Absurdly High Valuations
blog.42floors.com
blog.42floors.com
" They can afford to get into these bidding wars because they have the confidence that they are likely to at least get their money back, and yet they still get upside exposure if things go extremely well."
There is a lot of 'brand management' at a venture capital company. They want to be the 'cool kids' to the people who 'pick winners.' That keeps the money coming in and the partners paid. Because of that, being an investor in a company that makes a positive, splashy, exit (not necessarily really profitable) helps keep that brand alive.
Given that, when there are already acquisition offers being turned down, VCs no doubt see an opportunity to buff their brand by having a piece of the action. And a weird feedback loop is that founders are quite flattered to hear their company referred to with such high valuations, and it might make their personal fortunes seem large (since they generally still have a large chunk of stock) even though an exit that doesn't clear the preference hurdle will typically pay them little.
So we get this little dance.
Such dreams don't always work out of course. So it is much easier to stay focused on just building value for your customers and adding to their delight and satisfaction in using your products. That activity always pays dividends.
Like the guy that buys a car for $2,000, turns around to sell it and tells potential buyers that they can't accept an offer for $4,000 because they'd be taking a loss.
- Unlike somebody who flips a car, early investors are (typically) not selling their shares to later investors. Investors in different rounds do have differing interests, but they're not diametrically opposed like the interests of buyers and sellers
- The article is about high valuations in late investment rounds, not early ones.
- The reason for the high valuation is that risk in the late-round investments is comparatively low, not that investors want to hype the company for a future round that's even higher.
- To the extent that valuation in late rounds is "bullshit" it's because that valuation really only applies to the investors in the latest round, not to all shareholders. If somebody buys 10% of the company for $200M, we infer that the rest of the company is worth $1.8B, even though you couldn't actually sell it for that price.
If I understand correctly, the point is that the latest investor effectively buys between 10% and 100% of the company, depending on what it eventually gets sold for.
A major difference between big early investors and retail investors is that retail investors don't get that "bond-like" guarantee. Hence there's greater risk of loss, and retail investors should value the stock much lower, but frequently don't.
This article also makes it seem like the difference in value between common stock and preferred stock is larger than it is. When a company is small and very high risk, the difference between the common and preferred is extremely large. But as the company value goes up, this gap shrinks by quite a bit, because generally companies with 1B+ valuations have a risk profile closer to a public company than an early startup.
[1]: http://finance.yahoo.com/news/snapchats-20-something-founder...
I would hazard that it is unusual for the founders to take a 'soft' exit like this but admit I don't have any numbers to back that up. I know the Groupon founders did and got some harsh press but no long lasting damage.
Share prices DO NOT denote actual value. Hence things like the P/E (Price to Earnings) ratio. Share prices denote estimated worth, which is often never the case (some companies trade at 30x their actual earnings, and never live up to the promise of those expected earnings). The same concept applies to public/private acquisitions.
What is actually going on with these valuations? Well, it is kind of a way of conning public markets into buying this stuff. Even in the case of "private" acquisitions, these acquisitions are largely or entirely funded with publicly-traded money used by the publicly-traded acquiring company.
This is not always devious but I suspect there are at least a few cases of corruption. Sometimes companies are innocently acquired with the true belief that they will add value. Often times, companies are acquired to simply be "flipped" - i.e. destroyed within 3 years after the shares vest. The valley floor is littered with the skeletons of acquired companies. :)
[Edit: on reading further down, the author hints at this a bit).
That analysis is hard to do correctly if the company is not even generating revenue... Unfortunately it has now become standard practice to use what is basically goodwill (hype, or more charitably, brand equity) as the primary value proposition for many startups.
Goodwill is something you add to the value of a company to sweeten the pot during acquisitions but it should never be the primary value proposition.
>> This makes its estimation implicitly data-starved, because with a DCF at leat you are getting a time series of independent measurements.
It isn't a data-starved number. It is often as simple as DCF calculation of value - the book value. DCF isn't used to calculate book value. Book value is simply the sum of the tangible parts.
Funny thing is that I'm actually working on a purchase price allocation right now.
What? Goodwill is an accounting name for the excess paid to acquire a company beyond the fair market value of its assets. It's a "stub", basically used so that the books balance in terms of debits and credits (i.e. you paid X cash for the company, and that value splits between FMV of its assets and the rest is "goodwill".) Nobody ever says "I'm going to add some goodwill to sweeten the pot" when buying a company, nor would anyone attempt to use it for determining purchase price.
http://en.wikipedia.org/wiki/Goodwill_(accounting)
Also, the parent post refers to "flipping" but that generally means quickly reselling something, not killing it after three years.
