
Fuzzy Math That's Creating Many Billion-Dollar Tech Valuations - bko
http://www.bloomberg.com/news/articles/2015-03-17/the-fuzzy-insane-math-that-s-creating-so-many-billion-dollar-tech-companies
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kylelibra
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.).

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balls2you
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".

~~~
angersock
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?

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loumf
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).

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Balgair
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...](http://www.profitconfidential.com/stock-market/how-does-uber-make-
money-anticipated-ipo-of-2015/)). 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.

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neilk
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?

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dd36
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.

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zxcvvcxz
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.

~~~
nilkn
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.

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csense
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.

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gjem97
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.

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mrdrozdov
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.

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markbnj
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.

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ccozan
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](http://en.wikipedia.org/wiki/Tulip_mania)

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

~~~
loumf
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.

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xtrumanx
> 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?

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earlyrounder
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.

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downandout
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.

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julienchastang
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.

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howeyc
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".

~~~
mdda
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.

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

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SoCalNS_902
I think the fear of using the word 'bubble' is reaching a bubble.

~~~
hacknat
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.

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hnnewguy
> _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](http://en.wikipedia.org/wiki/Venture_capital)

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shrikant
> 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.

~~~
balls2you
when internet is down, snapchat will not work but clorox and campbell soup
will still continue to do their job. that's why :)

~~~
Chichikov
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.

~~~
balls2you
tell that to users of Comcast

