Five Years Too Late

October 24, 2008

Flat is the new 40% Markup

Filed under: Uncategorized — Tags: , , , , , , — fiveyearstoolate @ 11:57 am
Stuart Ellman

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...

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.

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  1. Thanks for this post and the very open tone of your blog that I have been following now for a few weeks!

    I understand your above reasoning and I agree with it for late stage start-up investments about to exit. But I have to admit I have a few questions about it for early stage investments. You mention that you are looking at what IRR you will make at exit to value an investment today. For early stage this exit, it is 4-7 years down the line. By always applying current multiples, you imply that equity markets are always right. But the last year events and many others tend to show that it is not case. In other words, by using current multiples with early stage investments during a bubble investors overestimate valuation at exit and during a very a bearish market they underestimate it. Shouldn’t you then use multiples that you consider make sense in the medium term (i.e. at exit) to make your investment decision? I guess that if you were convinced that equity markets were overvalued, you would not use current market multiples for early stage investments. So (for early stage investments) the question is rather do you believe that current market multiples are “fair”? If yes, then indeed “flat is the new 40% markup”.

    Don’t take me wrong, I think valuations will go down for early stage but it has little to do with current market multiples. It’s rather because there will be less VC investments because VCs will have difficulty raising their next fund and hence reduce pace of investments of the current fund.

    Anyway,I’ve been way to long for a comment… 🙂
    Thanks again for the tone of your blog!

    Comment by Wallen's — October 24, 2008 @ 4:50 pm

  2. Hmmm…not sure I agree with this one. The value of any illiquid deal is the price any two parties are willing to come to agreement on, with some implications for what each party believes the upside potential and future valuation to be.

    Now, you may say for older companies that a cyclical market has turned against them (especially web 2.0 plays focused on user acquisition over profits) and this would make the valuation of companies in the unfavored sectors decline precipitously, and I would agree.

    At the same time, however, for early stage companies, the characteristics of these companies that actually win funding will be radically different to allow for quick path to profitability and a much tighter focus on revenue models over user growth. Here, I fail to see why these early stage company valuations will be much different. Over the near term, it appears the previous criteria will not be received favorably (resulting in starvation or a down round per above). The few plays that fit the new criteria should see a more favorable environment for their approaches and have fewer competitors (as they were originally a contrarian or counter-cyclical play and there should be a relative shortage of follow-on companies given the current environment). People on the whole may be fleeing from risk, but there also aren’t many alternatives for those who need higher yields than a few percentage points (unless you think it all goes to value or vulture on the strength of mid- to long- term rebounds).

    Wouldn’t we expect a two-tailed distribution with new (fewer) deals at normal terms and follow-on deals at strikingly lower valuations than before. Is this how you reach a 40% lower valuation for the overall market? (as you’d weight larger, followon rounds quite a bit more heavily than smaller A’s and B’s)

    Comment by Vijay Goel, M.D. — October 25, 2008 @ 5:00 am

  3. This is Stuart, answering the prior two comments. Regarding Wallen’s comment. It would make long term sense to use medium term multiples. Unfortunately, when the markets are flying, nobody will take a lower “i.e. medium” valuation. The medium valuations will come from an average of lower valuations in down markets and higher valuations is up markets.

    Regarding Dr. Goel, the earliest stage companies will have the least variability. That is because there is usually quite standard pricing for early stage deals, with the exception of a proven winner of a CEO or something else unusual. However, in very high markets, even seed rounds can get priced up to very high levels (I have seen $200mm valuation for startups during the bubble.) This, on average, will not happen during down markets. However, as you say, as follow on deals happen at lower valuations than before, two eventualities happen. First, fewer seed rounds are done as people find that they can do the follow on rounds at lower prices. Second, the pricing of those seed rounds do get driven down because vc’s really dont like down rounds after they seeded a company. Either way, you will notice the declines in parallel with the public markets.

    Comment by Stuart Ellman — October 25, 2008 @ 6:06 pm

  4. Thanks for your answer Stuart. I agree with your point that in the “real world”, no VC will take a “medium” valuation and will offer a lower valuation. Just as entrepreneurs would look at it from the reverse angle. In up markets, it’s the other way around. And at the end, the negotiation power of each party decides, I guess.

    Comment by Wallen's — October 26, 2008 @ 1:12 pm

  5. So the more interesting question is what are the characteristics of a company now that would earn a full valuation?

    What are the most important factors and how has that changed from before in evaluating a new early stage investment (instead of sinking more into an existing play)

    a) user traction
    b) ramen profitability with capital used for platform expansion
    c) market pain (ie, cost-savings for the desperate)
    d) market/sector upside
    e) resumes of team
    f) capital efficiency

    Comment by Vijay Goel, M.D. — October 30, 2008 @ 3:25 am

  6. Vijay,

    It is impossible to say as finding an investment compelling is like defining beauty in a person. It is in the eye of a beholder, and changes from person to person. One thing I can tell you is that capital efficiency is definately more important than one year ago. Otherwise, “you know it when you see it”.


    Comment by Stuart Ellman — October 30, 2008 @ 1:38 pm

  7. Eric here. Just to chime in, I think that only in rare competitive situations are any companies going to get a “full valuation”, if that means pre-crisis price.

    In some sense, this is perfectly rational. When the public markets are roaring, you will pay up for any company in which you want to invest, and when they are in the tank prices are all cheaper. At no point during a bear market does Boeing or GE get to say, “Well, but we’ve got a great business, we cut costs, and are doing all the right things. So even though the markets are down, we deserve our full valuation before prices declied”. In a constantly marked-to-market context, it’s almost silly to even contemplate.

    I think the characteristics you site – traction, capital efficiency, strong team, low burn – are all going to make a company more likely to get funded at all, but I don’t think they in any way guarantee price stability relative to a few months ago. From RRE’s point of view, those are the qualities we look for in an early-stage company anyway, since we generally don’t pour money into big, capital-inefficient ideas.

    Comment by fiveyearstoolate — October 31, 2008 @ 8:58 am

  8. […] climate for startup venture financing has been thoroughly documented over the last few weeks, both here and elsewhere. I think you get it. But as my partner Stuart mentioned in a recent post, despite […]

    Pingback by Flipswap « Five Years Too late — November 14, 2008 @ 11:19 am

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