With all the excitement about today’s unicorns – privately held, venture capital-backed companies valued at over a billion dollars – and the anticipated stream of IPO’s this year, smart investors need to understand what venture valuation is all about. We’ll try here to arm investors with that understanding.
Valuation Fundamentals 101
Venture capital investing is simply buying shares of a privately held company. Investors may think of their investment as a lump sum rather than as buying a discrete number of shares, but conceptually it is no different than buying shares of a publicly traded company.
A publicly traded company’s share price times its number of shares outstanding equals its market capitalization. Similarly, for a venture capital-backed venture, its share price times the number of shares outstanding equals its valuation.
Remaining at the conceptual level, a public company’s market capitalization should equal the net present value of all projected future cash flows, discounting those future cash flows to reflect the time value of money as well as the riskiness of those projections. A venture capital-backed company’s valuation conceptually should represent the same thing. However, the reality is that such a disciplined methodology often just isn’t (and can’t be) the case for early stage ventures because so much simply is not yet known and/or could change.
Projecting the future for a solidly established business is generally more straightforward than for an early stage venture. Moreover, even with a solidly established company, those future projections and assumed risks can change substantially, explaining at least in part stock price changes and volatility.
The mystery of venture valuation is heightened by factors including: (1) venture shares are not generally liquid like publicly traded stocks; (2) it will likely be years (if ever) before the venture generates profits and positive cash flow; and so (3) the degree of discounting for both the time value of money and risk should be much greater for a still private venture, especially an early stage one, than for a mature, well established business. As the venture progresses, assuming its perceived potential remains steady or growing, discounting for risk, as well as for the wait until a return is expected, should diminish, increasing its valuation.
While one might be tempted to try to value VC-funded ventures at some multiple of revenues, this has rarely been helpful because of all the uncertainty of how a venture (and its revenues) might evolve, especially in the early stages. Such a formulaic approach seems an even greater ill fit with many of today’s high potential ventures.
For example, consider the investment made by the firm I work with, VCapital, in what appears to be a breakthrough new cancer treatment developed by Intensity Therapeutics. Intensity Therapeutics’ initial product is in clinical trial, and early results are extremely encouraging. While the company obviously has no revenue during clinical trials, its excellent clinical trial results to date already justify a very substantial valuation. Further clinical trial progress could even result in a lucrative exit, through either M&A or IPO, as investors or large drug companies consider the venture’s potential multi-billion dollar value if its initial product makes it through all clinical trial rounds to ultimate FDA approval.
Valuing an early stage breakthrough software venture at some prescribed multiple of current revenues similarly seems inappropriate. Consider our VCapital investment in big data/artificial intelligence innovator simMachines. Its current revenues consist of relatively modest proof-of-concept customer projects. Assuming those demonstration projects prove successful, the company’s revenue potential should be dramatically greater than any simple, formulaic multiple of existing revenues. Depending on the nature of a venture and its market, though, the further business development progresses, the more relevant its revenue may become in determining its exit valuation.
So establishing a valuation for an early stage venture is highly nuanced, more art than science. You might even say it’s arbitrary, since venture capital investments aren’t liquid like the public stock market, which determines a public company’s value continuously. Nevertheless, if the venture capital community and its investors won’t bite on a venture’s deal offering, they may be effectively saying the valuation is too high. If investors think the valuation is attractive relative to the company’s perceived potential, they’ll eagerly invest their funds.
Venture Capital Valuation Terminology
Venture capital valuation terminology reflects the industry’s orientation toward raising new funds to grow high potential ventures.
The first term you may hear is pre-money valuation. That is the price tag the company has negotiated for itself with venture capital firms as it prepares to raise additional funds. Again, if the venture capital community and its investors won’t bite on the venture’s deal offering, they are effectively saying the valuation is too high. Let’s assume here that it is reasonable and accepted by investors. Its valuation then represents its share price times the number of shares already outstanding.
The company and its venture capital backers then sell new shares to raise the additional funds sought, at a price per share reflecting its pre-money valuation. The pre-money valuation plus the amount of new funds raised then equal its post-money valuation.
The general expectation is that the additional funds being raised will enable the company to grow and progress toward an envisioned exit. Additional fundraising rounds generally take place only if investors continue to believe in the company’s prospects for success. Presumably the probability of success has increased and the time until exit has decreased. The new pre-money valuation is therefore usually set at a higher level than the latest round’s post-money valuation.
This isn’t always the case, though. It is conceivable that investors are not as optimistic about the venture’s prospects as before, yet they still believe enough in the venture’s ultimate chances, and so are willing to invest more, albeit at a lower price/share than before. This is called a “down round.” It is not a frequent event and is not positive, but it can happen.
This is the process followed through each round of private fundraising until the company moves to “exit” private ownership status, generally through either a sale or merger with another (generally larger) company or an initial public offering (IPO).
Let’s take a look at an illustrative scenario, where a venture goes through multiple fundraising rounds leading to an ultimate exit. We’ll assume that the founder and his/her initial colleagues’ early sweat equity is valued at $3 million as they begin their fundraising with an angel investor group seed round. While seed rounds often consist of selling a convertible note, for the sake of simplicity we assume here that the seed round and all subsequent rounds consist entirely of stock sales.
