To quote Paul Buchheit, the founder of Gmail, “If the company has a 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 history in the latter. You have no trend or price trajectory that can define expectations but just the idea and execution strategy of the team. The conventional DCF valuation falls flat and perhaps it is the user base growth that defines the expectations for future cash flows. As this landscape of private equity valuations is so 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, where one believes that as the company becomes a better proxy of an existing public companies the valuations should be better, whereas the others base their valuations on the security of returns guaranteed at exit. Valuations before and after the public listing, can be a good measure to check the transparency in VC valuations. As the company faces reality check and has to undergo regulator’s litmus test to be listed, that offers investors better access to qualified information.
As the caveats to exit and failure of the venture are so high, this makes the investments virtually risk-less, and VCs see it an opportunity to ride the next unicorn story. One 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. We found that it can exaggerate a company’s valuation by as much as 94 percent. Another common tool 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. Other incentives 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 billion dollars of fresh funding, look for it offers than what it was offered.
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