The Valuation Trap

There is a long article on Square and Box in TechCrunch this weekend. I am not sold on the arguments the author makes about the commodity nature of both products. But the author makes a point at the end in a section called “The Valuation Trap” that I very much agree with:

A second iron law of startups might be that the higher the valuation of a startup, the fewer options it has for financing and exits…… once a company has raised mezzanine capital and is valued in the billions, its options are essentially to go public or find a very interested buyer with deep pockets. There are few other options on this side of the startup pipeline.

The past three months have not been good for highflying tech stocks and now we are seeing IPOs being postponed. Both Square and Box have recently done that.

Another thing that Square and Box have in common is very high burn rates. The author of the Techcrunch post says that Square lost $100mm and Box lost $160mm in 2013.

The combination of sky high valuations, equally high burn rates, and a disappearing IPO market is not a pleasant one. I am fairly confident that both Square and Box can and will navigate the valuation trap, but it will require making some hard choices in the coming months.

So the moral of this story is that you can push valuations when you have investors knocking down your door, but unless you are cash flow positive and expect to remain so for the foreseeable future, you do that at your own risk. You will need to find someone to top that price down the road and that person may not be there.

Epilogue: I am a VC. I am talking my book here. I don’t like to pay sky high valuations. And I like to argue against them. So understand this post in that context. But I am also an investor in companies that have found, and may or will find themselves in the valuation trap. I have lived it, felt it, and suffered from it. It is a real issue.


Comments (Archived):

  1. Anand Sanwal

    Fred – what gives you confidence Box will make it through? They are in a hyper-competitive space and also seem to have pretty poor SaaS fundamentals (high Customer acquisition costs and illusory LTV)Curious.

    1. fredwilson

      I suspect they could cut sales and marketing expenses dramatically. That would cut their growth rate for sure but they might be able to bring their losses way down

      1. Anand Sanwal

        Yes – true. Think that ultimately hurts the growth narrative which is what public market investors might find compelling about Box.

        1. Bala

          If one needs to spend money to buy growth, $ for $ then there is something wrong in the business model because it is not the model that Analysts and IPO investors want to bet on. The model for Box is flawed, they need to figure out a scalable model to justify their growth story. The only answer is to innovate on the product and experience, Clay Christensen’s what job are you hiring Box for comes to mind. Not always obvious but with all these Enterprise sales people talking to companies I am sure they can find a use case to improve their product offering that is exactly what we did in GreenQloud.

          1. CJ

            I don’t see Box as offering anything unique or better than someone like Dropbox, Google, or Microsoft. They do have much less utility and brand recognition though. I’ve honestly found it puzzling that they’ve made it this far, but I’m often wrong about these things.

      2. avifreedman

        We always had those metrics on hand in the ISP business – what is our profit if we shut down the drivers of growth, or even shut down growth if we can’t keep funding from profit. I would think that most SaaS companies can take this view as well once they hit critical mass (gross margin covers G+A, core engineering, and the infrastructure needed for the backend).

        1. LE

          Wow Avi Freedman. One of the first people on the web that I ran into when I got into this thing. The man who said “the good provider today might be the shit provider tomorrow”. [1]Here it is, circa a long time ago:…[1] Actually it was “and the Best Provider of Today could be the Shit Provider of Tomorrow.”

          1. avifreedman

            Some dinosaurs are still around, and yes,the same math applies to SaaS :)Before it was new modems, marketing, and salespeople that were what could be stopped to instantly get to profitability as a judge of “can the business survive”.Then at Akamai it was iffy for years until gross margin (in magnitude) covered G+A, core opex, and dev. Once they hit that breakpoint they could have survived lower growth and val but luckily didn’t need to.Now with CloudHelix (network visibility + control SaaS) it’s core (vs nice to have features), infra, and the small G+A that are the drivers for the breakeven point if pulling back was needed – and most losses in growth phase come from extra dev – so just need to make sure that gets paid for in increased sales if it’s not missing core functionality.

      3. ShanaC

        How much can you cut them before you kill the business

      4. Salt Shaker

        But without sustained rev growth Box is dead in the water. Sales expense is the last place I’d cut, part at this stage in the company’s growth cycle. With a heavy debt load they need sustained rev growth to justify the present value of the company’s future cash flow, no? Delay in IPO alone is reason for suspicion, decline in rev kills it.

      5. George Revutsky

        Also, in the past few years, they scaled up their sales team very quickly using external recruiting firms. They have been bringing more of this activity in-house. This can save 10-15% off the 1st-year cost of the average sales person.

      6. IPOTroll

        Breaking the culture of spending $2 to make $1 is tough. I hope they can do it.

  2. jason wright


  3. Ryan Laubscher

    Michael Carney at Pando also made a valid point about the valuation trap when he said “It’s one thing to sell a high-burn, high-growth narrative when an entire category is going up and to the right … not everyone believes that you can spend your way to a healthy business.”Part of this post article tends to agree somewhat with the point made by Techcrunch about the need to burn when you have a product that is, or is perceived to be quite commodity-like in nature.Here’s the full article:

  4. William Mougayar

    Question is will this trend stop at these 2 companies, or are there others that might face a similar predicament?Marc Andreessen warned a month ago about some companies who are taking huge rounds from non-VC’s that are pushing high their valuations, and the list includes: AirBnB, Dropbox, Hortonworks, Wayfair, Eventbrite, Cloudera.…We should be worried that these hiccups don’t reverberate negatively on an otherwise healthy Tech ecosystem that is flush with VC money and gushing with entrepreneurs who are innovating and creating lots of startups.

    1. fredwilson

      There are certainly others. I don’t think this is an existential threat to the vibrant tech ecosystem but maybe a bit of cold water could be a good thing right now

      1. William Mougayar

        I agree. I may have over dramatized the last paragraph for that same reason you mention, i.e. let’s slow down the train a bit. It will still get us there, but without derailing.

  5. Tom Labus

    A corollary applies to existing public companies also that you better be making money when it’s your turn to get pounded. FB was always a buy when the world turned against them after going public but is Twitter/

    1. JLM

      .Well played.When you get in the deep end of the ocean and your numbers are public, you better be able to swim with the analysts. The love affair lasts about two quarters.Why shouldn’t it?JLM.

