Fuzzy Math That's Creating Many Billion-Dollar Tech Valuations | Hacker News Reader

Fuzzy Math That's Creating Many Billion-Dollar Tech Valuations

bloomberg.com

157 pointsbko73 comments

Seems to me (as a startup employee) that downside protection and liquidation preferences should be required to be disclosed to all previous stakeholders (employees, prior investors, etc.).

as someone who has worked in startups for the last 10 years as always an early employee and disillusioned by it... the VCs think of you as replaceable unlike themselves... more money buys more power... you as an employee have only a single power - "quitting".

I get that incentives are misaligned between involved parties (VC's, founders, employees), but it seems very disingenuous to knowingly withhold this information.

Hey! That is sort of the beginning of class-consciousness.

Is it being withheld? Have you asked?

Liquidation preferences are mostly there for the low exits -- the VC is trying to stop the founders from making ONE MILLION DOLLARS!!! by just selling it out right away for a low (but still very high for a pair of people) amount of money. I haven't found that this is a secret.

As an employee, you should assume that you aren't going to see much if the exit is low (no matter what the founders/VCs tell you).

I would also say that this is basically true for Angels if the company goes through a few more rounds and then fails to reach real exit velocity.

>>> Is it being withheld? Have you asked?

Does it needs to be asked? Isn't it transparency in operations and responsibility to people who believed and invested before in terms of effort or money? It is unbelievable, if they are hidden/undisclosed to remaining stakeholders.

Your disclosure rights are in the contract. If you don't like it, don't sign.

Did your equity comp get valued at these inflated numbers or at some lesser value given the lack of protection?

I am wondering if employees get screwed by the tax man due to these inflated valuations.

Can't speak for all companies, but at the three I know about, the employee valuation is the audit (much lower) one. The stock an employee gets is a different class and it's not unusual for different classes to have different prices (they are actually different -- have different payouts)

So, two questions for you (and anyone that cares to answer):

1. Has a founder ever said "Don't worry, we'll take care of you?"

2. Has that founder ever delivered during the exit?

1. No, and I wouldn't believe them if they did.

2. Nonetheless, they have always delivered more than what was contractually obligated (in the form as a retention bonus at the new company or some other commitment).

In my case, both the startups were "sold" off to another larger holding. I personally, did not get anything worthwhile in a serious dollar amount so I chose not to exercise my options. Really, after the dilution your employee stock options are miniscule. And savvy startup CFOs will give employees small quantities of options not large.

EDIT: Yes, and these were not traditional Silicon Valley startups, they were NYC/Finance area startups. The original founders were not developers (your "bros"), they were finance guys!

Yes.

Wanna share your equity %, the company exit size, and your final $ haul from stock?

no equity %. The savvy CFOs will not tell you what your percentage equity actually is. this allows the CEO/top brass to dilute the pool by issuing millions of options before the sale of the company to a buyer. Since I didnt work for a startup that went IPO, $ haul was 0. i didn't exercise the options, they felt useless compared to the effort I put in.

EDIT: also as a traditional employee (in my case developer), you will not be aware that your company is being readied for sale to another before it actually happens. Only, if you're a very tiny company like 10 folks maybe you can know. Otherwise a startup that grows from 10 to 100 or more, then forget it.

To clarify I was an early employee after a funding round and not before. Those who are employees before any funding round are basically "founders" and can get some sort of decent payout.

You should have known (should have asked, they should have told you) the percent. That should not be secret, at any size company. Too bad.

You don't think we did ? That's just silly to even think that employees who are more emotionally vested in a startup will forget to ask what their equity is. They don't tell you. That's the norm. Consider yourself lucky if you are told what your equity is worth. And it will be diluted to nothing regardless.

Why would you even join or stay at a startup who's not prepared to give you the real % figure ?

Notice that the Investor Fear of Missing Out = [(Hopes & Dreams x Rate of Growth) - Valuation]/ Downside Protection . Though you have to guess on some of the values, you can then use this to figure out what people actually think valuations are.

Say my Drone Delivery Tacos startup is going well, we have 10 guys all tacoed out and have delivered 100 tacos, on track to deliver 250 by Friday. We than have a growth rate of 250%. Our hopes and dreams are high, out of a 10 point scale, we are at 9.5. Also, one of the guy's cousins knows a guy that could value us at 100 million dollars. That guy wants a lot of protection though, say 8.0 out of 10. Plug in the numbers and you get: $ -12,500,000 ish. That's how much they actually think you are worth to them. To say this is all about appearances is putting it lightly.

