
Absurdly High Valuations - jaf12duke
http://blog.42floors.com/absurdly-high-valuations/
======
ChuckMcM
It is tempting to read this article as "wah, wah, wah! Nobody values us over a
billion dollars!" but it is actually much more insightful. This statement that
Jason makes is the key I think ...

 _" They can afford to get into these bidding wars because they have the
confidence that they are likely to at least get their money back, and yet they
still get upside exposure if things go extremely well."_

There is a lot of 'brand management' at a venture capital company. They want
to be the 'cool kids' to the people who 'pick winners.' That keeps the money
coming in and the partners paid. Because of that, being an investor in a
company that makes a positive, splashy, exit (not necessarily really
profitable) helps keep that brand alive.

Given that, when there are already acquisition offers being turned down, VCs
no doubt see an opportunity to buff their brand by having a piece of the
action. And a weird feedback loop is that founders are quite flattered to hear
their company referred to with such high valuations, and it might make their
personal fortunes seem large (since they generally still have a large chunk of
stock) even though an exit that doesn't clear the preference hurdle will
typically pay them little.

So we get this little dance.

Such dreams don't always work out of course. So it is much easier to stay
focused on just building value for your customers and adding to their delight
and satisfaction in using your products. That activity always pays dividends.

~~~
birken
These ultra-high value financing rounds _are_ exits for founders though. Not
for all of their stock, sure, but if your company is worth 1B+, you don't need
to sell all that much to get a security blanket. So founders are doing these
rounds not because it makes their personal fortune seem large, but because it
actually allows them to get a mini-fortune (and presumably they think it is
good for the company). This happened very publicly with snapchat [1], and I'm
sure it happened to many of the other companies listed in the article.

This article also makes it seem like the difference in value between common
stock and preferred stock is larger than it is. When a company is small and
very high risk, the difference between the common and preferred is extremely
large. But as the company value goes up, this gap shrinks by quite a bit,
because generally companies with 1B+ valuations have a risk profile closer to
a public company than an early startup.

[1]: [http://finance.yahoo.com/news/snapchats-20-something-
founder...](http://finance.yahoo.com/news/snapchats-20-something-founders-
pocketed-132100118.html)

~~~
ChuckMcM
As per the referenced link, I'm not surprised those sorts of deals backfire
(where the founder takes money off the table) you lose a lot of urgency when
'rich' is assured (for some definition of rich).

I would hazard that it is unusual for the founders to take a 'soft' exit like
this but admit I don't have any numbers to back that up. I know the Groupon
founders did and got some harsh press but no long lasting damage.

~~~
MaysonL
Of course, when founders take some money off the table, they will no longer be
tempted to take the first FU money offer that come along, so will be more
willing to push for big home runs.

------
gavanwoolery
Actually, I'd take that one step further:

Share prices DO NOT denote actual value. Hence things like the P/E (Price to
Earnings) ratio. Share prices denote estimated worth, which is often never the
case (some companies trade at 30x their actual earnings, and never live up to
the promise of those expected earnings). The same concept applies to
public/private acquisitions.

What is actually going on with these valuations? Well, it is kind of a way of
conning public markets into buying this stuff. Even in the case of "private"
acquisitions, these acquisitions are largely or entirely funded with publicly-
traded money used by the publicly-traded acquiring company.

This is not always devious but I suspect there are at least a few cases of
corruption. Sometimes companies are innocently acquired with the true belief
that they will add value. Often times, companies are acquired to simply be
"flipped" \- i.e. destroyed within 3 years after the shares vest. The valley
floor is littered with the skeletons of acquired companies. :)

[Edit: on reading further down, the author hints at this a bit).

~~~
Edmond
Share Price = Present Value of Future Cashflow...

That analysis is hard to do correctly if the company is not even generating
revenue... Unfortunately it has now become standard practice to use what is
basically goodwill (hype, or more charitably, brand equity) as the primary
value proposition for many startups.

Goodwill is something you add to the value of a company to sweeten the pot
during acquisitions but it should never be the primary value proposition.

~~~
tomkarlo
> Goodwill is something you add to the value of a company to sweeten the pot
> during acquisitions but it should never be the primary value proposition.

What? Goodwill is an accounting name for the excess paid to acquire a company
beyond the fair market value of its assets. It's a "stub", basically used so
that the books balance in terms of debits and credits (i.e. you paid X cash
for the company, and that value splits between FMV of its assets and the rest
is "goodwill".) Nobody ever says "I'm going to add some goodwill to sweeten
the pot" when buying a company, nor would anyone attempt to use it for
determining purchase price.

[http://en.wikipedia.org/wiki/Goodwill_(accounting)](http://en.wikipedia.org/wiki/Goodwill_\(accounting\))

Also, the parent post refers to "flipping" but that generally means quickly
reselling something, not killing it after three years.

