Much is being said these days about IPO valuation gap. The gap refers to a situation where IPO valuation drops below the valuation of the latest private financing round. WeWork is the most recent example with its massive $47B private valuation (we will call it “headline valuation”) being reduced by 70% to $15B as it was trying to go public.
We explain why headline valuations grossly misrepresent companies’ true worth. Most of the time the real fair value of the business is a lot less.
A fundamentally sound approach to valuing venture-backed companies entered the mainstream with the advent of IRC 409A and stock-based compensation accounting under FAS 123R (currently ASC 718) in mid-2000’s. It illustrated that each class of equity had a different value depending on the economic rights and preferences of each class. Headline valuations would ignore this fact.
As reports of headline valuations were becoming more prevalent, we wrote about IPO valuation gap in 2013 (here). In 2018, Stanford University published a broad-based study demonstrating the erroneous nature of headline valuations (here). The latest came from the Wall Street Journal, a short video illustrating the origins of headline valuation error:
The video attributes the origins of the IPO valuation gap to the following:
♦ Simplistic calculations behind headline valuations are grossly inaccurate.
♦ Non-traditional financial measures are prevalent with private companies.
♦ Lack of liquidity in private markets may result in excessive optimism.
Erroneous Headline Valuations (“EHV”)
Public company market capitalization is calculated by multiplying market share price by the number of shares outstanding. EHV do the same for private companies except they:
A. Ignore substantial valuation differences among different classes of equity, and
B. Pick the most valuable of the shares, usually last financing round.
For example, the most recent round of Series E preferred could be priced at $10 per share. At the same time, the common stock could be worth only $5 per share because it is lacking important economic attributes granted to Series E class. The EHV valuation would price all shares of stock at $10/share, including common. EHV becomes the product of $10 per share and the fully diluted number of shares outstanding (or even authorized).
The correct approach would be i) valuing each type of equity share separately, ii) calculating market capitalization of each class, iii) adding market capitalization of each class to the total market capitalization. Naturally, this would be too difficult, and not practical, for an average blogger to do.
Customized Financial Performance Metrics
While IPO investors tend to focus on SEC-sanctioned US GAAP-based financial metrics, private company investors tend to emphasize customised measures. For example, a private company may routinely report adjusted EBITDA which excludes everyday expenses such as depreciation (deferred costs of acquiring fixed assets), amortization (unavoidable costs of developing and acquiring IP-based assets), or stock-based compensation (payroll costs that dilute existing shareholders). In WeWork example “Community Adjusted EBITDA” excluded some rents that would be reported by other SEC registrants!
Certain adjusted financial measures are necessary to monitor the performance of a particular business. Yet, they make comparisons to publicly traded companies that much harder. One can not apply EBITDA valuation multiple of a publicly-traded company to something like Community Adjusted EBITDA. It is however very easy to default into thinking that adjusted EBITDA is a real EBITDA.
In this article here we argue that EBIT is more relevant than EBITDA in tracking venture-backed company performance. While often understated, amortization helps to account for the cost of acquiring IP.
The Wall Street Journal notes that lack of liquidity for existing investors and the absence of short-sellers (sorry Elon, we don’t sympathize with you on this particular issue) creates an environment where investors may be forced to cheer for the company they can’t otherwise exit. The public-market style transparency and diversity of opinions are mostly absent. WeWork’s EHV increased as SoftBank raised the amount it was paying for each subsequent round.
Companies don’t like down-rounds. They create perception of poor performance. A down-round is certainly out of the question if simply because S&P 500 or the company’s own industry is down; public companies don’t have this luxury.
One way to achieve the up-round is to give investors more for the same share of preferred stock. “More” may include participation rights, warrants, ratchet, dividends, voting rights or board seats. Thus, the next round may appear higher and increase that headline valuation, but the investors paid more to get more. It is not uncommon to see common stock value decline after such up-rounds.
In fact, most financings are “up-rounds” (or about 86% of all financings according to Q2 2019 study by Fenwick & West). Of course, this is in part because poorly performing startups have a hard time getting financed. This also means that it is hard to measure startup universe performance objectively, simply because many valuations, instead of moving south, disappear.
In defense of simplistic headline valuations, capital structures of privately-held companies are often too complex. Dealmakers need a practical expedient for calculating valuations in order to engage in high-level strategic discussions. Of course, the exact numbers require accurate calculations by a specialist because the difference can be enormous.
The down-sides of overusing EHVs are also aplenty. Overstated valuations inevitably lead to sub-optimal capital allocation for both VCs and startups. Business plans refocus on catching-up with inflated valuations, instead of doing what’s right for the business. Overstated late-round valuations prevent or delay companies going public. Just like in the game of musical chairs, the last investor needs the company to “grow into” their own faulty valuation number. Finally, secondary market transactions are affected as erroneous valuations reduce liquidity for holders of private company securities.
More reasonable fundamentally sound valuations are readily available in 409A valuation reports. While not without its own “bag-of-tricks,” 409A valuations will get observers a lot closer to the companies’ true worth.