Squaring Venture Capital Valuations with Reality | Hacker News Reader

Squaring Venture Capital Valuations with Reality

papers.ssrn.com

133 pointszapoist46 comments

Of equal interest is author's other paper entitled "How Do Venture Capitalist's Make Decisions?" And after 900+ interviews it's neither jockey nor horse nor any other correlation, but spray and pray all around.

Am currently negotiating a small ($10k) angel investment in an ecommerce startup in Indonesia. All "go" signals are there: ambitious team, growing market, outside foreign investment, etc. But as far as calculating a probability for any IRR? 50% it goes to zero, 50% chance 10x or better return, is as good as any model for the risks faced at early stage.

So what was the data point that finally tipped the scale for me to pull the trigger? The fact that in Jakarta you can hire a fresh, world-class engineering graduate for $500 a month to come work for you!

50% seems like pretty optimistic odds for an angel investment.

in general, but with just a $10k angel, the odds of becoming a $100k company are pretty decent.

A $100k company could only be a 10x return for a $10k investment if that investment was for 100% of the company.

> The fact that in Jakarta you can hire a fresh, world-class engineering graduate for $500 a month to come work for you!

That's nuts, considering English teachers make about $1000 per month. Then again, there's such a dearth of opportunity for talent in Indonesia that I don't doubt your figure at all. I can't count how many engineering graduates from Bandung I met who are low-skilled office or vocational careers.

I noticed you didn't mention government connections to the startup. At some point they need to either pay unsustainable bribes or call a highly-placed friend or relative to stay in business, or so I have been led to believe.

Jakarta is an amazing city. I would love to use a product developed in Indonesia. I hope to see that startup's Show HN sometime soon.

Will definitely post 6 months or so from today! And maybe in a year you can buy my shares ;)

For now, check out this interview with Adrian Li, partner at Convergence Ventures, dedicated to seed investments in Indonesian startups, as well as their portfolio:

Video: Indonesia is the next hyper-growth market

https://www.kauffmanfellows.org/video-indonesia-is-the-next-...

Convergence Ventures | Companies

http://www.convergencevc.com/companies/

The rank and file employees of VC-backed companies often receive much of their pay as stock options. The naiive approach, likely used by many of employees, would dramatically overvalue their wealth. For example, the stock options Square issued around the time of its 2014 funding round had a strike price of $9.11.4 The naiive approach would take Square’s 2014 financing round at $15.46 per share and view these options as $6 in the money. Our approach shows the “fair” common share price was actually closer to $5.62, so these options were significantly out of the money.

Seems like this paper could provide a new 409a-compliant valuation method for common stock which might help to price employee options a bit better for these later-stage companies.

Existing 409A valuations already take all of that into account. When an employee is issued options, the one thing he can be reasonably sure of is that they are not in the money. Options have to be issued at or above the FMV for common stock, or it is taxable compensation to the employee. Note the "at or above" language. An employee's option has to be out of the money the day it is issued, but that could be by .01 or many dollars. The Board almost always has a valuation report done by a third party that values each class of stock separately, taking into account the various preferences and so forth. All of that is taken into account when assigning a value to the common options being issued.

Correct me if I'm wrong but the relevant 409A valuation is the most recent one done when you exercise your options and taxes on them become due. I think that's the situation GP was referring to, that this approach might help fix.

Unless you're saying that when Square's valuation suggested a share price of ~$15, a 409A done at the same time would have returned a value closer to the ~$5 that the paper suggests is more reflective of the average employee's situation.

You're not wrong, but this isn't just about taxes. In the case of Square, apparently they got a 409a valuation done that set a FMV for common of $9.11 and then issued options with that strike price as is standard practice.

Anybody who exercised immediately at $9.11 probably wasn't subject to any tax liability (assuming appropriate 83b election). Employees exercising at that price may have fooled themselves into thinking they were already $6/share in profit-land, which would be incorrect and is the point of the article.

But the bigger problem to me is that employees were fooled into paying $9.11 for something that was actually worth far less.

The relevant 409A is the one that is done prior to options being issued. If the company issues options below FMV (i.e. below the FMV determined by an objective third party, "the 409A valuation"), they are giving you in-the-money options, that is, they are giving you something of value at that moment. That's compensation and needs to be taxed as such. Later, when you exercise, either it is because the company was just acquired (and the share is immediately sold and you pay taxes on the profit) or the company has gone public and the shares are now tradable, so FMV is set by the market not by a 409A report. (I am ignoring for simplicity the rarer case where an employee exercises an option that is not freely tradable).

> when you exercise, either it is because the company was just acquired (and the share is immediately sold and you pay taxes on the profit) or the company has gone public and the shares are now tradable,

Nope. I'd argue the most common case of exercising stock options is actually when you leave a company before it has had a liquidity event (and you have to exercise the options because of a 90-day exercise limit). It's also when you want the lowest possible 409A/FMV, so that your taxes are as low as possible. Because you can't sell the shares to pay taxes.

There's also the rarer case (as you said) of employees exercising options of a private company while still remaining employed there. This is done in anticipation of an IPO or similar, to get a head start on the long-term capital gains tax clock. It's still not that rare though.

In reality perhaps options can be very much ITM when considering private sales or on secondary markets, if allowed by the granting startup. Even considering recent funding rounds and accelerating valuations. Lyft, for example, in its recent run since the Uber woes, may trade at a premium with plenty more upside in the coming months.

The 409a sets the FMV. That's the whole point of getting it done.