~~~
Edmond
From that same article, if you read the third paragraph, you'll see what I am
saying.

~~~
tomkarlo
Are you referring to "Modern Meaning"? Maybe I'm not understanding what you're
saying. It seems like you're implying that "goodwill" is a material part of
the calculation of a purchase price prior to the deal being signed.

~~~
Edmond
That is indeed what I am saying...what good will (no pun intended:) ) it be
post-deal signing?...if you read that section "Modern Meaning" you see it
alludes to brand,customers and IP...in the case of zero-revenue startups that
translates to hype,users and maybe an iPhone app.

~~~
roel_v
The gp is using the strict accounting definition of goodwill, you use it in
its popular meaning. Strictly speaking nobody values goodwill before a deal,
but it's often used as a word for 'the soft stuff we find hard to quantify'.

------
alain94040
The protection that preferences provide is so important and so often ignored
by the media and general public.

Imagine if you could buy Twitter stock today at $50, with the guarantee that
if the stock went below that, you'd get your $50 back. Would you buy? I would,
for sure. I'd even be willing to buy at $100: it's all upside and no downside.
Does that mean that Twitter is worth twice its current valuation? Of course
not.

How do you think DST got into all those hot deals?

~~~
bjacokes
As mentioned in the article, there's always potential downside to preferred
stock. A more accurate comparison is if you could buy Twitter stock for $100,
would only start losing money if it went below $30, and would only start
making money if it went above $100. If that is starting to sound like a crummy
deal, then clearly the preferred stock price has some loose relation to that
of the common stock.

------
tvladeck
This article does mention this, but I think the point gets hidden: you cannot
compare series * funding rounds with stock market valuations because investors
in series * get downside protection. This is the "liquidity preference". If an
investor puts in 100m at a 2b valuation, any exit above 100m will return the
investment to the investors of that round [0]. So the payoff for these
investments is actually quite nuanced with more than one "critical point".

[0] I realize it's more complicated than this, but the point remains.

~~~
vasilipupkin
Valuation of 2 billion is not just for investors with downside protection, but
for all the investors that own any part of the stock. Valuation is valuation -
let's not confuse it with what will happen in the future - just because a
company is worth 2 billion today, doesn't mean it will be worth that or more
in X years. But today, if investors are willing to pay a price of 2 billion
and founders/current investors are willing to sell equity at 2 billion - then
current valuation is 2 billion, plain and simple

~~~
tvladeck
The point is that with public equity shares, the extrapolation from the price
of a single share to the value of the entire company is much simpler. This is
for two reasons: first, everybody owns the same security; second, the payoffs
are continuous in the market price of the shares.

Neither of these things hold for VC investments. Not everyone owns the same
security, and payoffs are NOT continuous in the market price of the shares.
This is because of the liquidity preference that is usually part of the deal.

> Valuation is valuation - let's not confuse it with what will happen in the
> future - just because a company is worth 2 billion today, doesn't mean it
> will be worth that or more in X years.

No, valuation is not just valuation. I've just spelled out two reasons
valuations can sometimes not be directly comparable. That's the whole point.

------
RyanZAG
_> When you look at the rumored Snapchat valuations of over 3 billion dollars,
it’s difficult to understand how an investor can think that Snapchat is worth
that much. Because the truth is, it’s not. _

How much is your house worth? Might be it cost you $100K, but if someone is
willing to give you $1M for it because they want to build a supermarket there,
then your house is worth $1M.

So if Snapchat is being offered $3B from Facebook because they think it would
give them at least that much value, then Snapchat is worth $3B.

~~~
loganfrederick
"Price is What You Pay, Value is What You Get". [1]

I could hypothetically buy an apple or an investment for $100 billion (if
someone gave me the money). There could be any number of reasons for doing so,
but those reasons don't change the fact that it's highly unlikely I will
derive $100 billion or more in pleasure or return from that money.

On the other hand, if I can buy something cheap and I find it to be more
enjoyable, or an investment returns more money, than expected, then the item
was more valuable than what I had paid for it.

[1]:
[http://en.wikiquote.org/wiki/Warren_Buffett](http://en.wikiquote.org/wiki/Warren_Buffett)

~~~
arethuza
"'you have a dog, and I have a cat. We agree that they are each worth a
billion dollars. You sell me the dog for a billion, and I sell you the cat for
a billion. Now we are no longer pet owners, but Icelandic banks, with a
billion dollars in new assets.'"

