Sunday, October 2, 2016

Aswath Damodaran Weighs In On Andreessen Horowitz's Valuations: "Venture Capital: It is a Pricing, Not a Value, Game!"

After having gentle fun poked at him last month by, among others Bloomberg's Matt Levine, for a post on the Tesla/SolarCity merger:
...Here is valuation expert Aswath Damodaran getting really mad at Lazard and Evercore for their fairness opinions of the Tesla/SolarCity deal: "My first reaction as I read through the descriptions of how the bankers in this deal (Evercore for Tesla and Lazard for Solar City) valued the two companies was 'You must be kidding me!'" There seems to be just a simple category error going on here. Damodaran wants to see valuations of the two companies. But that wasn't Evercore or Lazard's job. Nobody asked them for valuations. They were asked for fairness opinions.... 
the good professor approaches his current target subject more judiciously.

From Musings on Market, Oct. 2:
Venture capitalists (VCs) don’t value companies, they price them! Before you explode, implode or respond with righteous indignation, this is not a critique of what venture capitalists do, but a recognition of reality. In fact, not only is pricing exactly what you should expect from VCs but it lies at the heart of what separates the elite from the average venture capitalist. I was reminded of this when I read a response from Scott Kupor of Andreessen Horowitz, to a Wall Street Journal article about Andreessen, that suggested that the returns earned by the firm on its funds were not as good as those earned at other elite funds. While Scott’s intent was to show that the Wall Street Journal reporter erred in trusting total returns as a measure of VC performance, I think that he, perhaps unintentionally, opened a Pandora’s box when he talked about how VCs attach numbers to companies and how these numbers get updated, and how we (investors, founders and VCs) should read them, as a consequence.
The WSJ versus the VC: A Recap
Let’s start with the Wall Street Journal article that triggered the Kupor response. With the provocative title of “Andreessen Horowitz’s returns trail venture capital elite”, it had all the ingredients for click bait, since a big name (Andreessen Horowitz) failing (“trail venture capital elite”) is always going to attract attention. I must confess that I fell for the bait and read the article and walked away unimpressed. In effect, Rolfe Winkler, the Journal reporter, took the three VC funds run by Andreessen and computed an IRR based upon the realized and unrealized gains at these funds. I have reproduced his graph below:
While the title of the story is technically correct, I am not sure that there is much of a story here. Even if you take the Journal’s estimates of returns at face value, if I were an investor in any of the three Andreessen funds, I would not be complaining about annual returns of 25%-42%, depending on the fund that I invested in. Arguing that I could have done better by investing in a fund in the top 5% of the VC universe would be the equivalent of claiming that Kevin Durant did not having a good NBA season last year, because Lebron James and Stephan Curry had better seasons.
In the hyper-competitive business of venture capital, though, the article must have drawn blood, since it drew Scott Kupor's attention and a response. Scott focused attention specifically on what he believed was the weakest link in the Journal article, the combining of realized and unrealized gains to estimate an internal rate of return. Unlike investments in public equities, where the unrealized returns are based upon observed market prices for traded stocks and can be converted to realized returns relatively painlessly, Scott noted that unrealized returns at venture capital funds are based upon estimates and that these estimates are themselves based upon opaque VC investments in other companies in the space and not easily monetized. Implicitly, he seemed to be saying that not only are unrealized returns at VC funds subject to estimation error, but also to bias, and should thus be viewed as softer than realized returns. I agree, though I think it is disingenuous to go on to argue that unrealized returns should not be considered when evaluating venture capital performance, since VCs seem to have qualms about using them in sales pitches when they serve their purpose.
The VC Game
The Kupor response has been picked in the VC space, with some commenters augmenting legitimate points about return measurement but many more using the WSJ article to restate their view that non-VC people should stop opining about the VC business, because they don’t understand how it works. Having been on the receiving end of this critique at times in the past, you would think I would know better than to butt in, but I just can’t help myself. I may not be qualified to talk about the inner workings of the venture capital business, but I do believe that I am on firmer ground on the specific topic of how VCs attach numbers to the companies that they invest in.
VCs price businesses, not value them!
I have made the distinction between value and price so many times before that I sound like a broken record, but I will make it again. You can value an asset, based upon its fundamentals (cash flows, growth and risk) or price it, based upon what others are paying for similar assets, and the two can yield different numbers.