Post-money valuations aren’t enough for VC-backed firms

prologue

Valuing privately held companies can be challenging, especially when they grow rapidly and are involved in new technologies and markets. In contrast to publicly traded companies, there are no readily available market prices, and the use of commonly accepted techniques such as discounted cash flow (DCF) and multiple valuations is limited by the availability of financial information and appropriate comparables. It can be difficult due to lack of Instead, market participants often take the price paid per his share in a given external funding round and multiply it by the total number of shares outstanding (on a fully diluted basis), a so-called post It often depends on money valuation. rated company. \

However, this methodology is not suitable for the vast majority of venture capital (VC)-backed companies. This is because these companies typically issue different types of shares. These classes of shares can have substantially different values ​​depending on their structure, rights and preferences. Assuming all shares are worth the same as issued in the latest external funding round, investors typically receive convertible preferred stock and founders and employees receive common stock or options on common stock. , could lead to a significant overvaluation of the company. Additionally, recent investors often receive the most favorable terms compared to investors in previous funding rounds. A recent study found that a sample of 135 U.S. unicorns was overvalued on average by about 48% using post-money valuations, suggesting that these companies would be overvalued if proper valuation methods were used. Almost half lost their unicorn status. ¹

For at least two reasons, accurate valuation estimates are likely to be at the center of growing disputes in the years to come. First, the number of high-value VC-backed companies is steadily increasing, and many of these companies remain private. For example, in 2020 and 2021 alone, more than 310 US companies will become unicorns. Second, more recently, we’ve seen signs of a significant cooling in private markets amid heightened volatility, weakening the high valuations reached a few years ago.

Increased importance of funding from VCs, potential for valuation disputes

Venture capital plays a central role in financing US innovation and high-growth companies According to a recent study, VC-backed companies account for 41% of US market capitalization, with includes the world’s largest publicly traded companies, including: Microsoft, Amazon, Alphabet, Meta, Tesla. ² VC funding has grown significantly over the past 15 years, along with the growth of other private sources of capital. ³ It allowed companies to stay private longer. ^Four Additionally, as the VC market grew, it attracted the attention of a wider range of investors, including mutual funds and individual investors.

Disputes involving VC investors and other stakeholders (VCs and investors in private equity funds), entrepreneurs, other investors, lenders, competitors, tax authorities, etc. are often concentrates on evaluating companies in round of funding. Using post-money valuation in such cases is usually inappropriate. Instead, we need a methodology that adequately accounts for the complexity of the capital structure of VC-backed companies.

Gornall-Strebulaev Methodology

Will Gornall and Ilya Strebulaev (one of the co-authors of this article) developed a valuation method that explicitly models the characteristics of each class of shares issued by VC-backed companies. A fair price for a class of shares. ^Five Gornall-Strebulaev’s methodology is the basis for an academic paper published in 2020 in the Journal of Financial Economics, one of the top academic journals in the field of finance. ⁶

As mentioned earlier, the Gornall-Strebulaev method requires the fair price of at least one of a series of shares issued by a VC-backed company. This fair price is often seen as the price of an investment by an informed and sophisticated independent party (such as a VC fund), usually as part of an external funding round. The intuition behind this methodology is that the value of a firm at the time it raises external funding should be consistent with the price and terms of such funding.

The Gornall-Strebulaev methodology relies on state-of-the-art option pricing techniques to use the fair value of a class of stock to estimate the expected returns of various classes of stock issued by VC-backed companies at the time. model. (by liquidation, M&A, or IPO). Importantly, this methodology allows considerable flexibility in incorporating the payout structure and rights of each class of stock, arriving at an implied (fair) valuation of the company as a whole and each class of stock. ⁷

preferred convertible stock

VC-backed companies typically issue a new set of convertible preferred stock with each new round of external funding. Convertible preferred stock issued by a private company is significantly different from common or preferred stock issued by a publicly traded company. In particular, Preferred Convertible Shares have (1) Liquidation Preference. This means that if the company were to be liquidated, its holders would receive payment (usually the amount invested) ahead of other investors. (2) An option to convert to common stock allows the holder to benefit from an increase in the stock value of the company. In most cases, conversion to common stock may also be forced by the company if his IPO meets certain criteria.