    2. fredwilson

      Twitter has a lot of positive cash flow. The GAAP losses are all due to non cash stock comp

      1. JLM

        .The accounting for stock based comp IAW GAAP is the, well, GAAP.Companies make decisions as to how to handle compensation and must account for and live with these decisions.I do not think the current GAAP accounting methodology is particularly good but it is consistently applied.Earnings, cash flow, EBITDA are different and can be used for different purposes but they are not the same.If earnings do not accomplish what a company wants to communicate, the substitution of another standard is an attempt at misinformation.JLM.

        1. Tom Labus

          A rose is a rose …………

      2. LE

        Hence a failure in the twitter PR department [1] to not get that message across. All the stories leads are saying something different. The first time I came across this. Right here with your statement.Twitter must have the same quality PR people that the postal service uses that aren’t able to get across the message that the postal service would be in ok shape if it didn’t have to fund all those old pensions. From what I read at least.…[1] If you’re not going to toot your own horn nobody else is going to do it for you.

      3. kidmercury

        i suppose it is subjective as to what “a lot” means. operating cash flow from twtr’s latest quarterly filing shows +2.62 million for the past quarter:

    3. Salt Shaker

      Gee, I hope so. I went in pretty hard last week at 38.50 a share.

  6. William Mougayar

    Let’s Box these 2 cases tightly, and not let their ailments spread outside that Square.In 2000, two key reasons why the bubble dragged everything down were:1. The sky was the limit for valuations.2. Companies that shouldn’t go public were doing or prepping for IPOs.We should see these 2 stories as a good warning.

    1. JimHirshfield

      Did you make a pun? :-O

      1. William Mougayar

        Squarely did, but don’t Box me in that corner.

        1. JimHirshfield

          Time will tell. Let’s circle back later.

          1. Elia Freedman

            I should down vote you both. Ugh. Too early in the morning for such bad humor.

          2. William Mougayar

            You’re on the West coast!

          3. JimHirshfield

            Sorry. I’ll shape up right away.

          4. Elia Freedman

            Okay. You both are a lot funnier at 9am than at 7am.

          5. ShanaC

            You need coffee to appreciate the humor here sometimes

    2. JLM

      .The parallels between stock markets and the Ukraine are both the same.We disregard history at our peril.JLM.

      1. William Mougayar

        Yep, history and experience too. When you have been to that movie before, you can pretty much tell its ending.Unless you have the powers to change the script half-way, and that would be a cool thing. Actually, I’ve seen short films on the web where they give you the option for 3 different endings, and you can pick one or watch the variations. It’s an interesting tact.

      2. Dan

        Earlier this am I did a little “Hitler Putin 1938” googling to see what what being said. Crazy how much backtracking the politicians are doing about drawing any inference to Czechoslovakia. The topic of appeasement is an interesting one.Best piece I found from a few weeks ago:…Backtracking:

        1. JLM

          .Appeasing tyrants has never been a successful foreign policy.My 95 year old Father who lived through “peace in our times” laughs at us like we are idiots. Complete, total, clueless idiots.JLM.

          1. Cam MacRae

            He’s not Robinson Crusoe there — feels altogether too Chamberlainesque for my taste.

          2. JLM

            Well played.JLM.

          3. Dan

            My grandmother does the same. The older I get the more I truly appreciate her wisdom and perspective.

          4. sigmaalgebra

            Old story: “When I was 18 I was distressed to conclude that my father was an idiot. When I was 21 I was shocked at how much he had learned in just three years.” A Mark Twain, maybe?

          5. LE

            I’ve seen some rough correlation between parental intelligence and whether kids listen to their parents (yes for sure there are other factors).Loosely, parents who are totally stupid and have smart kids don’t have much leverage over those kids. Parents who are “to smart” don’t have much leverage either. Parents who are smart but not to smart generally can have an impact on their kids because they tend to be right and so the kid doesn’t have to look elsewhere for answer. Over time the kid (if smart themselves) will learn the parent is generally right most of the time and tend to listen to their advice. [1] Kind of like buying Sony. It’s a fine balance. Perhaps I haven’t explained it that well here.[1] Even knowing when to listen to them and about what and when not to.

          6. LE

            I think what it gets down to is that at a certain level the only thing that some people respond to is pain and punishment. And various people (as we have seen) are even crazy enough to not respond to pain and punishment unfortunately.On thing that most certainly typically doesn’t work with a crazy person (or something with a mental illness) is thinking that you can simply use logic and talk things out. To work out your differences. Which is what Obama (as you would say naively assumed) could be done.That said, and obviously I’m not fan of Putin etc., I do think the statement that he said (or perhaps someone else said) about pushing our values on the entire world (what was it, America’s imperialism?) has some merit.I mean just because we have it a certain way in this country with, for example, gay rights (or not harming animals in movies) doesn’t mean that the entire world has to share our values.I was in Puerto Rico recently. They had a cock fight arena next to a restaurant that I ate at. Not something that would ever happen in the state that I live in that’s for sure. But it’s their culture there and it’s what they do. Who am I to say they should instead have high school kids play football and get head injuries?

          7. Salt Shaker

            Hope the restaurant you were eating at in PR wasn’t promoting a fresh fowl special.

          8. JLM

            .Haha, I could take you to a cock fight within 10 miles of where I am typing.Do you know that Johnny Football’s family name “Manziel” is a brand of cockfighters his family developed.A Manziel is a fiercesome fighting animal.Bet you didn’t know that, eh?We still a bit wild down here in the hinterlands.JLM.

          9. LE

            See now this is a good example of how experience and knowledge trumps academic research.First I find this which disputes what you say:…(first google hit for “where is cockfighting legal?”)Then I find this which says “game the system”:…But more importantly if you say it’s happening then well it’s happening!

          10. sigmaalgebra

            > Haha, I could take you to a cock fight within 10 miles of where I am typing.Sounds like you live in, uh, Texas? Yup, suspicions confirmed. It’s next to a BBQ chicken joint, right?

          11. JLM

            .No, too tough to eat the Manziel Gray.Lucy’s Chicken is delicious. I am headed there today.Southern. Fried. Chicken. Fair trade for many people you know.JLM.

