The Unicorn Fantasy

Valuation is the most misunderstood concept in technology finance. Almost nobody seems to understand the obvious, which is that venture financings are not appraisals of businesses. In a financing, the only thing being sold is an instrument. And that’s also the only thing that is priced.

If a company does a Series B financing, the only “valuation” is what was paid for the Series B shares. A Series B financing says nothing about the value of the company itself. This is true in every form of preferred financing.

Common shares are bottom shares.

A venture preferred share is worth more than a common share. Period. And usually it’s worth a lot more than a common share. Venture preferred shares come with priority on liquidation, price protection, often accrued dividends, and a whole bunch of special shareholder rights that are particular to the investor—such as the power to block exits or financings.

You cannot work backwards from instruments to get at the valuation of a startup business. Instead, you start with an appraisal of the assets and then distribute the result across the various instruments.

Unicorn is just another word for “bubble.”
Sad unicorn.001.jpeg
If only that were true.

We’ve said for a long time that most unicorns are valuation fantasies. Turns out we were right.

With this in mind—something that 99 percent of the tech media and industry seems to not understand or want to admit—we turn to yesterday’s piece by Andrew Ross Sorkin. Writing in the Times, he says: “The average unicorn is worth half the headline price tag that is put out after each new valuation.” He continues –

…if the special side deals that most unicorn companies offer to certain investors…are taken into account, almost half of the companies would fall below the $1 billion threshold.

The research that Sorkin quotes was done by Professor Ilya A. Strebulaev (Stanford) and  Professor Will Gornall (UBC). In Squaring Venture Capital Valuations with Reality, they write:

Many finance professionals, both inside and outside of the VC industry, think of the post-money valuation as a fair valuation of the company. Both mutual funds and VC funds typically mark up the value of their investments to the price of the most recent funding round. The $6 billion assessment of Square was reported as its fair valuation by the financial media, from The Wall Street Journal to Fortune to Forbes to Bloomberg to the Economist.

That’s the problem. In most stages of a startup, that is plain bad logic, as we’ve said for years.

Our results show that it is inappropriate to equate post-money valuations and fair values. However, even sophisticated financial intermediaries make this error.

What’s astounding is that this basic error of financial logic is made by legions of MBA finance professionals managing billions of dollars. And it’s made by mutual fund managers and family office managers.

This is not hard stuff. And what’s amazed us over the years is that the very investors creating complex instruments seemed to miss the basic fundamentals of company valuation.

The right way to do it is:

  1. Start with the asset.
  2. Value it.
  3. Allocate that value across the stakeholders.
Why has this silliness gone on?

Because people see what it profits them to see. VCs are anxious to show good returns. Entrepreneurs want to brag about their valuation. The tech media wants a story.

Everybody benefits through reality-denial—for a while, anyway. (Later, the pain comes.)

Bubble markets depend on reality denial to keep the party going.

Winnie_the_Pooh_has_got_his_head_stuck_in_the_honey_pot.jpg
Who knew Pooh was in tech?

We saw this in 2001 with tech. We saw it in 2008 with mortgages and derivatives. And in 2013 with gold. It’s always the same.

And already we can see the signs of reality poking its unwanted nose into the tech tent. For example, many big VC investees are unable to exit because of their absurd paper “valuations.” Nobody will buy them at half the price. So insiders have keep funding these mighty “unicorns.” And seed funding is starting to tank too.

We call that “getting stuck in the honey jar.”

But more about that another time.


The unicorn image is from Spreadshirt; you can buy that image on a t-shirt here. Pooh is owned by Disney. Images are © their respective owners.

Windigo Bay Group is a business development firm. We develop and finance businesses, advise on strategy and restructuring, and negotiate strategic deals. We also handle the sale of strategic assets and businesses. Based in Toronto, we serve clients in North America and around the world. Contact us for a private discussion about your needs.

 

 

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