What if I told you that I had a business that built machines that were designed to miraculously transform sums of money into greater sums of money? You put money in one end and more money comes out the other end. Amazing!

Being the business person that you are, of course you ask to see the machines and want to understand more about what the inputs and outputs are. And being the business person that I am, I want to sell you the machines at the highest price possible. So, I take you into a room and show you three of my Money Alchemy machines:

Machine #1: Capable of ingesting a single dollar bill and transforming it into a single quarter every year forever

Machine #2: Capable of ingesting 100 dollar bills a day and producing 100 quarters every year forever

Machine #3: Capable of ingesting 1,000 dollar bills a day and producing 2,000 quarters every year forever, but due to the workload, the machine has a 10% chance every year of breaking down completely with no ability to fix it

How much are these machines worth? The first machine is amazing and produces a predictable and valuable stream of cash flows but due to capacity issues it’s not that interesting. I might not even want to buy it because it isn’t worth the hassle to produce a dollar every four years.

The second machine is slightly more interesting because it can put more than $1 to work. $36,500 a year to be precise. By feeding the machine every day I recoup my daily investment every 4 years and generate a 2X return in 8 years, a 3X return in 12 years, etc. It’s a very solid annuity, but sadly it also suffers from scale issues because it would take a very long time for the annuity to build into anything truly interesting. And, it would require many years of putting dollars into the machine before more money is coming out than was putting in.

The third machine is much more interesting because it has the capacity to put $365,000 to work every year. It also has much faster paybacks and better returns given it produces twice as many quarters per dollar as the other machines. But, it could break down and if it does, the money train goes away completely.

Which do you buy?  How much are you willing to pay?  Is the third machine worth the risk?

While you’re thinking about the machines you’ve just seen, you spot a half-completed fourth machine in the corner that has parts hanging off it loosely and diagrams in front of it that also don’t look quite finished. I tell you it’s a prototype for a new machine that if we can get it working will blow away the other machines. I show you the prototype for Machine #4.

Machine #4: Needs to be fed $100MM and in 5-years will spit out $1B

This is the machine you want! You know specific Investors who are capable of putting $100MM to work if they knew it would produce $1B in 5-years because the output is more than 3X their return expectation.  It means you can afford to pay a lot for the machine!

The only problem is that the machine isn’t ready yet and there’s a chance it will never be ready. And to make matters more complicated, the only way you know if it works is to put the money in and watch the manufacturing process unfold. The machine might need to be tuned up many times over the next few years until it’s working perfectly, and this might require additional investment in Engineers that doesn’t come with any tangible return. And it might perform better or worse than anticipated and there’s no way of knowing until the machine is ready. Lots of unknowns!

The operative question is: What are you willing to pay for this machine? This is a question we deal with every day in the world of Venture Capital, but to overstate an observation, the sad truth is that many Venture Capitalists aren’t disciplined when answering this question.  And in a competitive market, this is a real problem for the asset class.

What’s universally true is that every credible Entrepreneur paints a picture of a massive problem that their business can solve and their vision is almost always accompanied by an Excel spreadsheet that lays out how a very attractive money machine is created as a result. What’s also universally true is that the spreadsheet is full of assumptions that are initially loosely grounded and subsequently firmed up based on the stage of the business and their in-market experiences. And it’s also universally true that the variance inherent in the major assumptions is so significant that there’s a very high probability that instead of creating a money making machine, the resulting machine burns cash.

Because there are so many unknowns in building the money making machine, a disciplined Investor would stage their investment and hold the Entrepreneur accountable to answer the question: “How much can you learn for how much money?” And every time something is “learned” by the Entrepreneur, it should reduce the variance of what the final money making machine is going to look like.

To be clear, reducing variance doesn’t always mean de-risking the business. Nor does it mean that the business is more valuable after putting the money to work than it was beforehand. Just because a business has more customers or more revenue than it did a year previous doesn’t imply the business is worth more.

And IMHO this is precisely where things have broken down in the Venture Capital community recently. When we value companies we need to internalize that until a company is of sufficient scale that another entity wants to buy them (at which point we can actually value the company), we’re investing in the option value of the destination, not the traction of today. Today’s traction is merely shorthand proof for what the the company has learned in the market. And today’s traction provides inputs to the company’s forward looking forecast so that it’s grounded using real world experience.