          12. sigmaalgebra

            > too toughSecret: About 160 F, not more, not even 161 F, for about 18 hours while kept wet. I.e., BBQ it.That is, the protein muscle fibers are always tender. The cookbooks make this point clear, right?The issue is the collagen connective tissue; there is a lot of it in a ‘tough’ animal, have to ‘melt’ it out, and 160 F will do that; 140 F or so is safe from bacteria. Get to 180 F or so, and the proteins in the muscle fibers will contract, squeeze out all water, and become hard and brittle. So, pick time and temperature to melt the collagen but not damage the proteins.Mostly cookbooks don’t explain this. Not even books on ‘cooking chemistry’. But it’s one of the main secrets to BBQ, especially TX beef BBQ.Right, this is the explanation, one level deeper, for ‘low and slow’. But, do really need a thermometer.Cookbooks? From the formula fiction book publishing companies pushing vicarious, escapist fantasy, emotional experience entertainment as in, just buy this book, cook the great, easy dishes, and have adoring, admiring friends over for great dinners and no longer feel alone, indeed, add two candles and a match and get Mr. Right who just sold his startup to Yahoo, Google, Facebook or one of the usual suspects! Right, fool me once …!It took me a long time, ruining far too much round roast, to discover how to make good beef stew from round instead of chuck — which has much less collagen.You learned it here, not in a cookbook or a TV cooking show! Sometimes knowledge can actually be useful!

          13. JLM

            .160F is the magic temperature for BBQ.Southern Fried Chickens requires something altogether different.JLM.

          14. sigmaalgebra

            Yes, can only fry something fairly tender.I’m defrosting a NY Strip. Will coat with S&P and fry in olive oil in a steel skillet with an absurdly long handle until steak is slightly puffy and springs back. Pan sauce — second try: Remove the steak, pour out the oil, add 1 C of dry red wine, scrape up the brown stuff, add a can (~12 oz.) Campbell’s Beef Consomme, reduce to taste, add 1/2 stick of butter, melt, stir taste for S&P, and eat with a little of the wine and a lot of toast to soak up the ‘pan sauce’.I have some frozen chicken breasts: Thaw, poach in dry white Chardonnay and chicken stock with shallots, canned mushrooms, pepper, bay leaf, etc. Remove the chicken. Reduce the stock. Use a roux to make a volute. Add milk, heavy cream, and egg yolks and make a hot custard. Add lemon juice and S&P to taste. Dice the chicken. Combine with the sauce. Works but works much better with scallops — have some of those, too. Then use a fish stock or just bottled clam juice. Exact measurements not at hand just now.

          15. LE

            Interesting. Which makes both 160f and “160 Degrees” good names for a BBQ franchise.As it happens a burger restaurant is called “160 Degrees Burgers Done Well”.Amazing what you learn here. Not something I have ever thought about.When I cook food I go by various visual cues, oozing of juices as well as steam not by temperature. When cooking lobster I go by time.

          16. sigmaalgebra

            > head injuriesAh, that’s not the only great fun in football. There is also heat exhaustion, a large fraction of all possible serious orthopedic problems, and more!I mean, God surely made a mistake by putting just a hinge joint at the knee instead of a ball joint, right? Sooooo, a guy in my high school, with the help of football, tried to get a solution, to have one of his knees bend on an axis still horizontal but perpendicular to that of the hinge joint.Yes, yes, it was painful, and did cause him some difficulty walking for awhile, but think of all the upsides. I’m still thinking, …, still thinking, but, but, maybe sympathy from the cheerleaders? Right as he gets carried off the field with his new knee an approximation to a ball joint, his excruciating pains, and the cheerleaders bend over with concern and sympathy?Indeed, maybe it’s all about the cheerleaders? I’ve always wondered what it was about. ‘Bout has to be the cheerleaders, right? I mean, what the heck else?

          17. LE

            Yeah but you have to remember when selling to not oversell.You got the mom’s already on “head injury”. One word that has impact. No reason to throw in the other things or you might lose the sale. Message has to be simple!!!a large fraction of all possible serious orthopedic problems.I watch the Nightly New with Brian Williams. Last year I noticed that he was slurring some words and generally didn’t appear to be on top of his verbal delivery game.A bit later he revealed that he played football in high school (for some shit team in NJ I think) and had suffered his entire life with pain from that injury and had iirc 3 operations so far.”I’ve been in pain for 35 years,” he added. “I loved playing a team sport. I loved every minute of football. I’ve paid a very high price for what’s been confirmed to be the single worst New Jersey High School Catholic League football career in history. And now he was going in for the 4th to cure everything. [1] Imagine that. He said there wasn’t a single day he hadn’t dealt with pain as a result of playing football in college high school. A single day. How sucky is that? Not to mention the damage he caused to his body by taking pain meds for all those years.I mean you really don’t have to do any research or read anything to know that playing a contact sport like football is going to result in future and current problems that clearly outweigh any benefits, right?[1]

          18. JLM

            .Brian Williams did not attend college.JLM.

          19. LE

            Yeah my mistake (I did say in paragraph 4 “high school”).

          20. JLM

            .NATO made a horrible miscalculation in forcing the issue by allowing small, inconsequential countries to join NATO.NATO is a defensive alliance, a military alliance. We allowed it to be used like a social club, an economic alliance.Russia is entitled to its own Monroe Doctrine.Why do we want to partner up with Latvia which has 4,500 professional soldiers.Article 5 of the Atlantic Charter says: “An attack on one is an attack on all.”Me, I don’t want to go to war over Latvia. Guess what? We will not.JLM.

          21. LE

            As far as Latvia I’d say the following. “When something doesn’t make sense there is probably something about it you don’t know or understand”.(Some would call this the “fool at the table” theory I guess?).It is quite possible that you are right of course.But there could be other reasons why something on the surface that doesn’t make sense is being done.An example is our support of Israel. People say it’s because of the Jewish lobby which could be true. Or it could be that they are in a strategic position near the oil fields. Or both reasons, right? Same reason we allow Saudi Arabia to do all sorts of screwy things that piss us off about other countries that we don’t get oil from.That said I know nothing about Latvia or why they were allowed in Nato I will admit.

          22. JLM

            .Even at the time, Latvia was a provocation. The USSR was done. Russia was beaten. We were piling on just like the peace at the end of WWI.The US relationship with Israel and Saudi Arabia — both of which are at their low ebb right now — makes perfect strategic sense for the US when looking at both geographic and oil politics.JLM.