Michael Lewis in _Boomerang_

~~~
mathattack
He is amongst the best at converting the craziness of Wall Street and Finance
into plain English.

------
bri3d
This highlights another point: as an employee holding common options, your
interests are _not_ aligned with the investors or founders.

Investors still win in the "small win" scenario outlined. Founders will
generally still get _something_ financially (depending on just how bad the
deal was) and can almost universally turn the "small win" bad exit into
"advisory" roles or more favorable terms next time they play the startup game.
As an employee, you get nothing.

~~~
2pasc
True. I wrote a blog post about this 18 months ago that outlines just this:
[http://2pasc.com/2012/05/18/the-power-law-of-startup-
employe...](http://2pasc.com/2012/05/18/the-power-law-of-startup-employees/)

------
mathattack
I really like his point on market cap. When you have preferences if things go
South, the valuation isn't as simple as total shares multiplied by most recent
equity valuation. Not all shares are equal.

The # of IPOs is also consistent with my intuition. It feels like 1998
excitement, as opposed to 1999 or 2000 mania.

------
bsirkia
Sorry can someone explain a bit more about the Small Win Scenario and how you
still get all your money back? Say Snapchat IPO's for $1B and you invested
$100M at a $3B valuation, wouldn't you only get $33M of your money back? Or is
that the caveat in "assuming I’m the most senior investor"?. Everyone
investing at these valuation can't all be the most senior investor right?

~~~
james_alonso
This depends on how the liquidation preference is structured. Sometimes each
new Series is made more senior than the prior series, so the last money in
gets paid first - in that case if the last investor put in $100m they would
get it all out before any of the other investors got paid. In other cases, the
different series of preferred stock have a "pari passu" preference, meaning
they all have equal priority - so in that case, you'd calculate each
investor's liquidation preference as a percentage of the total liquidation
preference owed to all investors, and they'd split the available proceeds
according to that percentage.

~~~
hncommenter13
This is correct in an M&A scenario, but usually not in an IPO. In an IPO, the
most common treatment of preferred is to force-convert everyone who holds it
to the equivalent amount of common stock, and such a term typically appears in
later-round VC term sheets.

Not only do public investors dislike having a junior series of common stock
out of the gate (Google-style two-class shares notwithstanding), but the
special rights that come with VC-type preferred stock (series votes, class
votes, rights to appoint directors, anti-dilution, blocking M&A, etc.) are
eliminated once there are public shareholders.

[Speaking as a former VC now public investor who builds and sells VC cap table
modeling software.]

------
gojomo
As a counterpoint: at the moment of financing, existing shareholders also
think the latest round is a positive deal for themselves. That implies they
value their remaining, post-dilution (and less-preferenced) shares even higher
than the reported top-line 'valuation'.

And indeed, a main reason for the liquidation preference is to provide the
later investors a guarantee/signal that the insiders' intent isn't just to
soon settle for less that the 'valuation' – winning themselves a gain at the
expense of the latest investor.

So, sure, when later money adds "$100MM at a $3B valuation", those
3.3%-ownership investors might not truly value the entire company at exactly
30X their stake. But, the other 96.7% owners _do_ value the company at _even
more_ than $3B, or they wouldn't have granted the downside-protection and done
the deal.

So reporting the top-line valuation, as a market-negotiated fair value,
weighted by revealed preferences, still makes a lot of sense. Professionals
and insiders found it a reasonable meeting-point... and the downside-
protection (which implies the investors' number is really lower) is exactly
offset by the upside-expectation (which implies the insiders' number is really
higher).

------
adventured
"When you look at the rumored Snapchat valuations of over 3 billion dollars,
it’s difficult to understand how an investor can think that Snapchat is worth
that much. Because the truth is, it’s not."

This is wrong. Facebook offered to buy Snapchat for $3 billion. If there is a
better way to appraise market value than the fact that one of the most
successful companies on earth is willing to buy you for that price, I don't
know what it would be.

The notion a transaction has to occur for there to be a 'true' value set, is
also false. Try telling the IRS your billion dollar company is worth a dollar,
because it has never been involved in a merger / acquisition / publicly
floated. That simply is not how companies are valued in accounting or finance
(aka anywhere that matters when determining valuations).

------
tomasien
This is going to make my life so much easier for the next few years as these
situations come up more and more.

