The exuberant decade, from 2011 to 2021, was marked by all kinds of incoherence in venture capital. Practices to increase capital velocity and fee income were disguised as good practices for generating returns, separating unwitting LPs from their money.
Today, the divergence of fee-driven asset managers and performance-driven venture capitalists is clearer, but there are many lessons to unlearn.
Founders are also having to ditch a lot of the “common wisdom” from that period. It was common to hear greener GPs sneer at the utility of financial projections, or repeat trite soundbites like “only market passing prices matter.”
These talking points were unfortunate symptoms of venture capital’s decline, not useful input for founders. Indeed, founders need projections to determine fundraising strategy, and “market passing” prices only make sense in markets with real price discovery.
Where’s the value?
Valuation is an obvious problem to highlight as a consequence of this environment. We’ve seen in recent years how an over reliance on market-based pricing helped create the bubble that burst in 2022 while also failing entrepreneurs with truly novel solutions. It is more important than ever for venture capitalists to develop an independent lens on value in order to recognize opportunities that offer more upside than consensus themes.
Beneath this is a simpler question of financial literacy. Specifically, the ability to coherently connect stories and numbers — the narrative exposition in a pitch, and the financials that translate economic energy. This is where “value” lies, not in crude comparisons to roughly similar startups.
- Is there a sustainable competitive advantage, and how does that influence margins?
- How quickly can acquisition be scaled, and what is that likely to cost?
- What will drive customer loyalty, and what is the anticipated churn?
This basic probing of assumptions is useful to understand any pitch, and worth reflecting on from both sides of the table.
At a fundamental level, the value of any cash-generating asset is the discounted value of all future cash flow. This doesn’t require an MBA and you don’t need to build a complex DCF model in Excel. It’s a framework to think about valuation — a perspective on the scenario that lets you peer into the future.
Is there inherent uncertainty and the potential for unforeseen problems? Of course, but you might as well rule out the foreseeable problems first.
“The value of an asset that produces cash is the present value of the cash flows it generates over its life. Few investors explicitly use a DCF model all the time, but it is useful to keep the drivers of the model in mind constantly.” — Michael J. Mauboussin and Dan Callahan in “Everything is a DCF Model”
Today, there are hundreds of private unicorns that can’t land a good exit because they spent their lives being marked up with revenue multiples that offer no insight on financial health. It’s an issue that has been discussed for almost a decade, but there was little incentive to correct that as long as the money kept rolling in.
Indeed, now we know what happens when the money stops: everyone suffers. You can’t fuel growth with negative unit economics, you can’t prop up otherwise unworkable businesses, and the buyers at the end of the chain (public markets and corporate acquirers) can always spend elsewhere.
For a while it seemed like the job of venture capital was to raise funds and accelerate fee income. Many investors needed reminding of their fiduciary duty: delivering maximal returns to LPs. That speaks to a need for professionalization, encouraging some basic standards in finance and economic theory across the industry.
Dan Gray, a frequent guest author for Crunchbase News, is the head of insights at Equidam, a platform for startup valuation, and a venture partner at Social Impact Capital.
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Illustration: Dom Guzman
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