Even in a steady-state in which Snapchat is earning serious money, were it to be acquired, the acquirer would likely need to account for it predominantly through goodwill. What tangible assets does snapchat have? Data center/infrastructure is likely the only area where a company like snapchat could invest in a way that would increase its book value... but snapchat is more likely to stay on the cloud...
The typical tech startup has few tangible assets, hence the necessity to account through book value.
There are many ways of attempting to value a company, including looking at the discounted (and estimated) future cash flows, but they do not tell the full story.
For example, as an avid skier, I might be willing to pay $1000 for a better pair of skis as I will get more out of the ski. A beginner skier would see no increase in utility in my skis over a $200 pair. So, what's the value of the expensive pair of skis? Well, to me it's at least $1000. To the beginner, it's no more than $200.
The same holds true for companies. DCFs and multiples are useful hints at understanding the value of a company, but ultimately, they are insufficient. Companies can see strategic value in acquisitions differently, including the value of shutting it down (either because of concerns of competition or to acqui-hire the team).
On the public market, shares will more closely represent a discounted cash flow view of the future, but not always. The author's point about different share classes is also valid on public markets where control does not always go to common shareholders. That said, it's extremely hard to fool the market, as you've suggested. There's a ton of data to confirm that the market is exceptionally good at pricing the value (probability weighted against tons of factors) of future cash flows based on all current market information. There is a ton of data to support this, and very little to dispel it.
Check all those boxes off and you can say: "YES, I'VE CALCULATED THE FMV!" but the truth is you can never be sure that you've determined the ONE TRUE FMV(c).
There should be only once price at which the property will change hands. Any less, and there would be competing buyers. Any more, and the buyer may have more attractive purchase options. This assumes that it's not a fire-sale, and that the property isn't a unique must-have asset, i.e. that your 'no compulsion to transact' condition is satisfied.
There is an entire field of academic study dedicated to answering this question. While you may not be wrong, this is far from a settled issue. The confidence with which you make the assertion (in all caps even) doesn't really jive with the actual science being done here.
If you're interested, start with the efficient market theorem and work your way forward.
That said, you are correct - the free market basically determines a "real" anticipated value of a product, even though this value may be inflated or deflated by fear, hype, fake volume, other factors.
The market is therefore a reflection of ACTUAL value, not anticipated value. The actual value.
Again this is a hotly debated hypothesis, but what the value of a company on a public market actually means is most definitely up for debate.
Imagine if you could buy Twitter stock today at $50, with the guarantee that if the stock went below that, you'd get your $50 back. Would you buy? I would, for sure. I'd even be willing to buy at $100: it's all upside and no downside. Does that mean that Twitter is worth twice its current valuation? Of course not.
How do you think DST got into all those hot deals?
If you ignore the cost of doing the deal, any further investment of time and expertise into the company, and the opportunity cost.
And the fact that you still might lose all the money. Preference puts you (jointly) first in line for whatever is left, if anything.
EDIT: What I mean is, the absolute best possible case for the option is that the stock drops to zero. In that best case you get your money back: $50
[0] I realize it's more complicated than this, but the point remains.
Neither of these things hold for VC investments. Not everyone owns the same security, and payoffs are NOT continuous in the market price of the shares. This is because of the liquidity preference that is usually part of the deal.
> Valuation is valuation - let's not confuse it with what will happen in the future - just because a company is worth 2 billion today, doesn't mean it will be worth that or more in X years.
No, valuation is not just valuation. I've just spelled out two reasons valuations can sometimes not be directly comparable. That's the whole point.
If I own 1% of a company that raises a round at a $2B valuation, my shares are worth $20M, in theory. But does that mean I can sell my shares for $20M? No, it does not.
Even if I can find a buyer for them, they won't fetch the same price that the latest investors paid, because of the liquidation preference. (If they do, either I've found a sucker, or the company got suckered in the latest round.)
If I can't sell my shares for $20M, then they aren't really worth that much. Twenty million is a convenient estimate, but there's a reason we sometimes talk about people being rich "on paper."
How much is your house worth? Might be it cost you $100K, but if someone is willing to give you $1M for it because they want to build a supermarket there, then your house is worth $1M.
So if Snapchat is being offered $3B from Facebook because they think it would give them at least that much value, then Snapchat is worth $3B.
I could hypothetically buy an apple or an investment for $100 billion (if someone gave me the money). There could be any number of reasons for doing so, but those reasons don't change the fact that it's highly unlikely I will derive $100 billion or more in pleasure or return from that money.
On the other hand, if I can buy something cheap and I find it to be more enjoyable, or an investment returns more money, than expected, then the item was more valuable than what I had paid for it.
Michael Lewis in Boomerang
Yes, the real estate people at the supermarket must have decided that the plot has a value of more than $1M. They might be wrong or even foolish to think so, but they must clearly think that is the case, otherwise they'd be fools to pay it.