------
mariusz79
This "As long as we keep pumping out good IPOs, we’ll be fine." And this
"Fundamentally, bubbles need the mechanics of a ponzi scheme in order to
exist. "

Translation - keep building crap because there is still enough suckers for
this Ponzi to work for a while.

~~~
klawed
>A bubble can occur when speculators invest with the belief that a sucker will
come along after them to buy the stock at a higher price.

This seems more of a requirement for ANY market - not just a bubble. Aside
from fixed-income or high-dividend paying stocks, When would an investor ever
buy a stock without the belief that someone else will eventually buy it for a
higher price?

~~~
akgerber
Dividends.

------
ontoillogical
> All of the firms making investments into the Snapchats and Ubers of the
> world are sophisticated private equity funds with capital pools so large
> they can afford to take large risks. After our little discussion, you can
> now see that their bets are actually not quite as high risk as commonly
> thought.

> No, the real danger still comes later when the public markets get involved.
> When those retail investors with their mixture of envy and disbelief try to
> cash in on something they don’t understand. That’s when we should be
> nervous.

Somehow reading lines like this makes me nervous _now_.

------
rz2k
Since this article is meant to be accessible to a lot of different audiences,
it is difficult for me to parse what statements are just liberties being taken
for the sake of an easier explanation, or whether it is arguing what I think
it is arguing.

In a fundamental sense, the value of a share of a company's equity is the
current value of that share of future earnings (including future unknown lines
of business, proceeds of liquidating assets, etc) until the end of time.

In order to divine the _expected_ current value of future earnings is the
marginal cost of a share of the company's equity. Just as the price of the
last lot of GE shares sold determines the value of GE, the value of Snapchat
_is_ determined by the price of the most recently sold share.

That does not mean that any shareholders have an accurate assessment of the
value, and knowing the recent price is ~$25 does not tell us how many people
would be willing to buy it for $1 or how many people would sell it for $100.
Knowing the answers to the latter questions would be a step toward answering
how much current shareholders could get if they all wanted out, and how much
it would cost to buy every last share.

Since eternity takes a long time, the market's marginal price of a share is a
good proxy for the value of a company. It is the expected value according to
investors with the most recent skin in the game. Anyway, that's a long way to
get to what I find really puzzling:

>When you look at the rumored Snapchat valuations of over 3 billion dollars,
it’s difficult to understand how an investor can think that Snapchat is worth
that much. Because the truth is, it’s not. Those rumors, even if true, don’t
actually value Snapchat at 3 billion dollars. To be precise, they are bidding
on a price per share of a specific series of stock. As matter of common
discourse, we multiply that number by the total number of shares outstanding
and call that a valuation. But the difference still exists and it’s important.

I'm parsing the middle sentence with "value" as a transitive verb, and the
subject as actually an implied "investor" rather than "rumor", in line with
the sentences before and after. And, I find that the serious problem here is
that that _is at least_ the expected value according to that investor.

I read the rest of the explanation as a way to get at how the probability
distribution around that expected value may play out, but that does not change
the expected value.

However, to expand a little on the payouts: Suppose the disruption of Snapchat
could be known to cost a competitor future revenue with a present value of
exactly $3B, but the present value of all earnings of an independent Snapchat
could be known to exactly equal $2B. If that competitor can buy and shutter
Snapchat without any anti-trust hurdles, then in a fundamental sense the
competitor would pay up to $3B for Snapchat (and the shareholders would
fundamentally be willing to sell if paid more than $2B, with the market
eventually awarding between $2B and $3B to the owners depending on what is
negotiated).

In reality those numbers can not be predicted, but a valuation of $3B is a
statement that the expected value is really worth $3B. An investor who pays
$300M for 1%, but expects the future proceeds to be worth less than $3B is
gambling that there is a sucker who has expectations that are too high, not
respecting fundamentals. An investor could estimate that the earnings will be
a certain amount in the hands of other management and still be in line with
fundamentals, but claiming that the price will increase without producing some
future cash flow or having a fundamental value to another buyer is a gamble
that the market is stupid. (It's a safe bet that the market is stupid, but the
trick is knowing how stupid, in what direction, and for how long.)