But traction doesn’t directly equate to the value of the option for investing into a “still being figured out business”. The learnings of that traction are important and need to be examined in depth, and only after they’re understood at the atomic level do the high level metrics matter.

For instance, I can’t tell you how many Seed stage companies have been given the bad advice that getting to a $1MM ARR equates to product market fit. So many of these early stage companies growth hack their way into their first revenue and in many cases, the way they scale to $1MM ARR has nothing to do with what they’ll need to do to scale to $10MM ARR. The company might learn how hand-picked customers behave and they might learn if their product is buggy or is working the way they intend it to. But, because they impatiently want to show instant growth, they don’t take the time to learn about putting money to work in scaleable marketing channels or how general market customers behave. If a second company showed up with $250K of ARR and evidence that they could put a significant amount of money to work with great returns in very deep and scalable channels, it should be more valuable than the first company. But sadly many members of the Venture Community are agreeing less and less with this theory.  The view I’ve heard over and over is that team and momentum matter more than business model and forecasts.

And what’s emerging more and more in the Venture world is a class of company that’s structured to burn cash to grow without having very defined theories for how money is made.  It’s like they’re building a money making machine but concentrating on the packaging and lights and branding before figuring out how it actually makes money.  Investors don’t seem to be correlating the valuation or additional investments to the option value of the destination. Every time money is raised the valuation of these companies seems to grow by 2-3X when it’s unclear the combination of the intrinsic value of the company plus the option value of the destination is 2-3X greater than it was when the last money was invested in the company.

For instance, I spent time with a hot company that’s been very successful at raising money every 18 months at 2-3X its previous valuation. Every time they raised they pointed to additional market penetration and a 2X revenue growth rate. Today the company is “valued” at close to $1B at an extremely healthy multiple of revenue. How do you know if $1B is the right price to pay?  It’s obvious that they’ve built something of value, but it’s also clear that the intrinsic value of the business is much less than $1B because no strategic buyer would touch them at a fraction of this price.  This means that the vast majority of the $1B valuation has to be attributed to the option value of the destination.  And to generate a mediocre Venture Return, the company will need to be worth $3B+ when it’s bought or taken public.

Digging in deeper, the company has grown nicely and the team is amazing at shipping code that their customers like.  But the value of the company is unclear because today they have about 30% market-share in their core business and are still burning cash at an alarming rate.  How much more market-share can they capture?  When does the cash burn end? What will it take for them to turn a profit?  Is the profit enough to describe a $3B+ business?  Can the business really make $100-$200MM+ in earnings with the money they’ve raised?  These are all important questions to answer, but what’s clear is that the variance on the destination for their core business has been reduced which means the Option value of their core offering is easier to understand than in the past.  And when I look at the Option value relative to the maturity and results of the Core business it’s not attractive at all.

What’s not surprising is that the company has made the case to Investors that their near term expansion opportunities more than justify their valuation even though the core business isn’t interesting except as a low/zero margin wedge.  And Investors seem more than willing to value the Option on expansion opportunities at multiples of what an Option was worth when the core business was younger and their model described a much more attractive business than the one that actually materialized!

To be clear, I’m not saying that I’m right and that they’re wrong. What I am saying is that I talked to a few of the Venture Capitalists that invested in this company and they didn’t think of their investment in this way. They valued the company based on its customer and revenue growth rates as well as the dilution that Founders would take based on their requested funding amount.  They also pointed to the value of having a Preferred Security at the top of the stack which in their minds protects their downside (which is a topic for another day).  Maybe this is a great strategy because the team has proven that they can execute which implies there’s a higher probability they can execute against their expansion plans than there was when they were smaller. But maybe it means that the risk/return profile at this valuation isn’t a good one.

Investing at a $1B valuation should require an Entrepreneur to define how their business becomes a $3B+ business with high odds or a $5-$10B business with lower odds.  And this requires defining what the money machine looks like that would make a strategic buyer or public markets Investor buy the machine for this amount.  Otherwise, an Investor risks investing in a great team that builds a really pretty machine that’s great at burning money.

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