          23. sigmaalgebra

            Gee, learn something everyday! I long thought that the role of NATO was to bottle up nasty, old Europe and keep it from doing another Napoleon, WWI, or WWII. In a major sense, NATO was to keep Europe from attacking Russia again! :-)!The EU and the Euro were supposed to be the basis of the ‘economic alliance’?Latvia? There are some really pretty girls from Latvia! Also Ukraine! In the first college math class I taught, one of the students was a girl from Ukraine, blond, wearing apparently a peasant costume from Ukraine!

          24. jason wright

            small countries do have geo strategic significance to another country’s game plan. Bahrain, Qatar, Texas, et.c.

          25. Timothy Meade

            I read recently that Kerry and Lavrov had a meeting where they couldn’t agree on the definition of the word Ukraine. Each came to entirely different conclusions as to the same joint statement and took it back to their respective publics as a resounding success.

        2. Ray Charles

          Is “Hitler Putin 1938” the new “Hitler Medvedev 1938”??? Georgia on my mind, indeed!

          1. Dan

            Toe-may-toe, toe-maa-toe.(Nice reference though Ray)

          2. Ray Charles

            Yes, the screen shot is my point. Medvedev was president when Russia invaded Georgia…nearly 8 years ago. And if Georgia made Russia “Hitler 1938″ wouldn’t that mean Crimea makes Russia…”Hitler 1946”? Which would be weird, since Hitler died in 1945. Ahhhh history…

        3. pointsnfigures

          More appropos to Google 1914. Doesn’t remind me of WW2, but more like WW1

          1. Dan

            Valid. Hopefully the similarities end with alsace-lorraine.

    3. greggdourgarian

      +1 for puns, n’est-ce pas?Cloudy times ahead for startups Yelping, RAREing, Gulping for revenue.

  7. Ronan Perceval

    Fred, I’d be interested to hear why you don’t think that Box or Square are “commodity products”. I thought Crighton’s point was quite well made. Also Peter Thiel’s notes about what separates a mononpoly tech company from a commodity one here – really highlight for me why those companies, although growing super fast, are not really creating a moat between themselves and their competition.

    1. fredwilson

      I don’t know a ton about Box and its market. We aren’t big Enterprise SAAS investorsI think Square has built a brand and a user experience that protects it a bit. Its not a monopoly like market position but I don’t feel like its a commodity either

      1. Timothy Meade

        Could Square be a branded play in a commodity market?

      2. Ronan Perceval

        I’ve seen lots of alternatives to Square emerge in the last 6-12 months. Many which offer better processing rates to merchants. Nice design is great but when it comes to a core business process like payments – majority of merchants will go for the rates. Their main long term threat though is from First Data. They are offering vertical POS plays their own branded reader to offer to their users, again with much better rates. And now they have their own Android POS platform – Since Square has to use someone like First Data they’ll likely never be able to compete on price without investing billions more on becoming their own merchant services platform. For $1-2bn , square would be a decent purchase for First Data but their last round prices them out of that kind of outcome.

  8. pasmith

    Lots of easy money at sky high valuations also can also lead to changes in a business plan. Its almost as if the burn rate increases to justify the amount of money that was raised.

    1. Richard

      VCs are like the federal reserve in some ways. They both essentially print money. Its no surprise that high burn rates are the result.

  9. Dan Storms

    Any reason they can’t sell some shares on SecondMarket until the IPO market bounces back? Facebook did this with much zeal till they approached the investor count limit.

    1. Dave

      Unless something has changed recently, second markets main business is secondary sales, ie sales by someone other than the issuer/company. They have transaction/closing support for primary sales by issuers, which are capital raising events, but I’ve never understood that to be a big part of their business. And they don’t raise the capital. You’d need investors to be buying so it is a financing. I don’t think Facebook sold shares in sm. existing shareholders sold shares through sm. big difference.

  10. cp

    “So the morale of the story….”I wouldn’t normally point out a typo, but given what you said about hard choices — and what it might mean for those inside the companies — perhaps it was a Freudian slip?

    1. fredwilson

      maybe. but i fixed it. thanks for pointing it out.

  11. Liban Mahamed

    Fred, the problem maybe systematic more than one or two specific firms.Many startups should not have received funding in the first placeThey operate iin razor thin margin, overcrowded industries, with mature well capitalized players.In some sectors such as cloud computing and cloud storage probably no one will make any return. All the new startups Box, Dropbox etc and the established firms such Amazon. Microsoft. Google, etc, willl bleed each other to death.In essence, you have capital chasing few ideas Social media, cloud computing, mobile payment, mobile messaging and so on.This can work with finite no of firms. But people keep funding same idea in one too many firms.Believe it or not around 10 startups are working on mobile payments/credit card processing through mobile phones.Dwolla is probably the only one with some new methodology of handling paymentsA clear case of capital misallocation.The markets and gods of capitalism are getting angrier by the day.Judgment day comng soon. The tech bubble will burst.

  12. Sofia Fenichell

    As usual I find myself drawn in to this blog. It’s such a wonderful forum for discussion and debate and attracts such high quality thinking.In my eyes, the issue comes down to 1) how high are the switching costs?, 2) How useful is the solution for a given problem? 3) how competitive is the market. If switching costs are high (which they appear to be) than you can spend against a market if churn is also low. However, ultimately returns will go down if the landscape is crowded. This happened in the early days of the telco operators. It can become a zero sum game if you are competing against well capitalized competitors in a relatively commoditized space no matter how high your gross margin is. You have to increase R&D not just marketing spend so that you can constantly deliver superior product. That will impact your margins. So one way or another, I am sure these companies are fundable, it is just at what valuation? Are they 10x better than competitors? I was a sell side analyst for a decade (can hardly believe it myself) and took more than my fair share of companies public – ultimately the ability to get funded will depend on whether investors actually believe in these factors. It’s not just about gross margin. Gross margin enables you to reinvest in better product. But those product decisions are important.Also, this paragraph bothered me but I don’t know the companies well enough to judge. “Levie at Box speaks easily about his vision, but the company’s actual array of products is still blurry, with consumer and enterprise options still prominently featured and at times at odds with each other. Square is even more variable, launching a blistering array of products in the last few months including Square Market, Square Wallet, and Square Cash in addition to its core point of sales products. A lack of focus is not a good signal.”

    1. Liban Mahamed

      Excellent points you raised My modest opinion is at least Box being a provider of a cloud service (an almost commodity) is operating in a crowded low margin business. This is also it is only product.Box fails your test as of now.

