To quote Paul Buchheit, the founder of Gmail, “If the company has 1% chance of being a $100 billion company, then it’s worth about a billion dollars”.
One of the primary differences between investing in a public stock vs betting on private ventures is the lack of documented history of the latter. You have no trend or price trajectory that can define expectations but just the idea and execution strategy of the team. The DCF valuation falls soft and perhaps it is the user base growth that defines the expectations for future cash flows. As this landscape of private equity valuations is relatively new and unconventional, the numbers quoted sometimes go haywire and paint an extravagant picture. But the question still persists, why and when are these unicorns overvalued?
More often than not, startups are seen to magnify their value as they inch closer to being listed. Well, there are 2 schools of thought: while one side believes that as the company becomes a better proxy of existing public companies the valuations get better, the other side bases their valuation on the security of returns guaranteed at the exit. Ratios of Valuations before and after the public listing can be a good measure to check the transparency in VC valuations. As the company faces a reality check and undergoes regulators’ litmus test to be listed, it offers investors better access to qualified information, just like in the case of WeWork.
As the caveats to exit and failure of the venture are too high, it makes the investments virtually riskless, and VCs see it as an opportunity to ride the next unicorn story. One such provision frequently afforded to investors is called a liquidation preference: It guarantees a minimum payout in the event of an acquisition or other exit.
AppNexus, a digital advertising startup sold shares with a liquidation preference that guaranteed new backers at least double the amount they put in if AppNexus is acquired. The study found that it can exaggerate a company’s valuation by as much as 94 percent.
Another common tool used by the industry is known as a ratchet: It is a tool by which the VC investors are guaranteed a minimum return on the IPO of the company. Here is some maths around the concept: From Square’s S-1, we know that it's Series E investors paid $15.46 per share for Series E Preferred Stock. The ratchet in Square’s Series E provides that if the IPO price is less than $18.56 per share, the IPO conversion formula is adjusted such that the Series E investors would receive a number of common shares equivalent to a number if the IPO price had been $18.56. What does this mean? Square’s Series E investors were guaranteed a 20 percent return through an IPO. Other incentives that are widely used include the acquisition protections, which typically means last money in, first money out.
These elaborate provisions give investors in unicorn investments significantly more downside protection than public-company common-stock investors. We suggest that more attention should be paid to the contractual terms between investors and companies. Applying a discount factor for each class of securities in the capital structure, one can sum up the costs for all classes of securities and arrive at a more nuanced valuation. So next time you see a headline flash some million dollars of fresh funding, look for what the startup is offering than what it was offered.
This article is a part of the February'20 edition of our Startup Newsletter. Here's the complete publication: