Will Gornall of the University of British Colombia and Ilya A. Strebulaev of Stanford recently published a white paper that serves as a great catalyst for discussion of the valuations of VC-backed companies. It is a solid 54 page, fairly technical discussion on how post-money valuations can distort the true value of venture-backed companies.

To a large extent their approach is similar to that used by valuation firms like ours in conducting 409A valuations. Weaknesses in 409A are noted in the form of incentives to skew toward lower values and data from an essentially automated 409A provider is cited in support of this point. Though that data from that provider isn’t very reliable, the authors’ point stands that boards, management teams, and attorneys do tend to prefer that 409A valuators provide as conservative a valuation as is supportable.

One weakness not discussed, but inherent in any valuation is the fact that no valuation is “right”. I was the CFO of a venture-backed company and we ran a fully marketed process to sell the company. Three buyers made bids, with a significant spread between the lowest and highest bids. Was the highest bid the “right” value? It’s certainly the one we took. But it’s possible they overpaid. Was the middle value the “right” value? Was the lowest bid fundamentally wrong? The fact is the lowest bid came first and we might have been a willing seller at that price if the other bids hadn’t come in.

As an investment banker, we would have never provided a company with a valuation down to the penny the way we see in venture capital valuations. We helped companies file to go public with a range. We’d then build a book of orders from a diversity of investors. Even after a fully marketed process with a book of orders we’d labor over pricing the IPO hoping to ensure after-market performance would yield an upward trend – something bankers don’t always get right. Even once companies are public and have full and fair disclosure you can see very well informed investors with opposing long or short views on a stock.

As such, getting the exact right value for a VC investment or a 409A is a bit of a Quixotic venture. However, options need a strike price and investors need to draw some line in the sand. An issue we have with this is that we believe traditional models endorsed by the AICPA or even that put forth by Gornall and Strebulaev don’t adequately address the risk carried by the common shareholders in these companies. VCs have the benefit of diversification. This classic blog post from Seth Levine illustrates the point. His data comes from Correlation Ventures and it asserts that 65% of investments fail to generate even 1x return for VCs. If the data is correct, then 65% of venture backed companies yield virtually nothing to common shareholders since they have the VCs’ 1x liquidation preference on top of them. If the VC didn’t even get their 1x back in nearly two-thirds of cases, what was left for common? As such, it seems demonstrably unfair to model the likely outcomes for common assuming a standard normal distribution of outcomes.

I’m not trying to put forth the exact right solution, though we do have some thoughts on this. I am trying to join with Gornall and Strebulaev in further encouraging dialogue. We’d especially like to see the AICPA task force put forth better methods for adequately capturing the non-diversified risk carried by founders and other common shareholders. We’re glad Gornall and Strebulaev have pushed the discussion. Let’s keep it going!

 

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2018-11-02T20:21:25+00:00