Up the Down Staircase: How Venture Capital Valuations Rise in a Declining Market
By Rick Nathan, Senior Managing Director
The first half of 2022 has seen dramatic declines in public market valuations across much of the technology sector, with some of 2021’s market leaders down more than 50% from their peaks. It is therefore natural for many investors to ask how private market values are impacted in venture capital (VC), based on a sense that all technology companies should be similarly affected.
But most VC portfolio companies are nothing like their public market peers. They follow a much different pattern of growth and development, passing through various recognizable stages along the way¹. Their growth trajectory is not a straight line, but a staircase — the company climbs to a new level as key milestones are achieved:
The above staircase model shows the transition: a seed-stage company is vastly different from a venture stage or growth stage company, which are much larger businesses with clearly higher values. Some investors consider seed-stage as ‘baby companies’, passing through early-stage childhood, maturing into teenagers and adult companies as they grow up.
These companies typically raise new financing rounds at each step on the staircase. Different VCs specialize in different stages, with each completed financing transaction establishing a new valuation. While every company is different and each individual financing is independently negotiated, the venture market generally trades within a range: for example, a seed-stage company would be valued in the $5m-$15m range with a venture stage company at $50m-$100m. The key landing point within the range will be based on the characteristics of the specific company, such as its growth rate, and the negotiation dynamics. These arm’s-length negotiated values represent the most reliable measure of company value, and will typically remain in place until the next financing event when the company can move up to the next step in the staircase.
What happens in a hot market? In 2021, these valuation ranges moved up as a whole and the ranges grew. The market-driven ‘Up Staircase’ saw seed-stage valuations increase to a $10m-$25m range, with venture stage values rising to $75m-$150m. The steps in the staircase got steeper and the ranges expanded, but the venture model of step-based valuations remained.
The reverse trend occurs in a declining market. The first half of 2022 has clearly seen a ‘Down Staircase’, with valuation ranges tightening while moving lower. Last year’s valuations for venture stage financings are no longer available. But again, the step model remains the governing methodology because the ‘adult’ growth stage business is clearly larger and more valuable than when it completed its early-stage ‘childhood’ financing round.
We see this playing out in the current market for one of our venture portfolio companies:
ABC Corp.² is a fast-growing technology company. In 2019, while doubling annual revenues to about $8 million, they raised new capital selling shares at a post-money valuation of $90 million. From 2019 to date, we have maintained the portfolio valuation at the same $90 million level, even while the business doubled in revenues. With significant uncertainty and no new arm’s-length price, there was no better approach to valuation. We did not increase our valuation of ABC just because the market heated up.
The company needs additional growth capital today and is now raising its next financing round. In 2021, the CEO had set a target valuation for the new round in the $200 to $250 million range, consistent with market conditions. We agreed that those values seemed like a reasonable target as the company was clearly moving up the valuation staircase. But ABC did not raise funding in 2021; it is doing so now, in a much weaker market. Last month, ABC signed a term sheet to raise new capital at a valuation of $150 million.
The CEO feels like the value of ABC has fallen sharply from the $250 million target of 2021: down more than a third, similar to many publicly traded stocks. But in our portfolio, we will increase our reported value from $90 million, where it’s been held since 2019, up 67% to the $150 million price. This is today’s actual value and the correct price for our portfolio. Our valuation moves up because the company has climbed to the next step, even though the staircase as a whole is moving down with the market.
Most VC portfolios carry this kind of embedded potential valuation write-ups in many of their portfolio companies. These are generally small companies still developing their business models, with uncertain prospects even while revenues may be growing. These companies can see big shifts in their own momentum — sometimes a single new customer can have a big impact — and we do not attempt to adjust valuations based on daily or quarterly sales targets. VCs will adjust values based on fundamental changes in the business, typically waiting for tangible evidence from a new financing transaction. Most VC portfolio companies raise new funding every two to three years, with step-changes in valuation roughly corresponding to similar step-changes in their businesses.
Of course, not every company is successful and many venture-backed companies fail. If they do not continue to grow, they can fall off the staircase and decline rapidly. Venture investors will generally take write-downs in value when they see this happening, even in the absence of a new financing round.
Like most fund managers, we review the valuations of each of our portfolio companies regularly, preparing updated valuation reports that must withstand our annual audit review. We will sometimes have companies requiring a valuation drop if their performance is not meeting expectations and there is a clear adjustment required to their ongoing business prospects. But absent these kinds of fundamental changes, our VC valuations generally stay flat while a company remains on plan — maintaining its position on the staircase.
But even when the market falls significantly as we’ve seen this year, a company that continues to hit its growth targets will see a rising value when it returns to market at the next step in the staircase — just not as big a gain as it might have seen in last year’s markets. Just like a child growing into an adult, the reason is clear: it is much bigger and stronger than it was before.
Visit us at www.kcpl.ca for more information. Follow us on Twitter @kensingtonfunds.
References
¹ Later-stage growth companies valued at over $1 billion represent a separate category of ‘fully grown’ businesses that tend to behave in a similar way as public companies. This analysis refers generally to earlier-stage companies.
² While the example refers to an actual company in our portfolio, we are not identifying it here to preserve confidentiality.