Gornall-Strebulaev’s methodology can account for the liquidation preference and conversion rights of convertible preference shares issued by VC-backed companies. Importantly, it also explains other commonly observed characteristics of convertible preferred stock series. For example, certain series offer more favorable payout potential in the case of an IPO. For example, the right to add more shares in his IPO at a “lower price” (known as an IPO ratchet), or the right to receive the payout and benefit of both on conversion. Liquidation Preferences (called Participation). Other contractual features that are often included in convertible preferred stock series are protection against downside scenarios, such as protection from down rounds (known as anti-dilution) and protection from automatic conversion in his IPO. Provides additional protection. The latter exempts the automatic conversion of preferred stock in an IPO if the IPO does not reach certain thresholds in terms of price or earnings.

These and other rights can make a series of preferred stock more valuable than the rest of the class of stock, making a simple post-money valuation that ignores differences between classes of stock inappropriate. . The chart below shows the difference (%) between the post-money valuations of 135 US unicorns as described in Gornall and Strebulaev (2020) and the valuations estimated using the Gornall-Strebulaev methodology. The average unicorn post-money valuation is 48% above its estimated fair value using the Gornall-Strebulaev method. For more than 10% of the unicorns analyzed, post-money valuations were at least 100% higher than those obtained by the Gornall-Strebulaev method.

Source: Gornall and Strebulaev (2020)

The Gornall-Strebulaev methodology is designed to be used in the context of a funding round, but could also be used as a starting point for valuation on another date if fair prices for a series of stocks are available. I can do it. In such cases, the valuation may need to be adjusted or combined with other valuation techniques depending on the characteristics of the company and its growth.

Conclusion

VC fundraising has long been an important function of the capital markets for high-growth US companies, but its importance has increased significantly over the past 15 years, slowing IPOs and leaving very high More and more companies are reaching valuations. Valuation of VC-backed private companies can be challenging due to the lack of financial information and the different characteristics of these companies. Therefore, a market participant will be forced to change the price of the new funding round to recapture the total value of the company given by the post-money valuation, which is calculated by multiplying his price per share of the latest funding round by the total. often depends. Number of outstanding (fully diluted) shares.

However, this metric does not adequately reflect the complexity and heterogeneity of convertible preferred stock issued by VC-backed companies. Using an appropriate methodology for valuing companies at the time of a funding round, such as the Gornall-Strebulaev methodology, can result in significantly lower valuations than implied by post-money valuations, and often in practice. I do. ⁸ These differences can be at the center of many types of disputes involving VC-backed companies, their investors, employees, founders, tax authorities, and others.

Disclosure: As noted above, Professor Strebulaev is a co-author of the paper discussed in this article: Gornall, W. and IA Strebulaev (2020), “Squaring Venture Capital Valuations with Reality,” Journal of Financial Economics 135, pp. 120–143.

footnote

¹ Gornall, W. and IA Strebulaev (2020), “Squaring Venture Capital Valuations with Reality,” Journal of Financial Economics 135, pp. 120-143 (“Gornall and Strebulaev (2020)”). A VC-backed company that has reached over $1 billion and remains private.

² Gornall, W. and IA Strebulaev, “The Economic Impact of Venture Capital: Evidence from Public Companies,” Working Paper, June 2021.

³ For example, see Aramonte, S. and F. Avalos, “The rise of private market,” BIS Quarterly Review December 2021.

^Four See Ewens, M. and Joan Farre-Mensa (2020), “The Deregulation of the Private Equity Markets and the Decline in IPOs,” Review of Financial Studies 33, pp. 5463-5509.

^Five An important predecessor of the Gornall-Strebulaev method is covered in Metrick (2007). Metrick, A., Venture Capital & the Finance of Innovation, John Wiley & Son, 2007.

⁶ Gornall and Strebulaev (2020).

⁷ This methodology also requires certain other information, such as the expected volatility of enterprise values, which may need to be adjusted depending on the company under consideration.

⁸ Conceptually, the Gornall-Strebulaev methodology is similar to the backsolve methodology often used in the context of 409A valuations. This means that the value of the entire company and each stock claim can be canceled from the price of a single stock claim. However, there are some important differences. Among other things, the Gornall-Strebulaev method explicitly models the distribution of firm values ​​over time, allows more complex features to be incorporated more robustly, and allows each class of stocks, rather than a single point. Provides intervals for evaluation. Quote. In addition, 409A valuations often (erroneously) include authorized but unissued stock options in the calculation, while the Gornall-Strebulaev Act does not.