Monday, March 30, 2015

Venture Capital Valuation Confusion

How real are the nosebleed high implied venture capital valuations being tossed around? For example, Pinterest raised $370 million which gave it an implied value of $11 billion. Snapchat has an implied $15 billion value following an Alibaba investment. The number of “pre-IPO” venture capital backed firms with implied values exceeding $1 billion (AKA unicorns) has increased from under 50 last year to almost 80 this year. My suspicion many of these implied values are “funny money” i.e. not real.

What passes for valuation in venture capital is really relative pricing based on what someone else paid for something similar, which could be wrong. This is especially true in today’s environment where investors are driven more by FOMO (fear of missing out) than reason. Implied value is at best a proxy for market value and is often misleading. Implied value is determined by dividing an investor’s dollar investment by the proposed ownership percentage the investor receives. For example if you will receive 10% of the firm for a $10 million investment, then the implied value is $100 million.

Looks simple, but there are serious complications to consider including the following:

1)     The ownership percentage is a negotiated item reflecting relative bargaining positions and not a traditional market price. Comparables used to substantiate declining ownership percentages can result in an overvaluation when the comps themselves are overvalued.  Venture firms flush with newly raised capital have reduced bargaining power with potential issuers. Thus, they are accepting smaller ownership percentages which inflate implied values.
2)     A reality check is needed to justify the implied price. This can be estimated by determining the future performance required to justify the price paid. The aggressive future performance estimates, currently exceeding 15X+ next year revenues, are often based on continued assumed weak competition due to first mover or network effects which are as elusive as merger related synergies. Thus, the needed future performance is becoming more difficult to achieve.
3)     Beware of receiving different terms. Venture firms usually invest in preferred not common stock. Liquidation preference (AKA the ratchet) differences in preferred stock can impact real values and are often ignored in implied valuations. These liquidation preferences allow the holder to receive more shares upon a liquidation event (e.g. a sale or IPO) if the price received upon that event is below their investing value. This gives certain investors an in-effect look back re-pricing option, which is valuable and needs to be considered when pricing an investment. Warren Buffett refuses to invest in situations when he is not pari passu with other investors and so should you.
4)     Limited financial information, due diligence and issuer financial infrastructure increases the risk of error or worse yet-fraud for pre-IPO unicorns. Also, there is no guaranty of an IPO; hence the investments are illiquid. Holding a minority position in a non public firm is a potentially unpleasant experience. Even if there is an IPO, it may be at a lower than expected price, which can trigger a ratchet.

      You can only accurately value your venture capital investment twice-once when you make it and once when you exit. Relying on implied values going in can lead to some nasty surprises when exiting the investment. The implied values for many unicorns may not be real.


No comments:

Post a Comment