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Voting in the Responsible Manner

From Doug’s blog, The Deload:

Sanity is finally coming to private market valuations.

Klarna, a star private fintech company, announced new financing at a 85% discount to its last round in March 2021. Affirm is a close public comp. AFRM stock is down about 83% since last January.

Klarna’s release about the raise stated, “Klarna closes major financing round during worst stock downturn in 50 years.”

Sequoia partner Michael Moritz was quoted in that release: The shift in Klarna’s valuation is entirely due to investors suddenly voting in the opposite manner to the way they voted for the past few years. The irony is that Klarna’s business, its position in various markets and its popularity with consumers and merchants are all stronger than at any time since Sequoia first invested in 2010. Eventually, after investors emerge from their bunkers, the stocks of Klarna and other first-rate companies will receive the attention they deserve.”

The shift in Klarna’s valuation is because the odds of good investment returns at a $46 billion valuation, nonetheless anything higher, were extremely unlikely. Investors aren’t voting in the opposite manner. They’re now voting in a responsible manner with rational assessment of odds vs an irresponsible manner over the past few years.

Klarna retrospective

We looked at an opportunity to acquire some Klarna stock on secondary markets last year. We couldn’t get comfortable with the valuation.

Here’s the simple model we used at that time:

First, establish the target return, holding period, and what that implies for exit valuation.

  • Valuation at time of investment of $45.6 billion.
  • Four year holding period at a 20% target return. Investing from mid-2021 to mid-2024 liquidity event, which means the market would value the company on 2025 numbers.
  • 3% annual dilution.
  • The 20% target return plus 3% annual dilution implies around a $100 billion exit valuation.

Next, given the necessary exit valuation, what does that demand from business performance? Given the business performance demands in our set of assumptions, what were the odds that Klarna could yield a good outcome at $45.6 billion?

Didn’t seem good.

Accelerating revenue growth to over 50% off a $1 billion base, then sustaining it for years happens rarely in my studies of great growth businesses. As in almost never. The odds of also hitting a 25% net margin in four years after coming off a heavy cash burn period also seemed unlikely.

A defender of the prior valuation may challenge some of the assumptions up or down — multiples, margins, etc. Any such challenges don’t change the reality that the odds were uncomfortable at $45.6 billion that Klarna would yield a good outcome.

Simple models, like the one above, are powerful because they frame in broad strokes how the business needs to perform, and the investor can assess probabilities of that performance demand. It doesn’t matter if any of the assumptions are off a little.

When a simple model casts doubt on the potential for strong investment outcomes, a more complex model will often only bias the investor in the wrong direction. Harder work and more knowledge make us want to believe the work and knowledge are worthwhile.


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