This is why those kinds of plans are kept secret as long as possible, because the supermarket hopes to pick up the plot at much closer to $100K than $1M.
What Buffet means, quite sensibly, is that you should only buy an asset when (your assessment of) its value is a lot higher than its price, not when its price accurately reflects its value.
This is what it looks like to me:
Step 1) Buy 30% of a company at a $5 million valuation.
Step 2) Buy (or hopefully convince dumber investors to buy) 5% at a $3 billion valuation.
Step 3) Tell Yahoo to acquire you for at least $5 billion since your last raise was at $3 billion and you want your dumb investors to be happy.
Step 4) Cash your billion dollar check.
http://blogs.wsj.com/digits/2013/11/13/snapchat-spurned-3-bi...
http://allthingsd.com/20131029/snapchats-giant-funding-from-...
The investor does some other kind of magic math and whatever because it's worth whatever somebody's willing to pay for it anyways so why bother?
Investors still win in the "small win" scenario outlined. Founders will generally still get something financially (depending on just how bad the deal was) and can almost universally turn the "small win" bad exit into "advisory" roles or more favorable terms next time they play the startup game. As an employee, you get nothing.
The # of IPOs is also consistent with my intuition. It feels like 1998 excitement, as opposed to 1999 or 2000 mania.
That sounds like a good deal even if you think SnapChat is only worth 200M...
Not only do public investors dislike having a junior series of common stock out of the gate (Google-style two-class shares notwithstanding), but the special rights that come with VC-type preferred stock (series votes, class votes, rights to appoint directors, anti-dilution, blocking M&A, etc.) are eliminated once there are public shareholders.
[Speaking as a former VC now public investor who builds and sells VC cap table modeling software.]
And indeed, a main reason for the liquidation preference is to provide the later investors a guarantee/signal that the insiders' intent isn't just to soon settle for less that the 'valuation' – winning themselves a gain at the expense of the latest investor.
So, sure, when later money adds "$100MM at a $3B valuation", those 3.3%-ownership investors might not truly value the entire company at exactly 30X their stake. But, the other 96.7% owners do value the company at even more than $3B, or they wouldn't have granted the downside-protection and done the deal.
So reporting the top-line valuation, as a market-negotiated fair value, weighted by revealed preferences, still makes a lot of sense. Professionals and insiders found it a reasonable meeting-point... and the downside-protection (which implies the investors' number is really lower) is exactly offset by the upside-expectation (which implies the insiders' number is really higher).
This is wrong. Facebook offered to buy Snapchat for $3 billion. If there is a better way to appraise market value than the fact that one of the most successful companies on earth is willing to buy you for that price, I don't know what it would be.
The notion a transaction has to occur for there to be a 'true' value set, is also false. Try telling the IRS your billion dollar company is worth a dollar, because it has never been involved in a merger / acquisition / publicly floated. That simply is not how companies are valued in accounting or finance (aka anywhere that matters when determining valuations).
Translation - keep building crap because there is still enough suckers for this Ponzi to work for a while.
This seems more of a requirement for ANY market - not just a bubble. Aside from fixed-income or high-dividend paying stocks, When would an investor ever buy a stock without the belief that someone else will eventually buy it for a higher price?
> No, the real danger still comes later when the public markets get involved. When those retail investors with their mixture of envy and disbelief try to cash in on something they don’t understand. That’s when we should be nervous.
Somehow reading lines like this makes me nervous now.
In a fundamental sense, the value of a share of a company's equity is the current value of that share of future earnings (including future unknown lines of business, proceeds of liquidating assets, etc) until the end of time.
In order to divine the expected current value of future earnings is the marginal cost of a share of the company's equity. Just as the price of the last lot of GE shares sold determines the value of GE, the value of Snapchat is determined by the price of the most recently sold share.
That does not mean that any shareholders have an accurate assessment of the value, and knowing the recent price is ~$25 does not tell us how many people would be willing to buy it for $1 or how many people would sell it for $100. Knowing the answers to the latter questions would be a step toward answering how much current shareholders could get if they all wanted out, and how much it would cost to buy every last share.
Since eternity takes a long time, the market's marginal price of a share is a good proxy for the value of a company. It is the expected value according to investors with the most recent skin in the game. Anyway, that's a long way to get to what I find really puzzling:
>When you look at the rumored Snapchat valuations of over 3 billion dollars, it’s difficult to understand how an investor can think that Snapchat is worth that much. Because the truth is, it’s not. Those rumors, even if true, don’t actually value Snapchat at 3 billion dollars. To be precise, they are bidding on a price per share of a specific series of stock. As matter of common discourse, we multiply that number by the total number of shares outstanding and call that a valuation. But the difference still exists and it’s important.
