The talk of the town in the Israeli venture capital industry last week was the funding round for start-up Wiz. Last Monday, the cybersecurity company, headed by Assaf Rappaport, announced it had raised an additional $250 million at an extraordinary $6 billion valuation. This valuation is particularly unusual taking into account that Wiz was founded only a year and a half ago, and just six months ago raised funding at the much lower valuation of $1.7 billion.
Many in the venture capital industry thought the valuation made sense, given the experience of Wiz’s founders, who had already sold Adallom to Microsoft in 2015 and then joined the tech giant in senior positions, as well as Wiz’s area of activity - cloud security - the fastest growing market in cyber today. Some venture capitalists declared they would have been willing to invest their own money in Wiz, even at a $6 billion valuation.
In contrast, others referred to the valuation as a wild gamble. "When a fund makes such a growth investment, its goal is to reach a return of at least 2x within three years," one senior investor says. "Meaning that the investors who put $6 billion in Wiz believe it could be worth $12 billion in three years, and that's crazy. At the current valuation no-one will buy Wiz. Even if it goes public, it's hard to believe a company like Wiz with one product, as good as it may be, will reach a $12 billion market cap. To make that kind of investment, you have to believe the stock market will remain strong in the coming years, which isn’t necessarily what will happen."
Wiz is just one particularly extreme example of the past year's valuation inflation, which shows no signs of letting up. This inflation is manifest in the record number of Israeli unicorns, (start-ups valued at over one billion dollars), as well as by the double and triple leaps in their valuations within six months and sometimes less.
Underlying this inflation is a major change in the way VC funds consider and calculate the value of a startup, influenced by the big money flowing into the market.
Large funds less sensitive to valuation
One significant change in the tech world in recent years has been the massive entry of huge, cash-rich hedge funds investing in start-ups. Traditionally, hedge funds with ready cash, like US-based Tiger Global and Coatue Management, would invest in publicly-traded technology companies, but in recent years they have started investing in privately-held startups before they go public.
These funds do not have representation in Israel, but in the era of Covid-19, when investments are being conducted remotely via Zoom, geographical distance is no longer a factor. The result: over the past year, both hedge funds have become very active investors in local startups.
At the same time, foreign funds that have invested in the Israeli market for years have also picked up pace, because of the influx of big money, the result of a low interest rate policy that creates fewer alternative investment options, and in light of the belief that investing in software and technology is especially suited to the Covid-19 period.
A prominent example of this trend is veteran VC fund Insight Partners, which was also one of the two funds that led the investment in Wiz. Insight Partners closed its largest fund ever in April 2020, at $9.5 billion, and is now working on an even larger, $16 billion fund.
The Israeli market definitely feels the increase in the amount of money under management by Insight Partners. According to the IVC Research Center, Insight Partners made no less than 27 new investments in Israeli start-ups in 2021, more than double its investments in Israel last year.
Some market sources suggest that huge funds like Insight Partners and Tiger Global are not very sensitive to the valuations awarded to their startups, and are willing to be much more generous. "Every fund has its target, the return it promises to investors in the beginning. While a small or medium-sized fund should give a 30-40% annual return on the money, huge billion-dollar funds may settle for a 15-20% annual return, and maybe even less, which will satisfy their investors and enable them to raise the next fund. As a result, the huge funds are not as sensitive to the valuation they give to a company," explains Yanai Oron, a general partner at Vertex Ventures.
"It also pays for these funds to invest tens of millions of dollars in the early stages of startups at high valuations, just to get the option of being close to the company, and leading future rounds in the hundreds of millions."
"If you’re a multi-billion-dollar fund, what do you care about the valuation when you’re investing $20, 60 or 100 million," agrees a senior investor. "If you've invested $20 million in a company and it's successful, that’s great. And if not, then what's a $20 million investment out of billions?"
The insensitivity of these huge funds to valuations is basically forcing all players, big and small, to raise the amounts they are willing to pay. This was well described by investor Keith Rabois, a general partner in Peter Thiel's Founders Fund, who tweeted last July: "Biggest change in the venture landscape now: There are no VC funds with pricing discipline. All of us have caved."
Profit multiplier calculations are no longer relevant
The calculation of a company's value is based on multipliers. Once upon a time, valuations in traditional sectors like retail were determined by applying a multiple to the profits of the business. But startups are not expected to show profits in the early or even fairly late stages, but to focus on technology development and growth.
Therefore, their value is estimated using revenue multipliers. The specific multiplier that a startup will receive is determined in the negotiations between the investor leading the investment round and the startup entrepreneurs. A high quality company with fast growth will receive a higher multiplier than one growing slowly. But over the past year, things have got little out of hand.
