Poor Valuation Practices Have Slowed Innovation

Consider a simple truth: Professional investing requires understanding value. If you cannot understand the value of an asset, and how it appreciates over time, you will not invest in it.

At one point in time, this understanding was the “moat” for venture capital firms. Those that could see value where others couldn’t were able to make decisions that resulted in outsized returns. Consider the investors who recognized the potential for online marketplaces in 1997, the space industry in 2002, or crypto in 2012.

Over the past decade there has been such an incredible boom in software investment that it has completely distorted how venture capital operates and understands the world. Everything is now looked at through the lens of SaaS-style ARR multiples and growth rates. Many of today’s venture capitalists have not been around long enough to remember another environment.

This has recalibrated the whole asset class toward massive scalability and away from fundamentally innovative ideas like the semiconductor revolution that formed Silicon Valley.

The SaaS ‘Boom Loop’

When your income as a VC relies primarily on management fees, your incentive is to raise and deploy capital as quickly as possible, and to maximize funds raised and fee income. In the past, this was throttled by businesses that could only put a certain amount of money to work in a practical manner. Acquisition took time and scaling took effort.

SaaS blew this ceiling out with a model where capital could be fed into growth through online advertising for platforms that were essentially infinitely scalable. The more money you put in, the faster the company grows, the better the investment looks, and the easier it is to raise another fund. It created a “virtuous loop” for VCs that enabled the growth of the mega funds we’re familiar with today.

The enthusiasm for this incredible growth, and the wealth it created, started to reshape practices. Perhaps the worst example of this is how crude ARR multiples became the default valuation method as SaaS solutions were effectively commoditized. The priority was closing deals quickly, not optimizing the price, so discipline fell by the wayside. This would fundamentally change how VCs understood value.

Unintended consequences

Not only did the public markets not care for this era of investing (post-IPO investors care more about EBITDA or cash flow than ARR), but it also made life much more difficult for deep tech startups. Consider these two points:

• The goal of a VC is to make investments that triple or quadruple in value in two to three years.
• VCs understand increases in value primarily through the lens of ARR multiples.

So how does a company that spends years just in R&D or building the product look in this environment? They can’t demonstrate progress in revenue, so they don’t obviously increase in value in the short-term. This makes them unattractive for venture investors, despite the fact they tend to have much stronger and sustainable competitive moats and marginality, leading to a smoother path to exit.

All of this is a clear reflection of how venture capital has gone from “patient capital” creating lasting value, to a short-term trader mentality of riding volatility.

Fixing either one of these factors would help to put VC back on the right path, but changing the fundamental management fee incentive is going to take an immense, foundational shift. Restoring financial discipline to VC, and taking a more sophisticated approach to valuation, may be a more accessible short-term solution.

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.

Illustration: Dom Guzman