Squaring Venture Capital Valuations with Reality

Historically, most successful venture capital-backed companies went public within three to eight years of their initial venture capital (VC) funding.

More recently, many successful VC-backed companies have opted to remain private for substantial periods and have grown to enormous size without a public offering. Companies such as Uber, Airbnb, and Pinterest have been valued in the tens of billions of dollars, fueled by investor expectations that these companies may become the next Google or Facebook. The growth of these companies spawned the term "unicorn," which denotes a VC-backed company with a reported valuation above $1 billion. Once thought to be rare, as of mid-2017, there are more than 100 unicorns in the U.S. and another 100 in other countries with reported valuations totaling over $700 billion.

Despite their growing importance, the valuation of these companies has remained a black box. This is due in part to the difficulty of valuing high-growth companies. But to a large extent, it is due to the extreme complexity of these companies' financial structures. These financial structures and their valuation implications can be confusing and are grossly misunderstood not just by outsiders, but even by sophisticated insiders. Unlike public companies, who generally have a single class of common equity, VC-backed companies typically create a new class of equity every 12 to 24 months when they raise money. The average unicorn in our sample has eight share classes, where different classes can be owned by the founders, employees, VC funds, mutual funds, sovereign wealth funds, strategic investors, and others. Because these share classes have different rights, it is often difficult to decipher the capital structure of a unicorn.

As a motivating example, consider Square Inc.'s October 2014 sale of shares, where the company raised $150 million by issuing 9.7 million Series E Preferred Shares for $15.46 per share to a variety of investors. These shares had much higher payoffs than any of the company's existing Common and Series A, B-1, B-2, C, and D Preferred Shares. Specifically, Series E investors were promised at least $15.46 per share in a liquidation or acquisition and at least $18.56 per share in an IPO, with both of those claims senior to all other shareholders.

After this round, Square was assigned a so-called post-money valuation, the main valuation metric used in the VC industry. This post-money valuation is calculated by multiplying the per share price of the most recent round by the fully-diluted number of common shares (with convertible preferred shares and both issued and unissued stock options counted based on the number of common shares they convert into). After its Series E round financing, Square had 253 million common shares and options and 135 million preferred shares, for a total of 388 million shares on a fully-diluted basis. Multiplying total shares by the Series E share price of $15.46 yields a post-money valuation of $6 billion for Square.

This post-money valuation ignores the fact that Series E shares are more valuable than the other shares. Because of that, it dramatically overstates the value of Square. It assumes Series E shares have the same value as common shares, despite the Series E shares being far more valuable. The additional protections Series E shares had made them more valuable than other shares – as was proven when Square had an IPO below the $15.46 Series E price and Series E investors received extra shares giving them a much higher payoff than the other investors.

We develop a modeling framework to derive the fair value of VC-backed companies and of each class of share they issue, taking into account the intricacies of contractual cash flow terms. Beginning with Black and Scholes (1973) and Merton (1974), researchers have used share prices to value warrants, options, bonds, and other contracts.  We reverse this process and use the price of option-rich preferred shares to value common shares.  Our approach is close to the common practice of ``option-adjusting'' corporate bonds or mortgage-backed securities to back out underlying risk prices.

Our model shows that Square's fair valuation after Square's Series E financing round was $2.2 billion, not $6 billion as implied by the post-money valuation. Square's reported post-money valuation overvalued the company by 171%. Square is not a unique case: we apply our model to a sample of 135 of U.S. unicorns and show that the average unicorn reports a valuation 49% above its fair value, with common shares overvalued by 59%. Almost one half (53 out of 116) of unicorns see their value fall below the $1 billion threshold when we recalculate their valuation and 11 unicorns are overvalued by more than 100%. Overvaluation arises because the reported valuations assume all of a company’s shares have the same price as the most recently issued shares. In practice, these most recently issued shares almost always have better cash flow rights than the previously issued shares. Equating their prices therefore significantly inflates valuations. Specifically, we find 53% of unicorns have given their most recent investors either a return guarantees in IPO (14%), the ability to block IPOs that do not return most of their investment (20%), seniority over all other investors (31%), or other important terms.

Many finance professionals, both inside and outside of the VC industry, ignore the differences between share classes and treat post-money valuations as the fair values of companies. Both mutual funds and VC funds typically mark up the value of their investments to the price of the most recent funding round – ignoring the differences between share classes. As a representative example, in 2015 when Appdynamics issued a Series F round with an IPO ratchet, a provision offering a 20% bonus in down IPOs, Legg Mason wrote up their Series E Shares to the Series F price despite not being eligible for the 20% bonus. In that case and most others, marking unicorns to their most recent round's price leads both venture capitalists and mutual funds to overstate the value of their investments.

The rank and file employees of VC-backed companies often receive much of their pay as stock options. Many employees use post-money valuation as a reference when valuing their common stock or option grants, which can lead them to dramatically overestimate their wealth.