So the logic is circular. Yes, any options issued with a strike price at FMV are "by definition" not in the money at time of issuance. But I can tell you from multiple experiences soliciting 409a valuations that the FMV of common is incredibly debatable, and is often essentially just negotiated between the founders/board and the valuation firm to be as low as possible (for the benefit of employee exercise).

The valuation firms are absolutely not always taking all differences between classes of shares into account. My comment was hoping maybe this paper would provide a method that we can all agree should be used for valuation of common stock.

Sure, if the option is striking at $9.11 and the underlying asset has an actual value of $5.62, then it's out of the money. That doesn't mean that the option is worthless or even close to worthless though. VC-backed companies are usually hugely volatile which increases the value of options. This is a largely academic point, but there exists a sigma s.t. any call option ~$3.50 out of the money could be valued at $6 by a risk-neutral investor.

Related: Stewart Butterfield on his Unicorn status: "It's arbitrary as f*ck. There's no logic to what you get valued at" => https://pando.com/2015/02/10/stewart-butterfield-on-his-unic...

I wouldn't even call these complex mechanics - TFA basically says more favorable terms in later rounds (liquidations preferences, etc) mean that the high share price in those rounds shouldn't be used as the price for all outstanding shares. This is a great point that I hadn't really thought about before, but I would also expect people smarter than me to bake into their valuations.

I was always confused by this response:

> pg: "Yes, investors with preferred stock usually get their money back first. Sometimes they get a multiple, but that's considered overreaching nowadays and the more promising startups never have to agree to that. I suppose that is implicitly a target valuation in a sense. But no one views it as a target, because it only matters if things go badly." https://news.ycombinator.com/item?id=6896833

Of course it only matters if things go badly..

That's how I feel about it as an employee. If the startup doesn't do well my equity is worthless anyway, so I don't really care if it is a clean round or lots of tricks to get the valuation/share price up like that by promising investors more preference when it doesn't do well.

This is pretty short-sighted though. The definition of "doing well" is relative to the last round's valuation, regardless of business fundamentals.

So if your company is actually worth $100M, but you raise $150M at a $1B valuation with a 1x preference, you would get nothing if the company sells for $150M later that year. That would have been a 50% return on the actual true company valuation, had you actually raised at that.

This is an extreme example but hopefully you get what I'm saying.

In your example the company has lost $100M, not gained 50%...

E.g. company has $100M cash and no other assets, receives $150M cash, then later sells company for $150M.

Yes, that's my point. The company "didn't do well" by the standards of the previous round they raised. But had they raised a round that valued them more appropriately, they may have "done well".

The employees of Good Technology would most likely beg to differ.

https://venturebeat.com/2016/01/11/after-good-technologys-42...

I'm actually surprised that it's as low as 50% of unicorns playing these valuation games.

Some interesting data points and explanation of some of those terms

https://www.fenwick.com/publications/pages/the-terms-behind-...

https://www.fenwick.com/publications/pages/unicorn-survey-as...

Reminds me of the over-inflated house prices of Istanbul. (300% increase over the course of 5 years)

Perhaps prices aren't as dependent on "complex stock mechanics" as it is dependent on supply/demand. Demand being made up of increasing levels of wealth (or credit) and supply being made up of pure greed.

Isn't the massive devaluation of the lira over that time period the main factor?

Average devaluation is 10%/year in other sectors. Doesn't look like a main factor.

It's always the press claiming that valuation for the whole is equal to the latest preferred share price. Companies merely say, we issued a new class of shares and raised $ at price X. Company total value = sum of each class of stock#outstandingprice$

And the other other half are undervalued then.

It's not a zero sum game. Company valuations are independent.

But can't you be only either undervalued or overvalued? There is a knife's edge at properly valued but seems like almost all companies are one or the other.

The other half could be overvalued for other reasons.

Nope, because none of them are calculating valuations using their lowest priced shares are they?

That would be true if 1 + 1 = 2 but stock pricing changes by the minute/day/good news/scandal/hiring/firing, etc. Some of their valuations may have been on the money for the minute that it was determined but so many factors come into play even a huge over-valuation could even out next week based on a great quarterly report or a contract signed or if the right CEO is hired on an otherwise adrift ship.

You could at least read the paper abstract instead of relying on the made up HN title...

The actual claim is "almost one half (53 out of 116) lose their unicorn status when their valuation is recalculated". So, yes, if half lose unicorn status, then the other half do not lose their unicorn status. Is that really such a keen insight?

If we assume a simplistic log-normal distribution over the valuations of startups, and overvaluation is exactly half, this would mean that as a whole, startups are overvalued (median<mean)

> And the other other half are undervalued then.

You must be responding to the current HN title and not anything from the actual paper? This comment doesn't make any sense otherwise.

The paper literally has an entire section titled "All unicorns are overvalued" (section 4.2) and figure 3 shows the distribution of overvaluations given their methodology.

I would worry less about their value and figure out if they can make money or if after the IPO people believe it.

How is the paper getting its data? Maybe I didn't read carefully enough, but don't they need to know the liquidation preferences of the rounds?

It's not overvalued if people are still paying the price. Only the last fool in a long line will get hurt.

yeah, the last group of fools.

The last fool is likely to be some guy who eats and breathes finance. The last fool who did not negotiate liquidation preferences, ratchet provisions and a board seat will get hurt, though.

Reminds me of @dhh [1] except with causation. The example he used was Facebook but I think the oncoming adtech implosion might prove him right .

[1] https://signalvnoise.com/posts/2585-facebook-is-not-worth-33...

Given that Facebook is now worth $500B, this seems like a weird article to post.

Don't companies get bought out on the basis of how many users they have not some funny-number "valuation"?

Reply on news.ycombinator.com