    2. LE

      A lack of focus is not a good signal.A lack of focus can and often means there is no low hanging fruit that is exploitable or pulling the company clearly in one direction. So they are seeing what hits the fan.If you’ve ever started a business, even a small idea, from scratch with a product or service, you can usually clearly tell if the thing you are offering is going to be the low hanging fruit. Because things seem easy and people appear to be coming out of the woodwork to give you their money. And your only job is (as I have said before) “taking advantage of the low hanging fruit of opportunity”.The first thing out of college that I did in order to see what the market was I cold called for about a week. I quickly determined after that week that it would simply take to long to get customers for what I was going to do. No low hanging fruit. So I stopped doing that and decided to do something completely different. And with the new idea, before I had even opened up, people knocked on the door wanting to give me money for what I was doing. Before I even opened. Low hanging fruit.

  13. Sofia Fenichell

    Re your Epilogue, one thing I have learned re valuations is that the market is long-term efficient. If you don’t pay a sky high valuation, it is because you don’t believe the company will catch up to it. I watched your excellent interview with Jason Calcanis (50 minutes but I recommend it as background listening) where you talked about paying up for companies like Twitter which clearly has paid off.

  14. Rachael

    There are a few good reasons for Patents. Technology like square and box typically take time to hit its stride. As did the iphone. VCs can continue to ignore this, but they do so at a cost.

    1. CJ

      iPhone was an almost instant success. Took maybe a year, just after Steve figured out he should make AT&T subsidize the cost rather than having his customers buy it outright. Box has been going for much longer.Square on the other hand has a LOT of potential. I’d give them as much runway as possible as an investor, they really just have an issue of scale. The bigger they get, the smaller the transaction costs are for them which decreases their burn or leads directly to profit. And they’re expanding and still innovative. I’d hate to see them acquired actually, as I think they have great potential to disrupt payments, more than any other company thus far.

  15. Lucky

    At one point do you argue against a sky high valuation? Is there a set number for all tech companies ? What are common burn factors that many companies face other than employees and their salary? Is it smart to outsource as much as you can in the beginning ? Sorry if my questions are “green” I have a start up and this is “my first rodeo” in tech. Lucky

  16. Richard

    The premise that the public market is there to save an underperforming company is problematic.

  17. Elia Freedman

    Second to last paragraph: greater fool theory of investing?

  18. Liban Mahamed

    Box is facing extreme odds here You have Microsoft, Google, Amazon, Dropboxand many other less known playersKeep in mind these big companies can subsidize their cloud business and lose money for years Box has no unique product or differentiating factorThey really need a miracle to stay open for business much less go public

    1. CJ

      Yeah, I just posted the same thing but less detail. Totally agree.

  19. szx

    “morale” -> “moral”?

    1. fredwilson

      yup. thanks for pointing that out. i fixed it.

  20. Salt Shaker

    Last year Box did $59M in rev while burning through $154M. As of Jan 1 they have $361M in accumulated debt. Once some of these company’s go public after a qtr or two they turn into a modern-day version of “Fool’s Gold”–In the 1800’s a spirit of jubilation came tumbling back to earth hard and fast as many learned that not everything that looked like gold truly was.

  21. Dave

    As always, helpful article Fred. I also like your acknowledgement of your own conflicts, not defensive, not argumentative, just shooting straight as always.Of the two, Box has more long-term possibilities to me. Enterprise collaboration done right is a very difficult, very valuable problem to solve and is an emerging, growing space. Ultimately mid-sized and larger enterprises will pay real money to solve this problem. Box is the best enterprise class solution I’ve evaluated. They need to get moving though on revenue generation, particularly as Microsoft pushes Office 365 online and 1TB of included storage in OneDrive through their next enterprise renewal cycles to existing on premise users.Square is in a more difficult spot to me. Transaction processing is a low margin, volume based, mature, scale driven business. They have very high costs and (relatively) low volumes so do not get full economies of scale. The belief that cool design can compensate for too high of a cost structure in a back office function is great if it works but more likely to fail. Plenty of companies, such as Intuit, can leverage an existing strong SMB channel that Square hasn’t built. And Square’s chances with the large end of the market, where it is all about cost and where competitors have very large sales forces, seem non-existent.

  22. LE

    So the morale of this story is that you can push valuations when you have investors knocking down your door, but unless you are cash flow positive and expect to remain so for the foreseeable future, you do that at your own risk.When I was a kid my dad used to tell me that the employees that had negotiated the biggest raises were the ones that he let go when the economy went bad.The employees that were less aggressive [1] ended up keeping their jobs because he said that he could always find something for those employees to do at the amount they were getting paid. (Or something to that effect I don’t remember the exact words.)[1] And I’m guessing perhaps less greedy and maybe even more naive.

  23. Jordan Thaeler

    Hmm once a VC is on the same side of the table as the op co they’re pushing the high valuations too. Ironic since they position their services as the “smart” money…

  24. LE

    The past three months have not been good for highflying tech stocks and now we are seeing IPOs being postponed. Both Square and Box have recently done that.When you haven’t been through various cycles it’s really hard to believe that the party won’t last forever.

  25. LE

    But I am also an investor in companies that have found, and may or will find themselves in the valuation trap. I have lived it, felt it, and suffered from it. It is a real issue.I give you plenty of credit for being able to deal with the frustration of having invested in an entrepreneur that stubbornly won’t listen to, let alone accept, any advice you (or others) give them. About things that you clearly have a better probability of being right about. Which is different than being always right. Business is analog it’s not about being right all the time. The people that are smart and have experience generally have a big advantage.

  26. dave

    I had that happen with my startup in the 80s.We raised a series A at a modest price, but then Lotus IPO’d, and we felt we could justify a higher valuation, which we got from the series B investors. Then we had a few bad quarters and needed more money, and they said Hmmm maybe we can squeeze them for more shares for the last round, and they did — they got a much better price than even the series A guys did. Which of course pissed off the series A people.That screwed the company forever, from the standpoint of investors and their board reps. They felt we had been dishonest, cheated them, and refused to help us get more money. We were in a very cyclic business, feast or famine, so the next time we were doing well we sold out. They all made huge profits, and never said they were sorry or even thanks for doubting our integrity (of course).

    1. fredwilson

      ugh. i bet there are lot of stories like this in the world of startups.

