Overvaluation of Startups: A Technical Perspective (Part 2 of 2)

In the first part (available at bit.ly/38Xxwzf) I tried to explain how a simple two share structure with common shares and convertible preferred shares cannot be valued similarly due to lack of identical prospective cash flows. Though the probability of such a situation might be miniscule, it still persists and hence distorts valuation. It may make sense to, however, impose a single discount at the end of the arrived valuation for the entire firm than value this class separately in our base case. 

However, being the high-risk investments that startups are, their term sheets typically contain further provisions that make the valuation of these securities extremely complex. Moving forward, I will attempt to break down some of the more common provisions and provide an oversmiplified explanation of their usage & implications on firm value.

Venture Capital: The More Complicated Investment

Generally, startup investors get paid during what is termed as a liquidation event. As the name suggests, this is an event like an acquisition, IPO or bankruptcy, during which all or most of the investors within the startup are cashed out. Another way of cashing out on an investment is to sell the stake to the founder of the firm or to the other investors. 

At a base level of investment of let’s say an early stage investor in Pre-seed to Series A, we are looking at checks of $250k - $1mn. These investors generally sell the stake to later stage investors or get a payout during M&A. Hence, the sale is happening to someone else who is a qualified investor - in the sense that the individual/institution has a much higher risk appetite and is well versed with the risk-reward profile of the investments. Also, the check size is small hence the total value at risk is lower. Investors at this stage are more concerned with idea validation and base level sales than generating at least the risk-free rate. 

As we move to the later stage, the investment size could go up to $7bn (SoftBank & Uber) or even higher. At such ticket size, the startup has already covered a lot of ground in terms of idea validation, global expansion, stability of growth rate etc. (profitability, not so much). The firm is just waiting for the correct time to go for an IPO or M&A and needs more of what could be called bridge finance. Money to tide over the firm for a short duration before the aforementioned liquidation events. Investors who join the cap table at this stage are providing an infusion of a large amount of capital and hence need/deserve better terms. The focus at this stage of investment revolves around getting at least a minimum rate of return on top of the potential high value exit. This is fairly logical, the amount of even 2% on $1bn investment is larger than the $10mn investment in Series A.

The common provisions that I will attempt to explain are as follows:

1. Liquidation Preference
2. Participation (With/Without Cap)
3. Seniority
4. IPO Ratchet

Liquidation Preference

Liquidation preference refers to a simple right, i.e. to receive the minimum investment amount on liquidation even if the firm’s sale price is less than the post-money valuation of the investment. For instance, if an investor owns 1/4th of a firm on a fully-converted basis, and had invested $5mn and the firm gets sold for $10mn, the investor will receive the $5mn investment before any other common shareholder.

An investor may also add a multiple to the liquidation preference. For instance, if the liquidation multiple is 1.5x in the above example, the investor will receive 1.5 x $5mn =$7.5mn before the common shareholder gets paid. In the case of a 2x multiple, the investor would have left with the entire $10mn payout while the common shareholders would receive nothing. 

Hence, if there exists a liquidation multiple within the latest term sheet, we can easily state that the firm value derived from the conventional valuation methodology would be inflated.

Participation

Participation takes the liquidation preference a step further. It means that the investor is entitled to participate in the payout to the common shareholders on a fully-converted basis, after receiving the liquidation preference.

For instance, if an investor owns 1/5th of a startup for $5mn, with a 2x liquidation preference and a participation, and the startup gets acquired for $100mn, the payout for the investor will be $10mn for the liquidation preference, and another $18mn (1/5th of $100mn - $10mn paid for preference). This takes the investor payout to $28mn, as opposed to $20mn on a simple equity conversion basis.

Within participation as well, there exist multiples. These relate to the cap/non-cap provisions. The cap provision puts a ‘cap’ i.e. a limit to the participation of an investor - say 1.5x of liquidation preference. Beyond this amount, the investor cannot receive a payout. For example, if in the above case, the investor had the participation capped at 1.5x of liquidation preference, the investor would have received lower of $15mn (1.5x of $10mn) & $18mn. The total payout in this case would be $25mn for the investor, which is still higher than a $20mn payout had the preferred shares been converted to equity.

