Flat is the new 40% Markup

Stuart Ellman

I was in a board meeting yesterday and somebody was talking about selling some shares. He just wanted to sell his shares at the same price as the last round of financing. No problem, right? Actually, yes problem.

This is an issue with mark-to-market pricing of private companies. The assumption tends to be that, since no new round has been done, the company is worth the same as it was the last time money was raised (and hence a valuation was determined). That just isn’t reality, although during normal conditions it tends to be close enough. Today, however, most of the major public indices are down 40% or really close to it. Some of the tech indices are off even more, but let’s stick with 40% since it is a nice, round number.

You might reply (and some do) that because there is no IPO market, the public market pricing has nothing to do with venture valuations. This is totally wrong. Everything is priced off of public market valuations eventually.

Not a pretty picture...

When a VC invests in a company, many factors are in play, but there is one overriding consideration: at what IRR (Internal Rate of Return) can I exit this deal? We work for our limited partners. We can be the greatest guys in the world, but if we don’t make money for our limited partners, we are out of business. So, we invest assuming there will be a public market.

Well, you may ask, what about acquisitions? The answer is that the best acquisitions happen when the alternative is going public. For example, if I can go public at $500 million, I might be willing to take $450 million from an acquirer to save the risk of an IPO. However, when I cannot say to the acquirer that my alternative is to go public at $500 million, what is he going to offer me? What is his incentive to offer $450 million? More likely than not, he will put in a low-ball offer because I have no liquidity alternatives. And, by the way, when I do want to go public, the bankers will value the company against public market comparables. In the end all pricing derives from where the public market comparables are trading – even when using typical discount models from recent private transactions.

So, the number is 40% down. What does that really mean? It means I can buy 5% of a public technology company for 40% less than I could have one year ago. It also means that private market valuations — all other things held equal — need to come down 40%. Thus, if you have a company that has grown so much that it warrants a 40% markup in valuation in a normalized market, you should expect a flat round in this market. If your company has a few issues and would likely have a flat round in a normalized market, then it should have a 40% down-round in this market. You get the idea.

The reason that it usually takes 12 to 24 months for private market valuations to adjust is because of our necessity to mark to the last round and the way that VCs can play with that. Whenever I teach my class at Columbia Business School, I explain that VCs can only mark to the most recent round. Students typically yell out that it is not fair (or clunky at the very least). But, there is no better way. There is no liquid market. If we try to mark down to an arbitrary marking, then we also need to mark up to one. Since VCs don’t like to take write-downs, they will sometimes starve a company that needs a new round so that it doesn’t take in new money at a lower price. Or, they put in a bridge which is un-priced. Both of those scenarios are simply stalling tactics where people are hoping that markets will improve. We at RRE try not to do that. More often than not, we push for the washout rounds to “right price” the companies, even when that means we hurt ourselves a bit in the process. We refer to this discipline as ‘living in the present’.

So, everybody in startup land, pay attention. Pricing is down 40% right now. Until the markets come back up, that is the reality. If you want to raise money, take a realistic look at yourself. You might not like the pricing being offered, but it beats the alternative of running out of money.