For Uber we know the valuation is 40 Billion smackers, hopes and dreams are at 10/10, Downside protection is lower, call it 5/10, and growth rate is ~300% (http://www.profitconfidential.com/stock-market/how-does-uber...). So, we get $ -8 Billion dollars, what the investors actually think that Uber is worth.

Crazy times.

{Edit:} My math is off. Hopes and Dreams is in units of $/%/year and Downside Protection is in units of $. Assigning these to a 10 point scale is not exactly correct and they obviously do not cancel each other.

So why aren't startup valuations published as a range? This is like a measurement with no error bars.

I know the "real" reason - same reason why TVs are compared on the diagonal measure. But, why don't later investors insist on also learning the lowest possible imputed value, taking into account how investors are acting to protect themselves. Risk is hard to compare, but isn't this what Wall Street does all day?

> But, why don't later investors insist on also learning the lowest possible imputed value, taking into account how investors are acting to protect themselves. Risk is hard to compare, but isn't this what Wall Street does all day?

Presumably the later investors ARE doing this. But it's not in the investors' interest to publish their internal research on the error bars and it IS in the interest of the startup to publish as high a valuation as possible. Combine that with the fact that big numbers get pageviews and there's no incentive for anyone to report on the lower bound.

One way that you know this analysis is happening is that it's needed for an S1 filing. There's just no reason to publish any of it before then.

> So why aren't startup valuations published as a range?

Because it's marketing hype and merely negotiation tactic. Newcomers always have the opportunity to get the truth before investing.

Who are the parties who care about accurate valuations enough to sue if they get lied to?

1. Investors 2. Banks & Insurance 3. SEC If you aren't one of those parties, then i'm guessing you can be told to trust any valuation on a whim.

Analysts do exactly this. They pick a handful of metrics and produce a range. For an IPO, this information is usually published by varying sell-side firms for the benefit of their clients and to attract new clients (unless they are underwriting the deal then there's a lock up period - 45 days, IIRC).

The company itself will also have a slide deck for its pre-offering road show that has this analysis done by management. You can usually find these slide decks on an investor relations website or on the SEC Edgar system. It also may be in the SEC registration statement under management analysis - or even under risks.

Based on the headline, did anyone else expect this article to be about "deep learning"? Seems like everyone and their mother is using machine learning to do X these days.

My concern would be that neither the founders nor the investors understand the math/science behind it well enough to accurately forecast if most of these products could work. I don't know how many VCs have CS PhDs doing their due diligence, hopefully more than I think. Personally I don't care either way, but some academics are gonna get mad if/when the media starts comparing deep learning stuff to financial engineering...

To be clear I think machine learning methods add a lot of value, but given the current climate of hype, I'm seeing more noise and fluff surrounding product possibilities based on these technologies.

I was expecting this to be about simple fuzzy logic getting billed as sophisticated machine learning to drive up valuations and hype, or something like that. The actual value of data science is another discussion, but it sure is popular right now.

This article is trying to express that "valuation" has different meanings for different companies.

For most companies, valuation is based on the price investors are paying for the stock alone. The point of the article is that, for some tech companies, it's based on the price investors are paying for the stock plus some form of "downside insurance" which pays them back if the stock loses value.

It makes sense that the stock-plus-insurance basket would be more valuable than the stock alone, especially if there is a small probability of the insurer folding and thus a small probability of losing money.

This article is completely missing the point. These valuation numbers are made up. Say you have a basket of ten oranges, ten apples and ten pears. Someone comes along and says, "I'll give you $20 for your oranges." You give them the oranges and put the twenty dollar bill in the basket. You now announce to the world "This basket of fruit/cash is now worth $60!" It's not. You have no basis for assuming that the market will also pay $2 per apple or pear, but you need a nice round number to shout out to the world.

In this allegory, your oranges are preferred shares that may have "economic terms" like liquidation preferences and participation clauses that could make them 10 or more times more valuable than the common shares of your company. These companies that are now going through 5+ rounds of private financing often are negotiating different terms for each round. But when it comes time to issue a press release--even if they're not intentionally being disingenuous--it's easier to communicate a single number. That number is often just number of outstanding "shares" * purchase price of last funding round.

Seems to me, that if you take a rational perspective, then if a company like SnapChat has a high valuation then it must have some competitive advantage and effective market plan. Of course, this might just be confirmation bias because I want to believe that such a high valuation could not be the effect of just poor estimation. A different situation could also be true. One might not want to believe that a four year old messaging app might be worth more than some of the most well known names in household products. It's confirmation bias all the way down.

