
Squaring Venture Capital Valuations with Reality - zapoist
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2955455
======
indescions_2017
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!

~~~
linkregister
_> 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.

~~~
indescions_2017
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-...](https://www.kauffmanfellows.org/video-indonesia-is-the-next-hyper-
growth-market/)

Convergence Ventures | Companies

[http://www.convergencevc.com/companies/](http://www.convergencevc.com/companies/)

------
stanleydrew
_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.

~~~
pge
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.

~~~
jogjayr
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.

~~~
pge
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).

~~~
jogjayr
> 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.

------
justboxing
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...](https://pando.com/2015/02/10/stewart-butterfield-on-his-unicorn-
status-its-arbitrary-as-fuck-theres-no-logic-to-what-you-get-valued-at/)

------
zilchers
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.

------
cma
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](https://news.ycombinator.com/item?id=6896833)

Of course it only matters if things go badly..

~~~
lnanek2
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.

~~~
stanleydrew
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.

~~~
robocat
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.

~~~
stanleydrew
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".

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

------
ridruejo
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/the-terms-behind-the-
unicorn-valuations.aspx)

[https://www.fenwick.com/publications/pages/unicorn-survey-
as...](https://www.fenwick.com/publications/pages/unicorn-survey-as-of-
december-31-2016.aspx)

------
nurettin
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.

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

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

------
dkural
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 _#outstanding_ price$

------
tonmoy
And the other other half are undervalued then.

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

~~~
fullshark
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.

------
sjg007
I would worry less about their value and figure out if they can make money or
if after the IPO people believe it.

------
led76
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?

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

~~~
prostoalex
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.

------
zitterbewegung
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...](https://signalvnoise.com/posts/2585-facebook-is-not-
worth-33000000000)

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

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

