“The market can stay irrational longer than you can stay solvent.” John Maynard Keynes.
In April 2017, Yik Yak, the most important social networking startup founded in Atlanta since Social Fortress, threw in the towel, selling out to Square for $3 million – mainly to to “acquire” the company’s remaining software engineers. This was, to put it mildly, a disappointment to investors like Sequoia Capital, who had invested $62 million at a $400 million in December 2014. For those of you scoring at home, that is a return of negative 340%, annualized. #ow. There will be all kinds of post-mortem analysis about where Yik Yak went wrong, but that isn’t the goal of this article. What’s interesting is the change in value and how it is perceived. To be sure, there will be some schadenfreude out there from the “traditionalists” who don’t see the business case in social media. Besides, who doesn’t like to see the smarty-pants venture capitalists taken down a peg? Atlanta investors, who are generally baffled by the investment thesis of social media, will be sorely tempted to haul out the “I told you so’s”.
It is tempting to conclude that the valuation of $400 million back in 2014 was dumb, crazy, ill-advised, or just plain wrong. That may be unfair, and the key to understanding this lies in understanding the nature of risk and return. Over the years, I’ve come to observe what appear to be three “universal laws” of valuation. It’s not exactly Newton’s Prinicipa Mathematica (in which he published his three laws of motion), but they have served me well when I encounter tough valuation problems in order to simplify thought process. Come to think of it, maybe these are more guidelines than rules…
Law #1 – The prospect of a sustained high return must always be accompanied by sustained high risk
In a “reasonably” efficient market, meaning that buyers and sellers pretty much know what’s going on and can react to information in real-time, buyers and sellers bid up prices of low-risk assets and bid down the prices of high-risk assets. The low entry price of a high-risk asset offers a high return when that asset’s risk profile reduces over time. Can you catch lighting in a bottle and receive an outsized return one in a while – buying a low risk asset at a high risk price? Sure, but not sustainably, unless you’re Warren Buffett (and if you are, thanks for reading, Warren!)
It is illustrative to review the relationship between market returns and risk. Historically, observing the relationship between risk and return in the private markets has been difficult due to the absence of reliable data. Fortunately, there is now a fantastic program at Pepperdine University called the Private Capital Markets Project, and one of their key products is the annual Private Cost of Capital Report (“Report”). I’m a huge fan of the Report – the researchers survey actual capital providers, including angel investors and venture capitalists, among others to identify their respective target rates of return. And the price is right – free. Reviewing the chart below, you can see the ranges of return required by various capital providers in 2014, with data for returns for certain public securities juxtaposed.
As you can see, venture capitalists, and their cousins, angel capitalists and private equity investors, play in a different return universe from the conventional investment markets. Whereas bank loans, asset-based loans (usually secured by inventory and/or accounts receivable) and even mezzanine debt carries with them an investment thesis in which the risk of total loss is very low, venture capital, private equity, and especially angel capital, make there livings in a world where the prospect of total loss is a constant companion, and the required returns are much elevated in order to induce investors to assume that risk. The price of greed is high.
Law #2 – There is no such thing as a risk-free asset
All assets are subject to the risk of loss. While academicians and financial practitioners often refer to U.S. Treasury securities as risk-free to make their models work, even they bear risk that is above zero. However, debating this lies beyond the scope of this note. I mean, they even killed The Enterprise… And again… … and again.
The Yik Yak investment was, of course, never perceived to be a risk-free asset – far from it. The possibility of loss and even outright failure was priced into the investment valuation. Let’s look at how that works:
Law #3 – All investments are based on forecasts, and forecasts of more than 6 months into the future are wrong
While we don’t know what the actual forecasts used to formulate Yik Yak’s valuation in 2014 were, it’s a good bet they were far away from what actually happened. Of course, all forecasts are wrong – the variables are the degree of wrong-ness and the timing of wrong-ness. Even analysts of public companies, with relatively luxurious data to work with, rarely venture to provide forecasts more than 6 months out, and are typically loath to go that far. Unless you’ve got a souped-up DeLorian and some plutonium, wrong forecasts are a fact of life.