All in + Economics

There is, both historically and theoretically, a correlation between public market values and private market valuations. This is not just because most successful startups will eventually hit IPO and hence become public companies, but also because in the valuation models of private companies, public comparables are often included despite the obvious differences in growth potential and therefore valuation multiples.

When public market rose in the past couple of years, so did the valuation of private startups. If the market takes a hit in the months to come, it's reasonable to expect a correction on the valuation of startups that are raising new rounds. In the worst case scenario, a startup might be forced to take a down round, which might trigger some embedded rights in the contracts with previous investors, which leads to further dilution or a complete impasse in fundraising.

In the later case, the startup might run out of cash and roll over.

One can also apply Heisenberg's Uncertainty Principle to the stock market (and any asset market) in the spirit that the observation changes the behaviors of the observed. For example, even the most rigorous and painstaking DCF valuation model needs to decide on a discount rate (or multiple rates for different periods of the firm's life). Such a discount rate is related to the risk (volatility) of the free cash flows in each year of projection. If the risk is low, the discount rate is low and vice versa.

But risk is very difficult to measure even for the least sexy financial products such as bonds, as the recent financial crisis proved to us. It's even more difficult to assess for a disruptive startup trying to change the world — even the great Peter Thiel would be lying to say that he had known the proper discount rates for the years to come when he became the first external investor to Facebook in the summer of 2004, when he put in $500k on Mark in return for $10.2% of the shares, essentially valuing Facebook at $4.9M.

You now see the fallacy of valuing a real game-changer such as Uber using market sizes estimated with public information. And this is essentially the problem of employing classical equity analyses and strategic analyses – be it Porter Five Forces or SWOT – on startups. There will always be new markets coming up if the changes introduced by new business entities are fundamental enough. To value a game-changing startup using the visible market size goes essentially against the notion of disruptive startups.

The real question is: if we leave the world to purely risk-return optimizing, emotionless capital that operates on MPT, will we still have innovations?

To answer this, one can examine all the successful startups that have forever changed our lives. One will find that they were ALL sponsored by VCs during their pre-public phases. There's no exception, zero. At the same time, if we examine, or try to examine, the 99 times or 999 times more VC-sponsored startups that eventually died, we would instinctly conclude that investing in VCs (and therefore startups) doesn't make sense.

However, without enough capital venturing into the high-mortality-rate world of startups, will there still be real ground-breaking innovations? 

Or put it this way, without crazy people like Elon Musk, will GM, Ford and Toyota have come up with a real electric car like the ones sold by Tesla today? Maybe, but more likely not. As Peter Thiel highlighted in his Zero to One, most large corporates at the maturing stage fall into internal rent-seeking traps. Since it's hard to fathom the potential long-term upside of a risky small project, most managers would only fight to do projects that have big budgets and yield moderately better end products. Worse still, many more would not even bother working on moderately better products, but would spend their time engaging in politics to maximize their own rental income, whether it's windowed offices, corporate jets or golden parachutes.