Why Wall Street Doesn’t Get Startups

Conventional financial theory tries to boil an asset down to a few simple variables, all of which consist of measurable inputs. Plug in an interest rate and a default rate, and pow! you know how much your bond is worth. Plug in an interest rate, a cash flow growth rate, and a starting point, and boom! you’ve just valued an equity.

Moreover, the financial industry tries to break investments down into derivatives. Ask a quant to explain Microsoft, and he’ll boil it down to the equity asset class, plus the software business, plus a small variable with a tiny coefficient representing all that is unique about Microsoft.

For some industries, that’s exactly how things should be valued. Take the oil industry, for example: an oil company is basically a set of options on oil, where the strike price is the cost of extraction. It makes plenty of sense to use that to say that, for example, increasing oil volatility makes oil companies with lots of reserves worth more, even if oil isn’t actually going up.

But as well as that works for conventional industries, it breaks down for startups. Options are derivatives, and people in finance tend to prefer thinking about derivatives. Startups don’t behave like derivatives because they are, for lack of a better term, not derivative. A company like SecondMarket isn’t going to have the returns of the securities industry, multiplied by some extra factor to account for higher volatility—it’s going to qualitatively change the nature of the industry, in a way that’s hard to value.

This forces investors to make a rather impressionist asset allocation choice. Investing in a startup is less a question of allocating 5% or even 25% of one’s net worth to an asset class. It’s a question of allocating money to a different vision of the future.

Venture capital isn’t in quite the same bind. By the time a company raises venture capital, it’s in a position to start protecting a market position, rather than building one. It may not pay a dividend, but it’s earning de facto dividends on the investment in made in building a business with good economics. At that point, it’s a business tractable to conventional analysis and valuation. Even then, expect errors: as good as the major banks are at pricing most assets, they’re going to have a persistently hard time pricing newer companies with disruptive models. Current research reports on companies like LinkedIn or Zillow do a good job of talking about how those companies will build incremental revenue, but a bad job of talking about how fundamentally they will alter their markets.