I'm parsing the middle sentence with "value" as a transitive verb, and the subject as actually an implied "investor" rather than "rumor", in line with the sentences before and after. And, I find that the serious problem here is that that is at least the expected value according to that investor.
I read the rest of the explanation as a way to get at how the probability distribution around that expected value may play out, but that does not change the expected value.
However, to expand a little on the payouts: Suppose the disruption of Snapchat could be known to cost a competitor future revenue with a present value of exactly $3B, but the present value of all earnings of an independent Snapchat could be known to exactly equal $2B. If that competitor can buy and shutter Snapchat without any anti-trust hurdles, then in a fundamental sense the competitor would pay up to $3B for Snapchat (and the shareholders would fundamentally be willing to sell if paid more than $2B, with the market eventually awarding between $2B and $3B to the owners depending on what is negotiated).
In reality those numbers can not be predicted, but a valuation of $3B is a statement that the expected value is really worth $3B. An investor who pays $300M for 1%, but expects the future proceeds to be worth less than $3B is gambling that there is a sucker who has expectations that are too high, not respecting fundamentals. An investor could estimate that the earnings will be a certain amount in the hands of other management and still be in line with fundamentals, but claiming that the price will increase without producing some future cash flow or having a fundamental value to another buyer is a gamble that the market is stupid. (It's a safe bet that the market is stupid, but the trick is knowing how stupid, in what direction, and for how long.)
Again, maybe I am missing something, or misunderstanding what is being said, but on the surface it is really frightening to read columns like this that appear to claim that an entire market can have a mean of valuations that are not in line with fundamentals.
In the snapchat instance, he's highlighting a preferred stock deal that has 1. liquidation preference and 2. interest. So they effectively have a deal with components of both long and short options (i.e. they get a gain with exits above $3bn, but no loss unless the exit is below $100m), and a bond (~8% interest on the $100m as long as they don't default).
So you can't take what is effectively a $3bn strike price and say that's the implied value of the preferred stock deal, because it's not. To get the true implied price, you'd have to dissect the valuation of each option, bond, and stock component of the deal. There are standard methods to value each component, but don't expect the start up media to do the calculation for you.
It would be nice to see the scenarios expanded and stressing the outcomes for different classes of shares.
For example, on a second read I understand it that in scenario B the investor paid $100M for 3.33% of the "$3B" company, and gets a $108M payout even if the company sells for $1B (which would be equivalent to 10.8% of how much the buyer bought it for). If it sells for $30B, then he gets $1B.
These late stage investments are looked at like they are really low risk when in reality, it is always a substantial risk until you have a working business model. We say cash flow is king, but invest in the exact opposite fashion and flock to vanity metrics. Look at how Fab (a company everyone assumed would become the next monster e-commerce company) is flailing and trying to raise money every month while losing all viewership. I fear companies like twitter can foil the public market because less informed investors just equate them to facebook and there is some substantial chance this looks like a pump and dump in a couple of years.
So it would appear from the comments and from the article that there is a bit of misunderstanding in valuation theory and how it might apply to the valuations in the media. Hopefully this will help clarify some things.
1. FMV of equity is not 100% of the enterprise value of a given company. The enterprise value (EV) of a company is comprised of its equity value plus its net debt (total debt less cash).
2. The FMV of a given share will vary based on (as mentioned) the liquidation preference, any dividends and will also be affected by many other possible factors such as redemption/retraction, cumulative vs non-cumulative, ability to control/vote, etc...
Knowing this, it seems that what the author is trying to say is that it is misleading to suggest that the the value offered for a share of class A can be generalized across all classes of shares to provide a valuation. This is a valid and important point. Now, with respect to the valuation of Snapchat, I haven't seen the details of the offer to be able to question the basis for the valuation. Typically, a potential acquirer will have a valuation in mind when an offer is made. This may or may not be in line with the valuation that the media publishes.
Another issue that I see with what people are saying in the comments here is the confusion of price and value.
In the world of business valuation, the only time when price == value is the time when an acquisition offer is made that eventually closes at substantially the same terms. At any other time, we rely on the concept of fair market value as imagined using a hypothetical buyer and seller (there is a very specific definition). We may rely on past transactions as they given an indication of price/value at a moment in time to try to come up with a value at another date.
Now, none of this talks about the concept of special purchaser premiums, or the additional value that may accrue to a buyer for buyer-specific reasons. It may very well be that Snapchat is worth much less than $3b to most players in the market, however, part of the difinition of FMV is the hist and best price. This means that if Facebook is willing to pay a significant premium over others, then that premium should be considered as an indication of value.
[edit] The other thing is that a bubble doesn't need to be built on people knowingly selling worthless products. The things people are selling can actually have value, just usually not intrinsic value.