kind of momentum or trigger, I guess
Daniel Faloppa (31:44)
Yeah, I mean…
I don’t know. It’s the invisible hand, right? It’s the invisible hand of the market. I mean, unless we want to buy into many conspiracies. I don’t think. think the smart people, that’s what we saw, at least in our data, right? We saw very good results in.
Dan Gray (31:54)
Mm-hmm.
Daniel Faloppa (32:17)
like up until October last year, right? And then like it really stopped basically, right? So it feels like, and generally from what we see is the smarter like entrepreneurs and investors are the ones seeing these things early and then sort of everybody else follows, right? We’ll see if they’re smart in the end because if everything changes in like three months again, right?
Then it’s the opposite of smart. But I think that’s how these things progress. You have the first people that are either the first to be right or the first to be very wrong, depending on what happens with the trend afterwards. And they are kind the first movers and then they are followed and followed by more and more of the market until the whole thing.
goes down. So that’s kind of like the sort of the price discovery movement. Tangential to that is the idea of like, why do prices go up at all? Right? So like, if you take the word, right, and you say, okay, there is a limited supply, let’s say that there is like, limited supply, same resources, same population, same amount of money.
Why would prices go up? If you produce more money, because the money supply is governed, so you have people deciding how much money to print, If you print a lot of it, then its value is going go down, it’s going to become cheaper money. Then the same can of Coke is going to cost more money. It’s going to cost 10 euros instead of five, let’s say.
But that’s kind of artificial. Let’s say that that’s stable or like that they are good enough at… Well, let’s say that it’s stable, right? Why would the…
Like, why does the economy grow? Why does stuff in aggregate go up? And the interesting thing is that that’s because of specialization, by and large. If you keep the population the same, the amount of work that we can do is the same. So the amount of goods and services and value that we can create for each other, because this is all manmade. It’s a colony of ants that is just trading stuff within itself.
Dan Gray (34:51)
Mm-hmm.
Daniel Faloppa (34:58)
the whole economic value is the amount of trades, which is really funny, right? So one way is that we produce more, so we become more productive. So our productivity per unit of time per person is increasing, and that’s generally done with specialization. technology becomes part of that because it helps us.
specialize, we outsource jobs to it, we make better tools for ourselves. The second way is that we just trade faster. So that’s the other thing, that’s the opposite of the right to repair movement kind of pitch, right? That we just make the machine spin faster. And yeah, for me, that’s not the good growth, let’s say.
Dan Gray (35:41)
Yeah.
Daniel Faloppa (35:53)
super hard now to differentiate the two because GDP measures commerce, measures both at the same time. But yeah, but that’s interesting. So even if everything else would be equal, even if we wouldn’t make the wheel spin faster, the world economy would still grow in a sense. We would still have more benefits, more value to each of us because of this, which is pretty nice, I think.
Dan Gray (36:24)
True and interesting, but how like can you connect that back to the the startup valuation question? Like why why do why should valuations go up or not?
Daniel Faloppa (36:34)
Well, yeah, and that’s why I started to think about this whole thing because I was like, okay, when we calculate valuation and we help a company raise capital, is it just spinning the wheel faster? What if we start making valuation ubiquitous for everybody super, super easily and super cheap?
are we just making the machine spin faster? Are we going to be able to do a funding round every month or every week because valuation is so easy and you can ask for money on demand? And would that be a good thing or not? That’s why I started to think about it because if it just makes the machine spin faster, then I don’t think it’s good thing. But if it actually allows people to specialize even more,
and it can, right? Then it’s an interesting thing. So that’s why I started thinking about it. But the other thing is like, okay, the final ultimate thing that we measure with valuation is some sort of a societal agreed upon benefit that this company provides to the app.
probably humanity, if not even larger, like nature or the earth or something like that. So then, how can valuations in aggregate of the whole world grow? Again, we are a colony of ants in the little bowl of a planet playing with ourselves. So why does valuation grow? And it grows because of this, because we are able to produce more value
thanks to increasing productivity, thanks to specialization, which, yeah, I think is pretty interesting.
Dan Gray (38:32)
interesting. It also makes me wonder if there’s a question of, you know, in a a world where valuation is is very rough, you get kind of a let’s say if you can put companies on a spectrum of like useless and has no future to like, you know, the best company in the world that’s going to grow like crazy. There’s the capital is going to be on much more of a spectrum within that.
where the better valuation gets as a practice, the more the money is going to be concentrated towards the higher end of that, and the companies towards the bottom are just going to fail and fall out of existence. So what does that do to valuation trends as well?
