The price of shares sold in later financing rounds distorts values, a study says
11 Oct, 2017WSJ.COM
How much are startups worth? Perhaps not what you think.
Misuse of a common valuation method may be distorting the widely reported market values of startups, most noticeably so-called unicorns, or companies backed by venture capital that are valued at more than $1 billion.
That is the conclusion of a new working paper published by the Stanford Graduate School of Business.
The paper spotlights the problem of “post-money valuation,” which is a calculation performed by many analysts, venture capitalists, company employees, the media and often the companies themselves, after a company completes a round of fundraising. Shares issued in later rounds tend to carry higher valuations than shares issued in earlier rounds because the founders and their VC backers tend to award increasingly valuable benefits to later-round investors, such as the ability to cash out at a certain value after an initial public offering. Those increasing benefits can push up the value of shares issued in the later rounds.
Thus it isn’t always accurate to take the amount of money raised in the most recent fundraising round and use it to calculate the entire value of the company.
But that is what many companies, their backers, their employees and industry watchers do. They adopt a standard valuation method that is applied to companies that have already gone public, in which the market valuation is determined by the number of shares outstanding multiplied by the current price of one share.
“Overvaluation arises because the reported valuations assume all of a company’s shares have the same price as the most recently issued shares,” the researchers write. To calculate the real value of one of these private companies, it is crucial to look at the terms of each round, the researchers say.
The researchers looked at 135 U.S. unicorns and found that more than half granted special terms giving their most recent investors advantages that earlier investors lacked, such as a guaranteed return, ability to block the IPO if it doesn’t promise to return most of their investment, and seniority over all other investors.
The frequency with which such features appeared led the researchers to suspect they were affecting the valuations, says Will Gornal l, an assistant professor of finance at the University of British Columbia’s Sauder School of Business and one of the study’s authors.
Indeed, when the researchers calculated the companies’ valuations by taking into account the different financing terms that accompanied each financing round, in many cases they came up with very different figures from what was reported to be the company’s value in corporate press releases, news articles, interviews with founders and elsewhere.
“The average highly valued venture-capital-backed company [in the study] reports a valuation 50% above its fair value, with common shares overvalued by 58%,” the researchers wrote. Nearly half were not valued at more than $1 billion using the researchers’ method, and 15 companies saw their value drop by half, the paper found.
“I’m surprised the SEC hasn’t started exploring the way these companies should be valued,” says Ilya Strebulaev, a professor of finance at Stanford’s Graduate School of Business who is also one of the study’s authors.
One startup that is cited in the paper, software company Zscaler, for example, raised $100 million in August 2015.
“We are excited to join an elite group of security companies valued in excess of $1 billion,” CEO Jay Chaudhry said in a press release about the fundraising round. But Profs. Gornall and Strebulayev calculated Zscaler was actually worth $700 million at the time.
For IT-security company Tanium, which announced this May that it was worth $3.75 billion, the researchers looked at a December 2015 round that had a post-money valuation of $3.7 billion and determined that the company’s fair value at that point was $2.8 billion.
Both Zscaler and Tanium declined to comment on their valuations and the research.
When she was Securities and Exchange Commission chairman, Mary Jo White expressed concern about possible overvaluation of shares in privately held startups in a March 2016 speech in which she pointed at valuation as one of the problems facing Silicon Valley.
“In the unicorn context, there is a worry that the tail may wag the horn, so to speak, on valuation disclosures,” Ms. White said. “The concern is whether the prestige associated with reaching a sky-high valuation fast drives companies to try to appear more valuable than they actually are.”
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Most venture capitalists and founders who sign such financing agreements likely do understand what they’re signing, says David Wessels, an adjunct professor in finance at the University of Pennsylvania’s Wharton School who teaches courses on corporate valuation and venture capital. And at the time the company goes public, the shares usually convert to common stock, so public-market investors are buying shares that have a transparent value. All of the shares are worth the same amount as the different financing terms are subsumed into the common stock.
Employees, however, may not realize that the hefty valuation they hear cited might not be the company’s true value. This makes it difficult for them to decide whether or how long to work for a company when much of their compensation is in stock, Dr. Wessels says.
“They might be taking a real hit in salary, half the wage they would be able to garner on the open marketplace to work for this company,” he says.