Assume now that the startup was instead sold for $250mn, and a participation cap of 3x of the liquidation preference. In this case, the investor would receive $10mn under the liquidation preference of 2x and another $30mn totalling an amount of $40mn. In this case, the investor would benefit from converting the preferred shares to equity shares and receiving the $50mn i.e. 1/5th of the $250mn sale price.

As can be seen, the presence of participation inflates the valuation of startups. The presence of a cap however restores some normalcy to the valuation.

Seniority 

If you are comfortable with liquidation preference and participation, lets take this a step further with seniority. Seniority refers to the priority of claims on cash flow. As we have seen, convertible preference shares rank senior to common equity shares. As startups continue to issue new shares, they generally award their latest investor with the most senior class of shares. 

For example, if a startup raised $5mn from investor X in Series A at a post-money valuation of $45mn and thereafter raised $10mn from investor Y in Series B at a post-money valuation of of $100mn. Both of these investments came with 2x liquidation preference and participation. Now imagine, the startup gets acquired for $50mn. The investor Y would receive her 2x liquidation preference at $20mn, followed by the investor X would receive his 2x liquidation preference at $10mn. Thereafter, the remaining $20mn would be distributed to all on a fully-converted basis. Investor Y would take home $22mn, Investor X would take home $12mn and the others would get $16mn i.e. holders of 80% of equity on a fully converted basis receive only 32% of total company value.

Now assume that the firm were sold for just $25mn - $20mn would go to investor Y and $5mn would go to investor X. Instead, if the firm were sold for $500mn, investor Y would get $67mn, and investor X would get $57mn. If we imposed a cap on participation of 1.25x liquidation preference, then both players would instead receive $50mn each as equity shareholders as opposed to preferred shareholders, receiving $45mn & $22.5mn for investor Y and investor X respectively.

Thus, the presence of seniority in convertible preference shares inflates the value of the firm.

IPO Ratchet

An IPO Ratchet protects the investor in case the next round of financing is valued at less than the round the investor invested in - known as a ‘down’ round. The typical protection provided is of investor receiving a minimum total amount despite the valuation. This provision might sound like a liquidation preference but operates across the timeline as opposed to just during a liquidation event.

For instance, an investor takes 4% of a company for $2mn, at a post-money valuation of $50mn. In the next financing round, the firm raises $4mn at a post-money valuation of $40mn. The investor in the previous round, with the presense of a ratchet, will now get additional shares for free, taking its stake to 5% after the new round. This assumes that the investor invested in this very round, providing it a protection against lower valuation. This severely impacts the other shareholders, including founders of the company, whose equity gets diluted in the process.

The IPO Ratchet may also come with a multiple of say 1.5x, guaranteeing investors a return of minimum 50% in the case of IPO or down-round otherwise. A recent case study is that of Jack Dorsey founded Square, with Series E investors having 1.2x multiple on IPO Ratchet.

Hence, it is easy to observe that shares with IPO Ratchet are much more valuable than common shares. Presence of such provisions hence inflates the value of the startup.

Venture Capital Funds: Why Use The Incorrect Metrics?

It would be incorrect to say that venture investors choose to use the incorrect metrics, it would be fit rather to say that they tend to choose a more simplified approach. As the research paper shows, it is indeed extremely complex to use the new valuation methodology.

Most venture funds use what is commonly called an illiquidity discount, a direct reduction of 5% to 20% of the valuation of each startup under the commonly used methods. This helps the investors control for most of the provisional elements used in the term sheet. Additionally, it is obvious to note that with each new term sheet, the investor will have to figure out newer discounts to the valuation and provide detailed explanations for the same - assuming that the venture capital investor class has the required resources itself - does not seem necessary.

One could certainly make the case that the regulator should mandate some form of explanation to provide a more holistic view to the investor who does not have a finance/accounting background. However, such regulation would be prudent once venture capital as an asset class gains more traction - imposition of such laws at the present would only dampen the ecosystem.

Epilogue

The study used as the main background for this research was conducted solely on unicorns, which exhibit such strong provisions in a more consistent manner. Across the early stage investment landscape however, it does not necessarily provide enought ground to concern the investor in an early stage fund of potential overvaluations. Presence of clawback provisions can help mitigate all of the problems associated with incorrect valuation of the portfolio of these venture firms.

Bibliography

Gornall, Will and Strebulaev, Ilya A., Squaring Venture Capital Valuations with Reality (Dec 2, 2019). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2955455 or https://dx.doi.org/10.2139/ssrn.2955455