  27. Doug Helferich

    As one develops a business plan, is this a topic that should be taken into account when making a pitch? Rarely have I heard burn rate discussed past “this is what burn rate is” while being taught about financial modeling and forecasting.Taking a different perspective, does it make more sense as an investor to focus on less labor-intensive companies, in favor of ones who can automate away more non-core activities (assuming this is one method of strategically reducing burn rate)?

    1. JLM

      .No CEO or founder or entrepreneur should go to bed without knowing:1. How much cash do we have on hand?2. What is our burn rate as of today?3. How many months runway do we have as of 5:00 AM tom’w morning?When the runway gets down to less than six months, capital becomes job no 1.JLM.

      1. LE

        I personally feel that losing sleep over and getting no sleep is not a way to be able to work fully refreshed to solve a problem.I think this is similar to a person trying to lose weight by watching the scale to closely.Watching things to closely just creates to much anxiety that blocks creativity, inspiration and saps power that is needed to fight the battle.Of course it’s important to keep numbers in mind. But so is a positive attitude and if you are worrying to much day to day and everyday that has to have impact.

        1. Dave

          Someone needs to watch the cash every single day, particularly when you have outside investor capital. Otherwise it is way too common that a small business wakes up one day, realizes it thought it had 3 months of cash, but it miscalculated and has 3 weeks of cash. Lack of attention from management is why I’ve seen good investors have to write checks in to cover a final payroll to avoid personal liability. Management who lost sight of cash will struggle to ever raise capital again.

      2. Doug Helferich

        At a higher level, how much should your business strategy be dictated by your financing strategy?

        1. JLM

          .Finances are like water, air and fire. No more important than that.JLM.

        2. Dave

          No money, no business. So financing strategy and available capital informs everything. Particularly in a business like Square is in. Lack of capital can lead rapidly to loss of confidence which can lead to demands for capital/security to be posted from other players in the payment ecosystem which amplifies lack of capital. Payment processing is not capital intensive until the moment that it is. So must stay ahead of the curve.

  28. JVenator

    The conversation seems primarily about a company’s strategic options being constrained when they take investor money at too-high valuations. Specifically in the officially priced A, B, C… rounds.Does anyone have thoughts on how this applies to the valuation caps on convertible notes used in Pre-Seed/Seed rounds? Should a founder be weary of a too-high valuation cap, and it’s potential impact on follow-on investment in priced rounds or additional convertible notes?My understanding is that you should attempt to not discuss your seed round valuation caps with your A-round investors.Insights welcomed. Hopefully I haven’t completely missed the conversation window on this post.

  29. tga999

    It’s moral, not morale.

    1. fredwilson

      thanks for that. i will fix asap.

    1. fredwilson

      just left you a comment on your post howard. i loved it.

  30. Donald McIntyre

    There are two solutions to the valuation trap:1. Downround: accept the dilution and gather cash to survive and pass the “winter”.2. Downsize: quickly adjust costs, reduce payroll and marketing expenses to balance with your revenues and eliminate or minimize your burn rate.I would prescribe this if you have a real business like in the case of Square and Box (they have tangible users and revenues).

  31. jason wright

    the valuation trap dynamic seems similar to the bitcoin mining algorithm.

  32. Albin

    The TechCrunch writer had it – these are commodity businesses. Google and Microsoft, intelligently mentioned in that write up as different beasts, still have the best or only products available in search or enterprise support, respectively. Nobody yahoos or duck ducks or anything else to find what they want, they google, not because they love Google but because it still delivers first page satisfaction for 99% of searches.Square and Box were late to their respective parties, they have good products but don’t add much if anything to what’s already on the public markets. They have to hope for a buy out from Yahoo or some other similar agglomerator rather than to expect an IPO for what they do.

    1. Dave Pinsen

      I usually use Bing for search.

  33. IPOTroll

    Box and Square have been well timed execution plays from early on in their respective histories. The recent IPO headwinds aren’t surprising and will serve as a good test of leadership. @levie and @Jack get the unenviable chance to show their mettle.

  34. Pointsandfigures

    Corporate Finance is a strategy like anything else. Screw it. Up and you die.

  35. Poi

    It seems like all these companies IPO as soon as their risk becomes too high for their private investors to inject any more capital so they turn to the public market who will buy into the hype thereby reducing risk + providing returns to the privates. An IPO is really just great marketing.

    1. pointsnfigures

      No, I don’t think that is the reason. They can access the public market, so why not. It’s more efficient than the VC market, and cheaper cost of capital as well. For VCs, it’s the pay window.

      1. poi

        Exactly, it’s a marketing vehicle the VCs use to push the risk onto the public dummies and pull their cash out.

        1. pointsnfigures

          Meh, the public is smarter than that.

  36. Paul Sanwald

    if no one has mentioned it yet, this reminds me of ben horowitz’s “cash is king” post:

  37. Tyler Jamesson

    Listed companies raise capital at down round valuations all the time. Don’t know what it’s such an issue for startups. If need the capital raise as much as you can when your valuation is high, we all saw the dilutions that occurred to investment banks during the 2008 crash. If you plan on staying independent and being profitable one day, this is a part of the rite of passage and also part of being a public company and why the public market exists.

  38. Twain Twain

    Smartphones and Bitcoins are commodities with scaleable network effects. Square and Box are service utilities provided through a device.The receipt as a communication medium is an interesting concept from Jack Dorsey.It does indeed tell the small merchants where the consumer has been, what items they bought and how much they spent.However, does Square communicate the types of stories that Rambler does?*…Also, what will happen to Square when Coin launches?*

  39. Great insights. To me the issue also lies with most start ups, and I dare say driven by VCs/Angels, chasing revenues vs cash flows. The crux of these traps is the dependency on constant financing or liquidity because of lack of organic cash flows after all. See Gilt for example. Been waiting for IPO window for over a year but you don’t hear them panic do you?

  40. Juan Yagüe

    In Europe the scenario perceived by many startups is different: here a down round is really a catastrophe. I think it is this way for two reasons. With a narrow opportunity window for IPOs the ultimate exit strategy is usually limited to be bought by a deep-pocketed company. On the other hand is usual that new investors claim as necessary for them to take a share in a startup that previous investors remain there not exitting to show some kind of confidence in the company. In a situation where investors (if you have them) pile up endlessly not allowing any of them to exit and you face a bottleneck in the horizon regarding to ultimate exits, then a down round is really catastrophic!

