Why post-money valuation is often over-inflated (and what to do about it)
Venture Capital (VC) is a relatively small, yet highly impactful asset class. Despite the economic relevance of VC, only primitive methods are used when it comes to valuing these assets. In particular, in times of skyrocketing post-money valuations (PMV) it is of great importance to all stakeholders of the venture ecosystem to have a clear understanding of the fair value of the assets they hold.
VC-backed firms comprise 63% of US market capitalization, even though only 0.31% of all incorporated businesses receive VC financing. In recent years, VC-financed companies stay private longer, grow to enormous sizes and receive large investments from the private market before going public. In 2020, 66 EU-based, 158 Asia-based, 293 US-based companies received financing in excess of 100M USD. The most recent example of extraordinary valuations is the 95bn USD PMV of the US startup Stripe. While sophisticated evaluation methods exist in private equity and public markets, it is the more primitive method of PMV that is predominantly applied in VC. In the following, I will outline the flaws of PMV and introduce a concept to overcome these.
Why is PMV poorly suited to determine the fair value of a startup?
The concept of PMV is fairly simple and commonly applied in VC. In PMV, the share price paid in the most recent round of financing is multiplied by the fully diluted number of outstanding shares. Assuming a venture had 100k shares (60k common shares, 10k ESOP shares, 30k Seed shares) outstanding prior to a Series A financing round:
In the Series A financing round, the Series A investors provide capital (and hopefully additional value) to the firm, and in return receive a share of it. Let us assume they agreed to pay 100 EUR per share and receive 20k Series A shares, meaning they invest 100 EUR / Series A share * 20k Series A shares = 2M EUR into the firm. The PMV, in this case, would be: 120k total shares * 100 EUR = 12M EUR. That being said, it becomes obvious that the concept of PMV applies the share price paid in the most recent round of financing to all outstanding share classes in turn implying that all shares are the same. But this is exactly where the problem lies — the shares are, in actuality, NOT the same.
The fully diluted number of shares are composed of several, distinctive share classes. This is the case in all VC-backed firms. Founders and early employees usually hold common shares, sometimes in the form of ESOP. In a financing event, the investors usually receive shares that are not only structurally different from common shares (preferred- or participating-preferred-shares), but also subject to contractual clauses that influence cash flow and control rights. In every financing event, a unique class of shares is issued. The share price paid by the investors of such an event is specifically negotiated for the number and the contractual structure of the shares they receive. By applying this share price to all outstanding shares, both the general structure and contractual rights assigned to the different share classes are fully neglected.
I want to provide a brief example to display the importance of distinguishing the different share types. Space Exploration Technologies, better known as SpaceX, raised additional capital in August 2008 by issuing Series D preferred shares. Despite the troubled economic period and several failed rocket launches, the PMV of the Series D was 36% higher than in the previous financing round. Looking at the contractual rights associated with the Series D preferred shares explains why the investors were willing to pay the price they paid, in spite of the firm’s apparent difficulties. The Series D investors were provided a 2x liquidation preference in a liquidation event, their claim senior to all other shareholders. That means that in case of a liquidation event, Series D shareholders will receive twice their money back before any other shareholder will receive anything. It is clear that investors are willing to pay a high price for shares with such a strong downside protection. Applying this share price to all outstanding shares, even though other share classes do not have such downside protection, gives an ambiguous glimpse into a firm’s value, by assigning a false value to the other share classes.
Why is this relevant?
In a positive liquidation event, the protecting contractual terms do not come into effect and the proceeds are distributed according to the general ownership structure of the firm. In a negative liquidation event, however, the share structure and cash flow-related terms can have a substantial impact on the distribution of the proceeds. This is particularly relevant for founders, as the securities they usually hold, common shares, do not have any form of downside protection. Considering that investors pay a share price that incorporates a downside protection, this price naturally overstates the value of common shares without such protection. By using PMV, common shareholders tend to have a blurred understanding of their personal wealth associated with the shares they hold. The same thing goes for investors. Investors who mark their investments based on post-money valuation falsely assess their performance and communicate this performance mark to their limited partners, misleads their comprehension of risk exposure. Therefore, shareholders should assign a distinctive value to every different share class they hold, depending on the contractual rights associated with it.
How to do better than PMV?
Metrick and Yasuda (Yale & UC) introduce a contingent-claims model to obtain a better understanding of the value of VC-backed firms. Gornall and Strebulaev (Stanford) generalize this model, and propose a framework that accounts for a greater variety of parameters. When valuing share classes of VC-backed securities, we use this model to consider the most relevant contractual terms that influence cash flow rights. The model covers:
- Equity Types: Common Stock, ESOP, Convertible Preferred Stock, Participating Convertible Preferred Stock
- Contractual Rights: Liquidation Preference, Seniority, IPO Ratchet, Automatic Conversion Exemption, Investment Amount
The first fundamental contribution of the model is the detailed computation of payoff functions associated with the respective share classes. Post-money valuation simply assumes that the payoff in an exit scenario is distributed according to the proportion of equity owned by the respective shareholders. Thus, all contractual terms associated with the different equity classes are fully neglected, and assumptions about the payoff of a share class may be fundamentally wrong. To illustrate this, consider the following payoff diagram: On the x-axis, the liquidation value of the firm is displayed (Company exit value). The y-axis exhibits the payoff a share class is entitled to, conditioned by the company exit value. Herewith, it becomes obvious why it is crucial to consider such specifics.
As mentioned before, equity-type and contractual rights are of particular importance in the case of non-preferential exit scenarios. The following simulation impressively illustrates how powerful a simple downside protection with a 1x liquidation preference, that is subject to a senior claim, can have.
In down exits, the most recent investors always assert their senior claim, which shifts value from other equity holders to them. For example, in an exit event 90% below post-money valuation, Series B investors still recover 50% of their investment, while all other investors receive nothing. A recent example of an extremely unfavorable exit event is the IPO of the mattress startup Casper, which went public at a value of less than 50% of its most recent private market valuation. Another example is the acquisition of the music recognition startup Shazam, which was acquired at a price 60% below the most recent post-money valuation.
Simple information like this provides valuable insights for all shareholding parties of a firm. VC firms gain a more profound understanding of the value, and therefore also about the performance of their investments. We can additionally develop a scenario analysis that helps practitioners to pursue more informed decisions during periods of uncertainty within a firm. It allows founders and investors to negotiate deal terms on a sound basis, by having a clear understanding of the impact that each term has on share value. The same is true for all common stockholders, founders, and employees. The model allows them to evaluate their private wealth and their risk exposure more precisely. The above-shown figures also indicate the pressure equity financing rounds put on the payoff values of common equity holders. Specific numbers like this help founders and employees assess their financial plans and the performance pressure ´resting on the shoulders of their firm much clearer.
We at Picus Capital are a lifelong entrepreneurial sparring partner for founders around the globe. This partnership goes far beyond pure capital commitments. This is why it’s of great importance to us that all parties involved, especially the founders and employees, are fully aware of their shares’ actual value.
