The Peculiar Economics of Silicon Valley

This is the Chapter 21 of my e-book Silicon Valley for Foreigners, that can be downloaded for free on www.siliconvalleybook.com or purchased for $2.99 on the iBookStore and Kindle. A new chapter will be posted on this blog every week.

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Most CEOs and entrepreneurs from brick and mortar businesses do not understand how Silicon Valley economics work. The high startup valuations are probably the single most misunderstood aspect of this ecosystem.

In the real world, companies are valued by a method called discounted cashflow (DCF). Sophisticated financial buyers interested in acquiring a company will run “as complex as they want” calculations to figure out how much they are willing to pay today for the rights to earn a business’ future free cash flow.

Cash flow is different from profit because the later follows accounting principles for taxation purposes. Cash flow takes into consideration the moment the money is spent or received by the company, including working capital, investments, depreciation, and amortization, among others and is considered free to be distributed to company owners.

As an example, if you forecast a company will generate a million dollars of cash flow per year during its life, buyers would discount the cash flow by a rate that reflects their perception of risk for that particular business. As an exercise, let’s simplify the model and imagine investors want a 10 percent return per year for a company that will last only five years. In this case, the million dollars would be discounted by 10 percent every year ($1,000,000 divided by 1.10ⁿ, where “n” is the year of the cash flow).

In the first year, it would be $909,091, in the second $826,446, in the third $751,315, the fourth $683,013 and in the fifth year $620,921. If you add all the five discounted values, you would have a company valuation of $3.79 million or almost four times its nominal cash flow. When entrepreneurs negotiate with investors using the DCF model, they negotiate the discount rate, the cash flow forecast, and the number of years the company may be operating.

The problem in the digital world is that most tech startups may take many years to generate positive cash flow and are usually pre-revenue when evaluated at the present. That would make their valuation to be zero for the near future.

To solve the problem, Silicon Valley basically abolished the DCF model for a framework that is seen by outsiders as controversial, opaque, and subjective. As an extrapolation, this methodology could be analog to quantum physics: people know it exists, but they have no idea how it works.

In order to elaborate a fair startup valuation, Silicon Valley investors take into consideration the founding team’s track record, the potential of disrupting a large market, growth rate (users or revenue), retention, the existence of proprietary technologies, how feasible is it to scale up the operations, and the “momentum” of that business.

The main barriers to understanding the Silicon Valley framework are the perceived skewed and illogical valuations. For instance, the average valuation of early stage startups in Silicon Valley, according to AngelList, is about $5.1 million. The majority of these startups have no meaningful revenue and, surprisingly, they are valued at a higher price than the company from our example, with a million dollars in cash flow per year.

In practice, what happens with this Silicon Valley methodology is that the valuation of an early stage startup becomes what the founders are able to sell to investors. A good story, salesmanship, confidence, a great team and supply and demand are key factors that may define the valuation. Regular economics are not taken into consideration because these startups are too early and pre-revenue. Like before the Big Bang, the common rules cannot be applied.

Investors are willing to pay so much for tech startups with no profit because they are more likely to grow exponentially and be worth a much higher multiple than conventional companies, as the majority of startups can scale up without a proportional increase in fixed costs. Facebook, for instance, lost money from 2004–2008 and, in 2016, made $10 billion in profit. Its market capitalization, as of May 2017, was worth more than 40 times its earnings.

At a later stage financing round, Silicon Valley investors pay a high valuation due to a logic called salvage value. Instead of trying to establish the correct value of a startup during the round, they accept the company’s valuation with the expectation that other investors would likely pay even more for the company in the next round or at the event of an IPO.

Early stage investments in startups using the Silicon Valley valuation framework allow successful investors to make up to hundreds of times their original investment, in a decade. In rare cases, even thousands of times. Late stage investors are expected to get a single digit multiple from their money, but the amount invested is much larger. All Silicon Valley investors play a game where “the higher the risk, the higher the rewards.”

My advice to future tech investors is to embrace the Silicon Valley framework when evaluating tech companies in mature ecosystems. The cosmetics may not make sense or look reassuring, but they definitely work. In this case, what matters is that the invested startups get follow-on rounds at higher valuations by experienced investors. In the digital space, an early focus on profits may end up crippling the startup growth and thus its survivability in the long term.

In non-mature ecosystems, though, investors will probably continue to use discounted cash flow to evaluate tech startups. The DCF model may work for e-commerce or business models that generate quick cashflow, but these investors will never be able to own a piece of the next Facebook or Google.

If you are an entrepreneur, the value of your company will probably follow the rules of the ecosystem you are based on. You cannot have Silicon Valley priced rounds in places where investors value cash flow. If this affects your survival, your options might be to either migrate to Silicon Valley or change your company’s profile to focus on free cash flow. Both come with many challenges and must be thought through carefully.