Whereas in the past, even very good startups might be given a 30x earnings multiplier, in the past year, the floodgates appear to have opened, and 100x revenue multipliers have also become acceptable. The most extreme example is Wiz itself, whose annual recurring revenue (ARR) is estimated at $25 million.
This means that Wiz's current value is determined by a multiplier of 240x. Wiz is certainly growing very fast, but that is still a number no one could have dreamed of in the past.
"In the past, we looked at current ARR when assessing value, then that moved to calculating according to end-of-year ARR, and today we sometimes refer to next year's projected ARR as a basis for company value," says Amit Karp, a partner at US-based Bessemer Venture Partners. "If the company makes one million dollars and it's estimated that it will make four million next year, then they'll already award it a multiplier according to the latter amount. That's because companies today have learned to grow faster, the market is hungry for software, and today it's easier than it was to take a company public."
Investor Shomik Ghosh, of US-based Boldstart Ventures, tweeted in the same vein: "40x-50x LTM [last twelve months] ARR is now standard and in fact some rounds are now happening at 100x NTM [next twelve months] ARR!"
Accounting firm KPMG Somekh Chaikin is often hired to conduct valuations for Israeli startups, for various reasons. The firm continues to use the classic accounting methods for valuing a company, such as discounted cash flow (DCF), where value is determined according to expected cash flow. Dina Paska-Raz, partner and head of technology at KPMG Somekh Chaikin, admits that, these days, the gap between the valuations that startups receive according to these methods and the valuations given to them by venture capital funds is only widening. However, in her opinion, it is not a problem or a bubble, as many say.
"Venture capital funds that invest in startups look beyond revenue - for example, whether the company has groundbreaking technology, its potential market, and its chances of being acquired by a technology giant like Google, Facebook, or Amazon, or of going public," says Paska-Raz. "Remember, these considerations aren't new. Take, for example, Facebook's acquisition of WhatsApp in 2012 for $16 billion, or Google buying Israeli navigation app Waze for over $1 billion in 2013. These two companies didn't have a dollar in revenue and yet they still paid billions for them."
"Manufacturing" growth: a campaign to boost value
The startup entrepreneurs are, of course, no fools. They know that their companies will be judged by revenue and growth, and they know how to pump these up, for example, through expensive customer acquisition campaigns on Google and Facebook. "It's easy to generate hyper-growth when you're selling one dollar bills for 90 cents," is how investor David Sacks of Craft Ventures describes it.
To get some clarity, venture capital funds have developed a variety of formulas that test a company’s efficiency. In consumer applications, efficiency is tested on the basis of the startup's unit economics, meaning the degree of profitability of selling one unit of the product. For example, investors will check whether revenue from a single user purchasing an app exceeds, over time, the cost of acquiring that customer through Google and Facebook ad campaigns. In the B2B software world, it is customary to calculate efficiency using the Rule of 40, which states that a company's annual revenue growth rate and its profit margin should add up to 40% or more.
These concepts have become very popular in the venture capital world, but many in the market know that the speed at which investment decisions must be made today does not always allow for serious deliberation. Because of the large amounts of money and the huge competition for investments, hot companies will sometimes receive a memorandum of understanding at their initial meeting with a fund or, at most, a few days later.
"Some investors today are willing to be more flexible and not do a full quantitative analysis," the senior investor explains. "They'll look at revenue but not much beyond that. To some extent, growth investment has become more like early investment in non-revenue-generating startups, where you bet on the team behind the startup and how strong it is, or make a decision based on how big the startup's market is. If at one time, graphs and numbers made up 70% of the decision, today that's dropped to maybe 40%."
Nir Adler, general partner at State of Mind Ventures (SOMV) agrees that efficiency is still a black hole when it comes to evaluating startups. "Everyone will tell you that they consider data like the Customer Acquisition Cost (CAC) or how long it takes you to pay back that cost, but in practice, when huge funds present to their investment committee, they look mostly at company growth and revenue. That's something which could eventually explode, "says Adler.
Super-positive markets wear rose-colored glasses
Ultimately the high company valuations are a result of the super-positive atmosphere in the markets over the last year, where company values keep rising, huge IPOs are multiplying, and every investor seems to have a Midas touch. "When investors review the past decade, they see a market that has only gone up and up," concludes Nicole Priel, partner and managing director at Ibex Investors. "So, in some sense they've become used to paying high multipliers in the expectation that the market will continue to rise and provide returns on their investments. Of course, this approach starts to be problematic when the market trend reverses."
Published by Globes, Israel business news - en.globes.co.il - on October 20, 2021.
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