Daniel Faloppa (39:15)
I think it’s isn’t the opposite. No, like if we we manage to price everything right, that’s you know, I was thinking about this. So the the chicken thighs are cheaper than the breasts. So in Italy, nobody likes chicken like to eat chicken, you know, unless you do crazy recipes. Right. But but but breast is like the the the better part, you know, and that’s why it costs more.
So in a sense, a chicken always has two breasts and two thighs. They tried to make the four legged chicken, but they didn’t manage, luckily. So they always have to sell the whole thing, right? So that’s why…
legs become cheaper, right? Because less people like them, but they still need to sell them. So they become cheaper up to the point where they have the same production. They need to produce the same amount of legs and breasts, right? And I think with better valuation, we can do the same. It sounds like a bad analogy. But if you know…
If you have the startup that has little risk and that wants to be stable and doesn’t, or maybe it serves a niche that is not a two trillion market need or something, and it knows it and it knows about its valuation in a better way, it doesn’t think that it has the same valuation as Facebook, then there is a space to fund it, there is a space to make proper returns from it and…
And the same goes for investors. If you have one lens, you’re only going to see one color, let’s say. So if you start to understand that different risks, like what I saying before about these investors with a less risky portfolio at early stage, because the environment is changing. You don’t have any more massive network effects, first crazy first mover advantages,
network only in the Silicon Valley of incredible talent. You have a much, much wider approach to digital startups. If you start using all the colors and if you start thinking, this startup has less risk, I can invest in it, I’m going to expect a different return, but it’s going to be fine. can still make an alpha. can still make a good risk-adjusted return.
then I think we can invest in a lot more startups, first of all. And second, well, not second, but this needs to be in the whole chain. It cannot be only the investor. needs to be the startup, needs to be the investor, and it needs to be the investors’ investors that need to understand this. Because if a VC portfolio has three, four, five classes of risks, this needs to be agreed.
above, let’s say, and approved and interesting, because that’s also why VCs are after these type of startups is because their own investors are after these types of returns. I think that’s actually a huge thing for the future of investment, like these other types of companies. There are also things that are more risky, like games and movies and…
Well, maybe crypto has a bit of everything. And there is no VC for those. are production studios, there are other things, but maybe the same way that public money went into startups, maybe some startup money should go into those things and see how it does. So, yeah.
Dan Gray (43:17)
Mm-hmm.
I guess if there’s a change in that
it has to be led by the VCs because the kind of VC power law that dictates what you need to be able to provide in terms of returns, like a VC could say we’re going to make this adjustment and focus on slightly less risky companies, but therefore have decent returns from more of our portfolio companies in return.
and give LPs the same return they were getting before just with a different structure underneath. like for the LPs, like they could be okay with it. The problem is that the people raising capital can’t give them that story at the moment because VCs just won’t accept it. So it has to start there.
Daniel Faloppa (44:05)
No.
Yeah. Yeah. We got to that story in biotech, right? Biotech for the largest number of years was very, very difficult to invest in because everybody was expecting like sort of digital startup type of growth and returns and biotech has other economics or better said, startups like either biotech startups were undervalued or digital startups were overvalued.
Right. So the valuations didn’t match. And so the returns and the risks didn’t match. But in that case, I think A16Z started a different fund, which was focused on biotech. And they really started with this premise of, yeah, the returns are going to be different. The business models are different. The risk profiles are different. But there’s nobody investing in this thing. We can still make a risk adjusted return.
But of course, not everybody’s A16Z and then that pitch didn’t work for a lot of other people, I think, to the point that in Europe, there were several initiatives to try to pull resources together to keep the best biotech startups in Europe, because the moment they needed more than 50 million or something, they had to go in the US or mostly to the US to raise that follow on round, because there was not enough
capital in Europe for them.
Dan Gray (45:37)
Interesting. Yeah. And on the kind of mid risk companies, which we talked about a bit more in the last episode as well. I do know there is there’s calm fund, which is led by Tyler Tringus. And he he shares a lot on Twitter about this as well. This kind of topic, the opportunity of lower risk companies is that he’s quite an interesting fellow.
Daniel Faloppa (45:57)
Nice, yeah.
Yeah, because that’s the other thing. If we only talk about return and if we’re only after the Facebook crazy rise, we’re not talking about the right thing. What we should be talking about is risk-adjusted return. in finance, you can increase your risk just by leveraging.
Dan Gray (46:18)
Mm-hmm.
Daniel Faloppa (46:27)
Right, so if you want, so if something is not returning enough, but you really like conglomerates or something, you can just leverage 80 to one and then buy conglomerate shares and you’re gonna have like invested in conglomerates, but at your level of risk, at your preferred level of risk. So that can be sort of…
Dan Gray (46:51)
Mm-hmm.