Again, maybe I am missing something, or misunderstanding what is being said,
but on the surface it is really frightening to read columns like this that
appear to claim that an entire market can have a mean of valuations that are
not in line with fundamentals.

~~~
cjlars
I'm not sure Freedman is trying to make a theoretical argument that you can't
extrapolate marginal price per share into total market cap. What struck me
here, but what the author fails to point out directly, is that the implied
value from preferred stock does not equal the implied value from common stock.

In the snapchat instance, he's highlighting a preferred stock deal that has 1.
liquidation preference and 2. interest. So they effectively have a deal with
components of both long and short options (i.e. they get a gain with exits
above $3bn, but no loss unless the exit is below $100m), and a bond (~8%
interest on the $100m as long as they don't default).

So you can't take what is effectively a $3bn strike price and say that's the
implied value of the preferred stock deal, because it's not. To get the true
implied price, you'd have to dissect the valuation of each option, bond, and
stock component of the deal. There are standard methods to value each
component, but don't expect the start up media to do the calculation for you.

~~~
rz2k
Thanks, that makes a lot more sense, and you're right that is the point that
was being made.

It would be nice to see the scenarios expanded and stressing the outcomes for
different classes of shares.

For example, on a second read I understand it that in scenario B the investor
paid $100M for 3.33% of the "$3B" company, and gets a $108M payout even if the
company sells for $1B (which would be equivalent to 10.8% of how much the
buyer bought it for). If it sells for $30B, then he gets $1B.

------
dsugarman
with raising money at a $3b valuation, even considering liquidation
preferences, etc. you severely limit your exit opportunities. A $3b
acquisition is technically a possibility but I would assume everyone is
looking for at least a 2x exit, so now you need to be purchased for $6b.
Taking money at such a high valuation can be a serious risk because if you can
not get to that $6b IPO or acquisition (in snapchat's case I do believe that
would be very difficult to pull off) you will not be in good shape.

These late stage investments are looked at like they are really low risk when
in reality, it is always a substantial risk until you have a working business
model. We say cash flow is king, but invest in the exact opposite fashion and
flock to vanity metrics. Look at how Fab (a company everyone assumed would
become the next monster e-commerce company) is flailing and trying to raise
money every month while losing all viewership. I fear companies like twitter
can foil the public market because less informed investors just equate them to
facebook and there is some substantial chance this looks like a pump and dump
in a couple of years.

------
filearts
TLDR; Snapchat is probably worth more to Facebook than it would be to other
players in the market or to acquirers simply interested in cash flows to
equity.

So it would appear from the comments and from the article that there is a bit
of misunderstanding in valuation theory and how it might apply to the
valuations in the media. Hopefully this will help clarify some things.

1\. FMV of equity is not 100% of the enterprise value of a given company. The
enterprise value (EV) of a company is comprised of its equity value plus its
net debt (total debt less cash).

2\. The FMV of a given share will vary based on (as mentioned) the liquidation
preference, any dividends and will also be affected by many other possible
factors such as redemption/retraction, cumulative vs non-cumulative, ability
to control/vote, etc...

Knowing this, it seems that what the author is trying to say is that it is
misleading to suggest that the the value offered for a share of class A can be
generalized across all classes of shares to provide a valuation. This is a
valid and important point. Now, with respect to the valuation of Snapchat, I
haven't seen the details of the offer to be able to question the basis for the
valuation. Typically, a potential acquirer will have a valuation in mind when
an offer is made. This may or may not be in line with the valuation that the
media publishes.

Another issue that I see with what people are saying in the comments here is
the confusion of price and value.

In the world of business valuation, the only time when price == value is the
time when an acquisition offer is made that eventually closes at substantially
the same terms. At any other time, we rely on the concept of fair market value
as imagined using a hypothetical buyer and seller (there is a very specific
definition). We may rely on past transactions as they given an indication of
price/value at a moment in time to try to come up with a value at another
date.

Now, none of this talks about the concept of special purchaser premiums, or
the additional value that may accrue to a buyer for buyer-specific reasons. It
may very well be that Snapchat is worth much less than $3b to most players in
the market, however, part of the difinition of FMV is the hist and best price.
This means that if Facebook is willing to pay a significant premium over
others, then that premium should be considered as an indication of value.

------
ameister14
Is the graph just the number of internet IPO's in a particular year? Because
in the 90's it was much more common to have a smaller-value IPO than it is
today.

[edit] The other thing is that a bubble doesn't need to be built on people
knowingly selling worthless products. The things people are selling can
actually have value, just usually not intrinsic value.

------
james1071
The game is pretty simple. Most of the cash will usually be invested in the
later rounds. This would massively dilute the early investors unless the
valuation was much higher. Hence, they will push for as high a valuation as
possible.

------
gwu78
Maybe "valuation" does not represent the value to future investors. Maybe it
represents the magic number required for the early investors to achieve the
return the venture capital (or other) firm promised them.

------
taybin
Seems like if he splits winning into big wins and small wins he should also
split losses into big losses and small losses too.

------
mergy
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