Monday, May 4, 2015

Venture Capital Prices: Real or Make Believe?

Market efficiency and discounted cash flow analysis are important M&A concepts and tools. Their usefulness is questionable in the sometimes surreal realm of venture capital. Current venture capital valuation based on financing rounds keeps rising with the number of unicorns (private early stage firms with implied $1B+ values) at record levels. Reverse engineering the operating performance needed to justify such lofty values leads to some hard to believe let alone justify sales and margin estimates.

A possible explanation is the prices reflect the value of special downside protection features like liquidation preferences available to venture fund investors. The extra value for those features does not seem large enough to explain the huge current price run up.

This leads to another explanation; namely, the prices and implied values are an illusion. Unlike public shares you cannot short sell private investments if you believe they are overvalued. Absent short sales or some other mechanism prices take on a life of their own. All that is needed for a self fulfilling momentum based pricing cascade are optimistic investors and liquidity. The uptick in prices draws additional investors and the beat goes on. Disbelieving investors are unable to bet against the “excessive” prices. Thus, an apparent arbitrage opportunity goes unanswered.

It appears venture capital markets are inefficient-their prices do not reflect available information and views. Instead, they resemble lotteries-relatively low ticket prices for negative expected value investments with a large positively skewed payoff distribution. Venture funds and other investors are pressured to participate even at higher prices. They fear missing out in getting a winning ticket, and suffering a relative performance drop, which impacts their fund raising efforts. These types of one way markets can remain inefficient for long periods until some event occurs causing a revaluation. Optimistic momentum venture investors with sufficient liquidity will keep bidding up implied finding round valuations.

Interesting to see what values, if any, are realized once surviving start-ups are taken public and begin trading in a market where short sales are possible. I predict IPO investors will be in for a wild ride. Optimists will keep setting venture values until we run out of optimists. Sounds like a game of musical chairs-you do not want to be the last one standing when the music stops.


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