How to Value a Revolution

By Ravi Viswanathan (ENG’90/WG’98)

It’s an exciting time to be a venture capitalist. As an investor at NEA in Silicon Valley, I’m seeing some of today’s greatest technology and business revolutions up close:

  • Software-as-a-Service: the new model for business applications
  • Cloud computing: enabling unprecedented infrastructure performance and flexibility
  • Payments: now being integrating into mobile devices and apps
  • Education: democratized and globalized for the first time ever

But these revolutions also present a challenge. Eager investors are driving valuations to extremely high levels. In the public markets, fast-growing leaders like Workday are trading at 25x forward revenue. In the private markets, zero revenue companies such as Instagram are being valued at $1 billion or more.

No matter how great the company, long-term investment success requires a careful approach to valuation. Ignoring fundamentals leads to disasters like the 1997-2000 tech bubble. On the other hand, big valuations often reflect big opportunities, even if the companies are small at the time. Valuations often just get ahead of companies’ true progress. We saw this during the bubble as well, when the stock prices of great companies (Amazon, eBay, Intel, etc.) crashed, despite ultimately achieving long-term success. The devastation was even more brutal for venture-stage companies. Being early can be just as bad as being wrong.

How should VCs think about valuation when we make venture-stage investments? A Wharton class may advise a DCF, but due to long-term uncertainty and the large volume of deals we evaluate, this is impractical for day-to-day work. Similarly, a rigorous comps-based analysis is difficult, since many of the startups we back are unlike any companies that have existed before.

At NEA, we find opportunities by looking for fundamental technology, disruptive transformations, great teams, and big markets. Once we identify something exciting, we think about a range of components of value to determine an entry valuation that will lead to strong returns when the company IPOs or gets acquired down the road:

  • Company stage: early stage companies must have appropriate valuations to compensate investors for the time it will take to build the company and the risk involved
  • Growth rate: faster growing companies will get big faster, justifying higher valuations
  • Market size: a company that is credibly attacking a big market, or trying to create a potentially big market, will get a higher valuation
  • Achievable market share: even if the market is huge, the startup has to be a credible attacker
  • Profitability and strategic importance: some markets and technologies are more likely to support profitable or strategically important companies, leading to higher valuations

As a very rough example, we can look at Workday (a leading enterprise SaaS company) and Palo Alto Networks (a leading network security company):

  • Workday is trading at 25x revenue and Palo Alto at 6x revenue. So, Workday has about 4 times the revenue multiple of Palo Alto.
  • However, if you divide the revenue multiples by consensus estimates of future revenue growth, Workday then has a 0.42x multiple and Palo Alto has a 0.16x multiple. Based on this adjusted measure, Workday’s multiple is only 2.6 times that of Palo Alto.
  • Analysts believe that Workday’s total available market (TAM) is ~$19 billion in HCM and Financials, and assume it will get 25% market share (=$4.75 billion). For Palo Alto, they see a smaller TAM of ~$10 billion, and 20% market share (=$2 billion).
  • If you take the companies’ adjustment multiples, you can make yet another adjustment, and divide by the expected market share (0.42x/$4.75 for Workday and 0.16x/$2 for Palo Alto). Now these adjusted measures come to 0.09x and 0.08x. Surprisingly close, even though Workday has a revenue multiple much greater than Palo Alto Networks.

On this “twice adjusted” basis, then, these two leading companies actually trade pretty close together. Although this is a very rough analysis, it explains much of how public and private markets place values on fast-growing companies.

For venture capitalists, a thought process like this offers a workable heuristic for heavier-grade valuation exercises such as DCFs. We need to be both disciplined in thinking about the company’s future value, but not so disciplined that we’re frozen in our tracks by the challenges of uncertainty. Venture capital is high risk, low liquidity investing, so these tools are critical to moving forward confidently.

RaviViswanathan_headshotBios: Ravi Viswanathan joined NEA in 2004 and co-heads the firm’s Technology Venture Growth Equity effort and Energy Technology investment practice.  Prior to NEA, Ravi worked at Goldman, Sachs & Co. as co-head of the technology practice in their private equity group. Ravi has also worked for McKinsey & Company and Raychem Corporation focusing on R&D in various materials systems. Ravi received an MBA from Wharton and a PhD in Chemical Engineering from UCSB. Ravi also earned a BS in Bioengineering from the University of Pennsylvania. He currently serves on the Wharton Entrepreneurship Advisory Board.