Illustration of a Highly Successful Venture
Now let’s look at the returns enjoyed by venture investors at the exit of this illustrative path. Again for the sake of simplicity, while IPO’s often require private venture investors to hold onto their shares for some period (often six months) following the IPO, we assume here that the exit was through M&A and that all shareholders were bought out by the purchaser. Incidentally, the founders’ 1.5 million shares represent 23% of the total shares at exit, resulting in a $45 million payout. This may not be one of those heralded unicorns, but it would be a lucrative outcome for the founders and the early stage investors.
Valuing a Fund or Pool of Investments
Setting the valuation of a given venture can admittedly be tricky. Setting a valuation for a venture capital fund or pool of multiple venture investments, some of which may not even yet have been made, is even more difficult.
Despite the standard disclaimer that past performance is no guarantee of future results, past performance may be the best metric available in deciding whether to accept a given valuation and invest in the fund/pool. We recognize that past performance may be an indication of both investment acumen and luck. But the best VCs often play an important role in creating their luck.
It should become clearer over time whether ventures in the pool continue to look like potential winners. As progress becomes clearer, setting a pool valuation may become somewhat more objective. As those judgments are made, it is important to keep in mind venture capital fundamentals. Only about 20% of deals make money. Especially skilled investors may boost their win rate to 30-40% of deals. However, even among the most skilled investors, the large majority of venture capital’s rich returns on average are attributed to a small number of really big winners, perhaps 10% of all ventures. The table below presents a potential scenario for a small pool of investments.
Illustration: Investment/Return Scenario for Small Pool of Ventures
Translating These Fundamentals into Investment Strategy
We at VCapital believe strongly in the potential of early stage investments selected through extremely rigorous deal screening and due diligence. A key to achieving venture capital’s rich returns on average is investing in the very best ventures at early stages before their valuations have been bid up to high levels in the late deal rounds. We at VCapital pursue exhaustive screening – discarding 100-200 opportunities for every one we select. We further subscribe to noted venture capitalist Peter Thiel’s practice of focusing follow-up investments only in those ventures that continue to display home run potential. We, like he, pass on follow-up rounds for ventures that may still have a good chance at success but are unlikely to deliver the home run returns that drive overall venture capital returns.
Making Sense of Today’s Valuations: Beware Over-Valued Unicorns
With all due respect to the venture capital and investor communities, we think that some of today’s most notable unicorns are substantially over-valued. Their businesses may have sustainable marketplace potential, and their early investors may make lots of money, but we suspect that their late stage investors and possibly their anticipated IPO investors may lose a bundle.
While venture capital investments are generally illiquid until exit and so early stage investors have a long wait for what, on average, are highly attractive returns, some early investors are able to trade some of that lucrative gain for a lesser but sooner gain through a secondary market that is still limited but could grow in the future. According to a January 26 Wall Street Journal report, an “opaque market” for pre-IPO venture shares is “heating up” as several recognized unicorns approach the IPO starting gate. “Bankers, brokers, and investors that specialize in buying or selling unlisted shares of companies say there has been a significant increase in interest and activity. Hedge funds, wealthy individuals and family offices – as well as some large institutions – are lining up to buy shares that venture capital firms, companies, and others are trying to cash out of.” The establishment of a more formalized exchange for such trading has also recently been proposed by some major venture capital investors.
But let’s get back to those contemplating participation in upcoming unicorn IPO’s, for whom we urge caution. IPO investors don’t always win. Consider ride-hailing service Lyft, which went public in March. It hardly seemed like a start-up. Having already raised $4.7 billion prior to IPO, its broad presence suggested an already well established business. Yet Lyft still posted a $911 million loss last year. Given that loss, would you have bet on an IPO investment with Lyft valued at $24 billion? We wouldn’t have. And for now at least, we feel good about our assessment, as Lyft currently trades at 17% below its IPO price.
Ride-hailing leader Uber, which seems even more ubiquitous and well established, is expected to IPO later this year at an anticipated valuation of around $120 billion. Yet The Wall Street Journal reported that Uber is still losing more than $800 million a quarter!
And then there’s WeWork, the purveyor of shared office spaces and services for today’s entrepreneurs. As of January 2019, WeWork managed 10 million square feet of office space and was valued at $47 billion. Yet WeWork Companies reported a 2018 net loss of $1.9 billion on $1.8 billion of revenue. It seems that as their revenues have been growing, their losses have been growing at about the same rate.
Will these mega-unicorns ever generate the profits and cash flow ultimately needed to justify these valuations? Some might, just as Facebook and Amazon have (though it took Amazon six years after its IPO to finally deliver an annual profit), by translating marketplace dominance into profitability and investment winners. For example, Zoom, which began public trading today, is already profitable, even as rapid revenue growth continues, with revenue expected to exceed $1 billion within two years. But we believe many others’ valuations strain credulity and will not be winners for their IPO investors.
Even if their anticipated IPO’s come out of the gates successfully, keep in mind earlier vaunted unicorns whose shares have declined precipitously since their IPO’s. Such losers include Blue Apron (share price down 90% since its 2017 IPO), Groupon (-83% since 2011 IPO), Snap (-37% since 2017 IPO), and Vonage (-44% since 2006 IPO).
We hope this has helped investors better understand venture valuations and how to translate that understanding into better informed investing. While venture capital historical returns on average have exceeded almost all other major asset classes, investors need to be well informed on the fundamentals in order to set reasonable expectations, make smart choices, and avoid needless disappointment.