Did Bloomberg just discover preferred shares and liquidation preferences? Or is this meant for a lay audience? I'm not sure how many of Bloomberg's readers would find this surprising or newsworthy.

There is nohing strange here. It's a market and the price is set to any amount you wish. If someone buys it, good for you.

I saw recently a movie, where there was an example of this happening in the past too, the Tulip Mania[0], where the evaluations were way of the scale. What followed was a crash.

[0] http://en.wikipedia.org/wiki/Tulip_mania

This isn't just simple price-setting. It's advertising a very different price than the actual valuation, mostly because of the downside protection.

The stock that the VC owns and the stock that the employee owns are materially different and thus have different values. The kind of stock the employee has is not for sale.

It is better for employees if the stock they own (or have options for) is initially low-priced (for tax reasons).

This whole "valuation set by auditing" is kind of meaningless -- it's as artificially low as some might think the VC valuation is high. It's based more on regulations about what is valuable than what the market thinks is valuable. For example, cash in the bank, factory equipment, and accounts receivable are worth something -- having a billion free users is not.

> investors agree to grant higher valuations... in exchange for guarantees that they'll get their money back first if the company goes public or sells.

Is that not normal? To pay your investors and other preferred stock holders first (along with your creditors and such) back first before those who were granted common stock.

Or is the author saying the preferred/common stock deal is just a tech industry thing?

It is normal

Yes it is normal for investors to be repaid first, However the article is saying is that there is a LIFO arrangement for different investors. Last in , first out.

Example: C round investors , in exchange for new, higher valuation, will be repaid before B or seed round investors. The Liquidation Preference.

If C rounders are paying up for this protection, then I guess it's ok. And if the C round is led by firms that primarily invest in public markets ( T Rowe Price, Wellington, Fidelity etc) then the private company is hoping those firms anchor the next round - an IPO at at least the same or higher valuation.

What is the disaster is when the exit comes, and other public fund managers not previously involved in the deal that need to absorb the remainder of the demand balk at the valuation proposed by the investment bank leading the deal. The public round fetches a lower valuation than the most recent private round(s), and people are not pleased.

This is very similar to "death spiral financing" in which lenders are guaranteed enough stock to return the loan plus interest, regardless of the stock price. Here, investors instead of lenders are receiving very similar guarantees. It doesn't usually work out well for later stage investors.

Can anyone here comment on the broader societal and economic impacts and whether this is a threat to capitalism? It seems to me to be a bad thing when inside players can rig the game to become immensely wealthy based on companies that are making little or no money.

It looks to me, with liquidation preferences, like the valuation the investors believe is probably closer to "all the money raised"+x% than the published "valuation".

Agreed - what I don't understand is why most of the discussion here is about high valuations. The big reveal of the article is that the valuations are known by investors to be illusory - and (colloquially) the VCs are ripping the faces off the entrepreneurs.

From the title I thought this was going to be a deep belief network hype piece.

I think the fear of using the word 'bubble' is reaching a bubble.

You could call it a bubble, but it really doesn't matter to anyone if it pops. VC money is a rounding error in the overall economy.

It's not a rounding error in the technology industry. Many startups would die within a year if VC funding dried up, which means thousands of talented programmers would be unemployed. Many others would survive, but would be forced to significantly curtail growth and have large layoffs. Any "growth now, revenue later" startups would be in serious trouble.

Salaries would go down (demand for programming jobs would outstrip supply) and there might even be a real estate crash in geographic areas heavily dominated by startups (e.g., Silicon Valley/San Francisco).

>VC money is a rounding error in the overall economy.

According to Wikipedia, it's no rounding error:

"11% of private sector jobs come from venture-backed companies and venture-backed revenue accounts for 21% of US GDP."

http://en.wikipedia.org/wiki/Venture_capital

> Snapchat, the photo-messaging app raising cash at a $15 billion valuation, probably isn't actually worth more than Clorox or Campbell Soup.

Why not?

Edit: Okay, personally and intuitively, I'd value a convenient means of communication more than processed food and snacks.

Some are these are companies with products that produce profits and the other is a photo-sharing app that doesn't.

when internet is down, snapchat will not work but clorox and campbell soup will still continue to do their job. that's why :)

Same goes for Google.

The internet will never be down again (barring the Apocalypse). Human life changed in the nineties in ways that we have not even begun to grasp.

tell that to users of Comcast

haha, downvoted due to lack of a sense of humor in the crowd.

