My company, Evernote, recently raised a round of funding that valued the business at a little more than $1 billion. There's been a lot of talk lately about the valuations of Internet start-ups and whether they're really worth the prices they're commanding. Unfortunately, much of the discussion seems to be confused about the basic facts. So, as someone fortunate enough to be the CEO of a company that's just become a member of the Billion-Dollar Club, I'd like to try to clear things up a bit.
A billion dollars is a big number, so a natural way to think about the valuation is to compare it with that of a well-known public company, such as The New York Times Company. It's a great, famous, and long-lasting company. By many measures, its namesake publication is the most successful and important newspaper in the United States and a world leader in both traditional and electronic media. I've been reading The New York Times every day for about 25 years. It's not an exaggeration to say that I love The New York Times. Around the time of our financing, in the beginning of May, The New York Times had a market cap of approximately $950 million. Does that mean Evernote is worth more than The New York Times? I was frankly a little shocked when I thought of the question. It feels like there's something wrong with the world to even ask.
Luckily, though this kind of comparison might be natural, it's not very useful. The valuations of mature public companies and quickly growing private start-ups mean very different things. Here's why: The valuation of a public company represents a rough consensus among a large number of supposedly equally well-informed buyers and sellers. When companies are financed privately, however, there is usually only one seller (the company) and one buyer who sets the price (usually the lead investor). That means that a private valuation is not a consensus at all, but rather the highest price to which a single buyer will agree.
So, if a company wants to jack up the valuation, all it has to do is find the craziest investor who's willing to pay much more than anyone else. That might sound good, and a lot of hot start-ups are quick to avail themselves of the multitude of crazy people with fat wallets. However, there's a problem with this that entrepreneurs should consider: If you take money from a crazy person, you'll get a crazy person as your boss. And soon, your boss will be an angry crazy person, when that unjustifiable valuation crumbles under the weight of eventual reality. That's why we never chased the highest possible valuation at Evernote. We've been lucky enough to be able to start with the investors we thought would provide the best long-term strategic value and find the right deal that works for everyone.
Besides finding crazy investors, there are other ways to inflate valuations. Public company valuations are usually determined by common stock. Common shares are shares that anyone can buy or sell, and they're all the same when it comes to price, voting rights, and other privileges. Not so with valuations at start-ups. Most start-up investors buy preferred shares from the company, while founders and employees get common stock. Comparing common stock valuations with preferred stock valuations is tricky.
Preferred shares are usually better than common shares, because they have some additional benefits, or preferences. For example, one typical preference guarantees that, if the company is ever bought or goes public, the investors get their money back first, before the common shareholders get a return. Sometimes, the preferred shareholders are even guaranteed that they'll get their money back multiple times over before common shareholders get anything.
Other preferences include the right to accrued dividends, guaranteed seats on the board of directors, antidilution protection in the event that the company loses value, and veto power over important business transactions.
These benefits make preferred shares more expensive than common stock. How much more? That depends heavily on the details, but I've seen start-up company common stock discounted as much as 90 percent.
Some simple preferences are fair to both sides. After all, most start-up common shareholders (the founders and employees) will draw salaries for years, even if the company eventually goes bankrupt and the investors get nothing. So, a little protection for the investors makes sense.
However, manipulating preferences gives the start-up entrepreneur another ill-advised tool for maximizing valuation in a private financing. By agreeing to give the investors increasingly generous preferences, you can get them to pay more. Not happy with your valuation? Give the investors a guaranteed way to get more stock for free in the future, and they'll pay more for the stock up front.
This is a temptation that many entrepreneurs feel, but it's a temptation best avoided. Excessive preferences can quickly create a conflict of interest between the founders and the investors if the company stumbles a little. These conflicts rarely end up favoring the entrepreneur. And the start-up world is littered with founders who made nothing when their companies were sold, because they gave too many preferences to early investors.
So, if we had looked for crazy investors and given them extreme preferences, Evernote could have had an even higher valuation than the one we have today. But is it still worth more than The New York Times? There's one more thing to consider.
The valuation of any company is an estimate of the present value of all expected future profits, discounted for risk, inflation, and other factors. Thus, the other key difference in how mature public companies and quickly growing start-ups are valued lies in how much emphasis is placed on expectations of future growth.
Most public companies have relatively predictable levels of growth, so their valuations are heavily based on the current values of their businesses. In other words, few investors expect The New York Times's profits to grow tenfold in the next few years. Just as important, if the company does start to grow quickly (as of September, the company's market cap had climbed to about $1.4 billion), investors will be able to buy and sell the stock at any time. So the market tends to wait to see sustained evidence of growth before rewarding the company. That's why public companies that can produce that evidence consistently, like Apple, are worth such astronomical figures--and why public companies that make a mistake in setting expectations, like Facebook, are quickly punished.
A hot private start-up, on the other hand, is in a completely different position. Investors do expect the business to grow by 10 times, or even 100 or 1,000 times. Plus, the opportunities to buy stock in that start-up may be hard to come by. A venture capitalist who likes a company but decides to pass on investing one day may not get another chance. There are prominent investors who passed on Evernote at a valuation of $10 million and couldn't get in four years later at $1 billion. As a CEO and a small investor, I've seen this from both sides several times.
Because of this, start-up investors have to be much more aggressive in identifying and betting on future success. That's very difficult, which is why the average return on VC funds is pretty low. But the small number of people who do it right can literally change the world.
Simply stated: Evernote is not valued at $1 billion because our current business is worth a billion dollars today but because there is a good chance that it will be worth $100 billion in a few years.
So, is Evernote really worth more than The New York Times? It's hard to give a precise answer for all the reasons above, so let me answer personally, and from the heart: not today. But if we work hard, keep making an excellent product that millions of users will fall in love with, and continue to build the business on the same trajectory we've been on for the past four years, I think we will eventually be worth much more. And our investors agree.