Daniel Faloppa (46:56)
engineered out, let’s say. And then what we end up talking about is risk adjusted return. Risk adjusted return, like you normally find it in things that are under looked, right? And that’s why I think this idea of like these startups that nobody’s looking at because they don’t fit the mold could potentially be financially very sound because it’s risk adjusted return is
Dan Gray (46:57)
Mm-hmm.
Daniel Faloppa (47:25)
is interesting because nobody’s investing in those things. And that’s probably what A16Z pitched on the BioTech Fund. And then if you don’t like that type of return, then just leverage and get to whatever return you want on that side. So yeah, that’s very interesting topic as well. And that’s also where a little bit more like…
sophistication on these things could really change the industry, I think. Yeah.
Dan Gray (48:02)
Sophistication definitely seems to be lacking in some of the practices, at least from our perspective, perhaps.
Daniel Faloppa (48:11)
I mean, it’s a difficult thing to do, right? Because like a large mutual fund or something has the incentives to have a large staff to have different types of expertise in there. And they have the financial, they have the business side, they have maybe the industry expert and all those types of things. For small investors, yeah, you have to kind of know all these things in one person. And that’s maybe not the easiest.
Dan Gray (48:40)
And also I
imagine the kind of benefits that you get out of systematization or building a more rational approach to valuation, for example, which may not produce better returns in any short period of time. You’re only going to see that the kind of feedback window for a VC is already like 10 years. So you say, if you’re more rational,
know, maybe in 20 years, your fund will really start seeing the benefit of this. It’s a tough sell.
Daniel Faloppa (49:16)
It
is, it really is.
Dan Gray (49:19)
Interesting. Well, I have one last question, which is kind of a wrap up to most of this. And it’s like, do you have a feeling maybe in terms of like a percentage or a split, like how much valuation today for venture capitalists specifically early stage, like how much is it based on the market and how much is it based on the company?
And this is not like what you think it should be, this is more like, you know, what do think it is in reality?
Daniel Faloppa (49:52)
I think it’s like 70 % mark.
Dan Gray (49:56)
And what do you think it should be?
Daniel Faloppa (49:58)
It’s.
Dan Gray (50:01)
The obvious answer is like, know, 50-50 or something. It should be rational. Maybe it’s less. Maybe it should be 60 % on the specifics of the company if you can measure it well, and then like 40 % calibration or something.
Daniel Faloppa (50:17)
Yeah, it’s a good question. It’s a good question. Like, because of what we do, I think I have a bias towards like the specificity of the company. And then maybe I would look too much at the company and not, you know, and not enough at the market itself. I think it should be more towards like 50-50, maybe 40-40 market 60 company. If you want to…
if you want to really pick. Maybe that’s the other thing, right? Market is faster, company takes more time, right? So it depends a bit maybe on the strategy of the specific investor, like how much time they want to dedicate to really picking the top companies rather than picking, like for example, more companies like spray and pray type of approaches. But for me, I think, you know…
the effectiveness would be on really picking better and paying better per company, like paying more rationally per company. And then also, I think the large, large opportunity is on like portfolio analysis and truly thinking, because that’s the really difficult thing. Like if you would have like held on investing for the last two years,
and you had all the capital to deploy right now instead of deploying it over the past two years, that would have been the move. That part is, I think, where also there could be a lot of gain for investors.
Dan Gray (52:03)
Yeah, makes sense. know, old sayings about timing the market and how difficult that is, etc.
Daniel Faloppa (52:10)
Oh, yeah, yeah, for sure. Otherwise,
wouldn’t be here. If we were 100 % correct in timing the market, maybe we would be doing something else.
Dan Gray (52:21)
Yeah,
but yeah, as a kind of little summary to round that out, know, maybe that’s a good way of describing what we do specifically is helping solve that problem of evaluation, understanding the specific scenario of the company. You know, that’s the hard part. We have the market aspect too, but the main challenge is the company itself and getting a read on the…
objective value or rational value or fair value, whatever you want to call it.
Daniel Faloppa (52:51)
Yeah.
Yeah, I think, yeah, like what we do very well is to do that quickly, right? So even if you are like that investor that prefers to like do stuff quickly, look at the market only and stuff, if we manage to make the other side very quick, then does it add value? Like that’s the assumption that it adds value if you can do it quickly.
Dan Gray (52:58)
Mm-hmm.
Interesting. maybe that’s something we can explore more in the next episode, whenever that’s going to be. But for now, it’s been good. Thanks, Daniel.
Daniel Faloppa (53:32)
Thanks Dan, always awesome.
Dan Gray (53:34)
Alright, talk soon.