You too can invest in my $1 million company for investing just $1000 to buy 0.001 shares.

Probably because Clorox and Campbell pull in ~$5 billion and ~$8 billion in revenue and have done so for the last 5 years. Pretax earning for both are ~$1 billion.

I agree that future cash flows are more important than historical performance but a track record counts for something, right?

Would you rather invest in Campbell soup or Snapchat?

Clorox stock price 5 years ago: ~65 Clorox stock price today: ~108 Annual return: 10.7%

Campbell stock price 5 years ago: ~35 Campbell stock price today: ~45 Annual return: 5.15%

I get it, soup isn't sexy. Doesn't mean its not a good investment. Personally, I don't claim to have a preference for one or the other. Investment is more about risk profile than blind speculation.

Clorox is also paying a 2.7% dividend. Campbell is 2.8%. Would be reasonable to bump those five year annual returns up to perhaps ~13% and ~7.5% (let's assume the dividend was lower five years ago).

Chlorox is the slow-and-steady type. SnapChat is the hare, to Chlorox's tortoise.

The chances that Chlorox or Campbell will still be around in 10 years? Very high. Snapchat? Not so much.

I would invest in Campbell soup all day long. And I would gamble on Snapchat.

On the other hand, I personally think the chances that Snapchat (or its technology) will be acquired down the road are a lot higher than either Campbell or Chlorox.

Acquisition isn't necessarily a good thing for normal investors.

I'm guessing you think that because you didn't experience the dotcom era first hand. Companies that have raised huge sums of money can go under. It's not happened recently but when it does it'll be horrible to watch. I'm not suggesting that we're in a bubble either - the fact is that companies die for a bewildering variety of reasons, and it is inevitable that one or more of the unicorns will die eventually.

Well, Clorox was acquired by Procter & Gamble in 1957 and then divested. Campbell Soup in the UK was acquired in 2008. So acquisition odds are higher than you'd think.

You may think that food companies are boring, but there are a lot more acquisitions, spinoffs, and mergers of food companies than you'd think. Take a look at http://en.wikipedia.org/wiki/List_of_ConAgra_brands and consider that there are multiple acquisitions behind most of these. Kraft has gone through too many mergers, acquisitions, and takeovers to even try to explain. http://en.wikipedia.org/wiki/Kraft_Foods

Anyway, my point is that it's not just the computer industry where acquisitions are happening for billions of dollars.

Depends on the price. One would rather own a cheap Clorox than an expensive Snapchat.

Depends on the valuation. If much of the upside is already baked into Snapchat then there's a lot of downside risk (hence the downside protection that these institutional investors are demanding). I wouldn't touch Snapchat at that valuation with anything more than spec funds. I certainly wouldn't view equity comp as valuable.

I'd pick Campbell's, that 2.77% dividend yield is nothing to sneeze at when interest rates are this low.

"investors agree to grant higher valuations, which help the companies with recruitment and building credibility, in exchange for guarantees that they'll get their money back first if the company goes public or sells"

That's all she wrote- unless of course your startup actually sells something, than you might have a bottom number that still looks impressive once the initial investors have moved on.

I can clone Snapchat in a weekend. So can couple of million other people. It's fall could be as rapid as its rise.

I cannot even begin to grasp the challenges of delivering canned soup around five continents.

Campbell solve hard problem. Snapchat - easy one.

It's amusing to see that you think that to compete with SC is as simple as copying its functionality.

It sill makes the idea that someone would pay billions (in cash) for Snapchat technology pretty funny.

As how to value their users...

It's not that it's easy, it's the barrier to entry. One person can build a potential SnapChat clone (or next big thing that ends up being hip), and have access to the same potential user/customer base.

I can sell home made soup on my front lawn, but i sure as hell can't scale to Campbells size overnight.

This is why Campbells is the safe investment.

Because Snapchat's valuation is solely based on their technology?

Snapchat had the right product with the right marketing that lead them to gaining a large user base with high engagement.

Furthermore, is Campbell's valuation based on their soup recipe? I can make chicken soup in hour. They are valuable for their brand, distribution, and production capabilities.

Snapchat success came by fraud. They lied their audience about the self destruction of their messages.

> Snapchat had the right product with the right marketing that lead them to gaining a large user base with high engagement.

You can say this of any fad. The ice bucket challenge certainly engaged millions of people, but that doesn't mean it's a brand worth investing billions.

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