  41. JamesHRH

    There are niche issues, there are micro-niche issues & then there is the valuation trap issue for non-CF+ startups.

  42. Anthony P. Lee

    Well said @fredwilson:disqus. This trap applies throughout the startup financing lifecycle, including companies raising their first rounds and subsequent “growth” rounds of financing. As you say it is important for entrepreneurs to know what they are signing up for when they optimize for high valuation.Related article inspired by one of your early posts on why startups fail:….

  43. kevin

    Fred, what is the best way to get a proper valuation that’s not ridicules, if you want to sell off technology that your company has created, yet does not want to pursue?

  44. Clay Selby

    Great insight. My opinion comes as a founder in a early stage company. This is one of the things that keep me up at night. Of course, it depends on where you are sitting. On this side of the table, it could be equally disastrous to undervalue the company.How are founders and the teams dedicated to building the company able to stay fully-vested and passionate with the success of the company? Especially when a low valuation allows institutional investors to be the (near) majority stake holders? Pushing a valuation only on cash-flow seems (respectfully) a little short sighted.

  45. JLM

    .Extremely strong insight. The VC business, VC funded companies do not operate like real public companies, do they?Well played.JLM.

  46. William Mougayar

    Actually I somewhat disagree with your last paragraph.These companies are at the cusp of bridging themselves from being startups to large/established companies. They haven’t made that jump yet, and are shooting for it. Once they cross to the other side, then your argument is solid, I think.

  47. fredwilson

    Great point. Facebook had a down round. Worked out well for Yuri Milner

  48. Richard

    They are called High Beta stocks for a reason. Volatility can be valuable.

  49. Dave

    Great insight on the people side. Square’s business is trickier though. Payment processing runs in an ecosystem where lack of funding (real or perceived) can cause a business crash because other players in the chain stop dealing with them for fear of being left holding the bag when the money runs out. It is like a mini-run on the bank. It is not uncommon for people in that chain to say to other (smaller) players in the chain, “Pay $XXX on deposit to increase your security to [Large player, JP Morgan] by 1 week from today or we will shut you off”. Unfortunately, I’ve seen it happen. It starts with a move from having your financials reviewed every 6 months, to every month, to every week. That is a real risk for Square if their cash burn is as reported to be.

  50. jason wright

    “…employee morale?”it does if there’s a bonus structure linked to share price performance.

  51. ShanaC

    This is already happening with much smaller businesses. The sex appeal/thought of career growth is higher at a startup than a bank, a big Co, or a consulting firm. I’m seeing big cos put out ads for entrepreneurial candidates. It is a function of the minor bubble we are in

  52. Aaron Klein

    I’ve never done a down round, but in my opinion, down rounds are not disastrous for startups. Disastrous startups often do down rounds, though. 😉

  53. LE

    Down rounds are usually thought of as disastrous at startups, but at the size of Box and Square I am not sure they really are.Something is disastrous if people, or the peanut gallery, think it is. Which is totally separate from whether it really is or not.This is the reason that a man can place his hand on a random women’s arm, but not over her mouth or breast. By definition you can’t do that. Except if you are a Physician doing an exam in which case you can. Or married to the women. But not in a restaurant. You get the point.

  54. awaldstein

    You are no longer a startup when?

  55. Richard

    Sounds like an opening of a new standup comic bit.

  56. William Mougayar

    It’s probably a long answer, but a good question to ask, and you’ll probably get a variety of disagreements and range of opinions.

  57. JamesHRH

    Growth + profits + low customer churn for 3 years.

  58. awaldstein

    For the first 15 years of my career I worked at ground floor start ups or major public restarts.We raised hundreds of millions of dollars on the private and public markets.We didn’t think of ourselves as startups but as companies who needed (like they all do) capitalization.We thought of ourselves as businesses. We managed by a P & L and honestly I still do.

  59. Richard

    Well said.

  60. CJ

    I’m from Chicago and aside from our history of corruption, it’s really hard to think in terms of product first, revenue second for me and others here – Midwest mentality. Whenever I evaluate a potential idea I start with revenue potential first, I think it’ll eventually be a benefit – if I ever start a company – but is a detriment to building some of the cool things I’ve had in mind.

  61. maithreyi

    While it is ideal for startups and companies to have revenue/business models from the onset, I think theres still a place for companies to focus on adding as much value to users as possible (finding product/market) first and then figuring out viable revenue streams – The first is a much harder problem to solve than the latter and often leads to much more revenue in the long term.

  62. awaldstein

    When I read start up– I hear business.When someone makes a distinction, i feel ok in asking them what the difference is?

  63. ShanaC

    The word is being used in a way where it is now meaningless

  64. awaldstein

    It’s arbitrary but it makes sense to me.

  65. William Mougayar

    Well, the first difference is that the startup is in search of business model. It doesn’t have one initially.

  66. LE

    It’s a word that has grown up with the web and sounds sexier than just business. Just like the word “consultant” or “boutique” sounds better than “mom and pop” or “1 person business”. (You must remember of course when “sanitation engineer” replaced “trash man”.)SoI just did a search to see the use of the word startup from the period 1995 to 1998 and came up with zilch in terms of relation to business:…”Value Proposition” appears to date to about mid 90’s as well.

  67. Dave

    Square didn’t invent payment processing for small businesses. They have a nice solution and one that is better for many, but players like Intuit have been in that space a long time. I think Intuit entered that space 7 or 8 years ago and has a sizeable payments business.

