Did Fidelity wipe out $14 billion off SnapChat’s valuation?

A couple weeks ago Fidelity announced a 25% write down on their investment in SnapChat. This comes just three months after Fidelity participated in a $650M Series F round that reportedly valued SnapChat at $15B. Some commentators have suggested that this write down cuts SnapChat’s valuation by 25%, but it could be much lower than that.

As private equity investors come into the pre-IPO market, they’re typically taking Senior Preferred shares that have 1x-1.5x liquidity preferences and ratchet provisions that insure against downside protection. While these kinds of protections have been discussed in detail by others, they effectively impose a LIFO (Last In First Out) order on investors and their ability to get their money back; investors coming in at the last round are more Senior to investors coming before them, and therefore these protections give them first claim to get their money back in the event of a bankruptcy, IPO, or acquisition. And this could possibly come with some additional premium for taking on the risk in the first place.

So, let’s assume that Fidelity had ratchets and liquidity preferences in place (and to keep this simple has no debt). This is reasonable, since Fidelity’s fund managers have a fiduciary duty to their investors and it’s hard to justify high valuations with Net Present Value (NPV) calculations that are based on revenues. If so, then Fidelity is saying that in the event of a bankruptcy, sale, or IPO tomorrow that they will expect to get no more than $0.75 cents on the dollar for their investment. Ouch!

However, since Fidelity and the other investors in the last round (Benchmark, Kleiner Perkins, and others), are first in line to get 100% (or more) of their money back, Fidelity’s write down effectively values SnapChat at 25% less than the $650M that was invested earlier this year, or around $462.5M. That’s not just 25% less than $15 billion, that wipes out over $14.5B in valuation.

Even if there was just a dollar more than $462.5M left over, it would immediately be split up amongst Fidelity and the other investors in the last round, leaving nothing for the remaining equity holders. In fact, only if there was more than $650M leftover would there even be anything left for the investors in the penultimate round. And so on and so forth if those investors also have similar protections. Lastly, you get to the common stock held by employees and founders who are the last in line to get anything.

And this is why all the speculation about bubbles may be much ado about nothing. Valuing all of a private company’s common stock at the price paid for the most Senior Preferred shares in the last round is just bad accounting. It simply doesn’t take into account the risk that a company will IPO less than this supposed valuation. In fact, the value of common shares may be better priced by some kind of options pricing methods like Black-Scholes, where the the price is determined from a probability distribution of achieving various possible future outcomes as a function of time and risk.

In the absence of a proper pricing model for common stock, shareholders of private companies will need to wait for a strong secondary market for the shares to be established. Even then, as we saw with Facebook’s IPO, the secondary market can value common shares much higher than a liquid public market, which ultimately crushed Facebook’s stock price in the days and weeks following their IPO, before receiving on a successful mobile monetization strategy.

So what does this mean? Well it means that most of these so-called unicorn companies should probably be valued at 50% — 88% less than what is being reported. For example, compare Box’s $1.7B public market cap with DropBox’s supposed $10B billion valuation. If this is the case, then the cumulative value of the 143 Unicorn companies reported by CB Insights may sit somewhere between $76B and $254B. That’s less than Facebook’s $308B market cap.

This also means that many employees may be deluding themselves, and that founders are able to leverage these unicorn valuations to get talent and to acquire companies for pennies on the dollar while limiting their own dilution. Getting $500,000 in stock options could be a real incentive to stick around and work 80-hour weeks. Far less so if those options are valued at $100,000.

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