  68. sigmaalgebra

    I read your link. Summary: Yup, he wanted to go to film school!There’s no shortage of companies who know how to run a big data center, and then ‘cloud storage’ is an easy thing. So, there’s Google, Amazon, Microsoft, the larger colocation companies, and no doubt more, e.g., NASDAQ in CT and a backup location, IBM, Rackspace, Akamai, CloudFlare, NSA (hire the people), Apple (if only for their download services). There might be some significant server farms on Wall Street? Maybe?Moreover, it is in the interest of Microsoft to document how to build a big server farm since they sell big bucks products for doing just that. They have some quite successful, big server farms and, for a candidate big customer, might very well be quite willing (eager?) to outline just how to use Microsoft’s products to do that. So, a large user could, then, DIY, roll their own.But Box wants to branch out to running the customer’s software on their servers. Okay, but that puts them in competition with Amazon’s AWS and, likely, becomes yet another large scale application of virtual machines (VMware anyone?) where there is no shortage of good experience.We’re talking high capital costs for equipment with a remarkably short useful lifetime (SanDisk has SSDs at 4 TB now and is promising 8 TB next year), essentially all the crucial technology — processors, disks, virtual machines, operating systems, database management systems, backup and recovery technology, systems management, communications, power sources — from others, next to zilch in barrier to entry or technological advantage. So, maybe in one of their server farms they have 100,000 square feet of floor space of racks with, say, 1 TB rotating disks and 100 GB SSDs, and now a competitor has all 4 TB SSDs?As I recall, it seems that at times some people have emphasized roles for barrier to entry and technological advantage? Hmm ….I’m drooling over 8 TB SSDs which stand to be fantastic for reading a lot of data really fast, just what I want. Since the data changes slowly and is nearly read-only, the operations are especially fast, and the SSDs don’t wear out from too much writing. My initial back of the envelop estimate for that data for a fairly successful company was 150 TB, and with 8 TB SSDs we’re talking, what, 150/8 = 19 or so SSDs, that is, a $100 wire shelf unit from Sam’s Club with 12 mid-tower cases, for a crude solution. That’s all of 6 square feet of floor space! The need for a server farm with a million square feet, at a bend in the Columbia River (cooling water!) is fading fast!Besides last night, i.e., to 4 AM this morning, made progress on my de/serialization problem! I checked everything down to where I serialized an instance of a class to a byte array — it’s got the user’s input requesting a calculation. Then I converted the byte array to hex in a string, wrote out the string, sent the byte array to the server (to do the calculation) via TCP/IP, wrote out the hex again, compared, and saw that they are equal!So, the problem is right at the next statement in the server, the deserialization, and the cause looks like a subtle Microsoft issue having to do with ‘strongly named assemblies’ based on one program sending to a different program. So, so far, for this issue, all my code down to the deserialization is is working!Ambition and even hard work are important, maybe usually necessary, but not always sufficient. The Box guy might want to consider trying film school again? Heck, his first movie could be something really dramatic about startups, driving down Sand Hill Road for VC fishing, spending big bucks, attention from Silicon Valley babes, hiring 25 people a month for a backup plan of an acqui hire, etc.! Sounds better than cloud storage to me! :-)!

  69. Liban Mahamed

    In the case of Square you are on the mark. The reader makes credit card easy for merchants. Box is really a more complicated case, cloud storage existed in some form since Sun Microsystems in early 1990, so far even the big players can not make money in cloud.Square is market leader in mobile payment, will probably make it in some formI think for it is very hard to be optimistic

  70. awaldstein

    There is something cleansing about making something that can be sold. A service, a chunk of sw, food, transportation–whatever.ZipCar and Uber were like that from the beginning.Airbnb I bet not.But things like Twitter and Facebook, Tumbler and Instagram–culture changers that are key to how i live–never would of happened then of course.

  71. shareme

    Midwest guy myself, just joined a startup where I looked at not revenue first but target’s user’s reaction to the product..seem to guess right so far..obviously there is stuff I cannot mention just yet though

  72. JLM

    .The land of the broad shoulders.JLM.

  73. jason wright

    he of Bank Menatep.

  74. CJ

    You’re totally right, I just think it’s less likely that a FB or Twitter or … will be made in the Midwest due to that predisposition.

  75. CJ

    What about my wife’s shoulders? 😛

  76. JLM

    .Malcolm, I am so not going there………….JLM.

  77. ShanaC

    I’m broad shouldered… It isn’t a bad thing

  78. markslater

    lest we forget.

  79. awaldstein

    Both are equally hard just in different ways and different strategies of funding.

  80. Salt Shaker

    And that’s where the fundamental prob lies. A start-up in search of a biz isn’t a biz. To that point, they’re just hobbies. Too many start-ups don’t have a clearly defined market, identified a market need, have done the requisite due diligence, developed a sustainable positioning w/ a point-of-difference, etc. The success/failure rate is so low cause too many start-ups frankly aren’t well thought out and are run by people lacking in fundamental biz skills.

  81. William Mougayar

    Yep. I can assure you there’s a version of the “business canvas” (part of Lean) that we used at HP in the early 90’s, but it was called “10-step plan for sustainable competitive advantage”; a not so sexy term, but it was a solid methodology.

  82. LE

    Right. By the way HP would still be the great company that it was if the competition hadn’t lowered the quality bar and caused them to do what they probably needed to do to stay alive.It’s easy to be a “keh-nock-er” (that’s a derogatory yiddish word almost sounds like “nocker”) when you are the only newspaper in town with no competition and the Internet hasn’t been invented. (This doesn’t relate to HP btw, they actually had good things I’m talking about other companies that are around today that have a pile of cash as a result of some lucky market position (as well as execution to be sure). Most people aren’t smart enough to care about a quality product they just want a cheap product.By the way almost hidden, and probably easy miss in my comment, was something that has always bothered me. Starting sentences with so.

  83. JehanT

    Like Facebook?

  84. Salt Shaker

    Facebook solved a need, defined a market, etc., although their biz at origin was hardly built in a classic, strategic manner. The notion that creating scale automatically leads to monetization is a fallacy. Facebook is still grappling w/ revenue growth and sustainability, particularly in mobile. Facebook is far more an aberration than the norm and its success falsely created visions of grandeur for far too many. Biz fundamentals still matter, as (another) reset will shortly begin to demonstrate.

  85. awaldstein

    All true.They just really suck when you do them. And they are so so painful to make happen.

  86. awaldstein

    I almost never use it.

  87. Aaron Klein

    I have done painful!

  88. pointsnfigures


  89. awaldstein

    Seems very arbitrary to me.

  90. Cam MacRae

    Use of so as a discourse marker is neither improper, nor a hanging offence, although persistent overuse in modern speech is somewhat monotonous.

  91. Timothy Meade

    In Midwest or elsewhere?

  92. kidmercury

    operating cash flow is slightly positive, though has been positive and negative over the past few years. free cash flow is consistently negative. neither is supportive of the thesis that the business has proven itself.

  93. stevenwillmott

    Lets say they had to lay off 30% of the staff – as long as it was done to preserve focus and the core going concern, I doubt the news would even filter much to their users on the street.It would need to be managed well, but Square is big enough that that kind of fright would not likely kick in too fast. Obviously if they need to make cuts and don’t then, that’s another story.