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Absurdly High Valuations (42floors.com)
135 points by jaf12duke 1383 days ago | hide | past | web | 81 comments | favorite

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.

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...

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.

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.

Correct me if I'm wrong, but what everybody seems to be saying, but not outright, is that early valuations are basically bullshit designed to make everybody think that the company is worth more than it is, immediately after the early valuators got their money in.

Like the guy that buys a car for $2,000, turns around to sell it and tells potential buyers that they can't accept an offer for $4,000 because they'd be taking a loss.

No. There are a few reasons why this isn't an apt characterization:

- Unlike somebody who flips a car, early investors are (typically) not selling their shares to later investors. Investors in different rounds do have differing interests, but they're not diametrically opposed like the interests of buyers and sellers

- The article is about high valuations in late investment rounds, not early ones.

- The reason for the high valuation is that risk in the late-round investments is comparatively low, not that investors want to hype the company for a future round that's even higher.

- To the extent that valuation in late rounds is "bullshit" it's because that valuation really only applies to the investors in the latest round, not to all shareholders. If somebody buys 10% of the company for $200M, we infer that the rest of the company is worth $1.8B, even though you couldn't actually sell it for that price.

> If somebody buys 10% of the company for $200M, we infer that the rest of the company is worth $1.8B, even though you couldn't actually sell it for that price.

If I understand correctly, the point is that the latest investor effectively buys between 10% and 100% of the company, depending on what it eventually gets sold for.

Yes, exactly. They have 10% of the shares but they might end up with more than 10% of the proceeds of a sale, if the sale price is less than $2B. That has an impact on the value of the remaining shares.

I think it would be more accurate to say they're getting a promise to pay back their investment with interest (the "bond-like" comment in the article), and also 10% of the company stock. It could turn out that the "bond" is more valuable, or the stock is more valuable, or they're both totally worthless.

A major difference between big early investors and retail investors is that retail investors don't get that "bond-like" guarantee. Hence there's greater risk of loss, and retail investors should value the stock much lower, but frequently don't.

Thank you for that explanation.

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).

Share prices DO NOT denote actual value

There is an entire field of academic study dedicated to answering this question. While you may not be wrong, this is far from a settled issue. The confidence with which you make the assertion (in all caps even) doesn't really jive with the actual science being done here.

If you're interested, start with the efficient market theorem and work your way forward.

I understand what you are getting at, but what I meant (and I should have clarified, my fault) - by actual value, I mean current (i.e. not estimated or anticipated) value - rather, empirical value based on hard evidence (the books, preferably non-cooked version ;) ). The value that companies are traded at does not reflect their current value -- if it did, trading would be kind of meaningless, like placing bets on a finished race.

That said, you are correct - the free market basically determines a "real" anticipated value of a product, even though this value may be inflated or deflated by fear, hype, fake volume, other factors.

Not exactly. The strong-form efficient market hypothesis, for instance, suggests that the value of something in a unregulated and truly public market would fully capture all information in existence about a company.

The market is therefore a reflection of ACTUAL value, not anticipated value. The actual value.

Again this is a hotly debated hypothesis, but what the value of a company on a public market actually means is most definitely up for debate.

I think you are confused by what 'value' is. 'Estimated worth', as you put it, is value.

There are many ways of attempting to value a company, including looking at the discounted (and estimated) future cash flows, but they do not tell the full story.

For example, as an avid skier, I might be willing to pay $1000 for a better pair of skis as I will get more out of the ski. A beginner skier would see no increase in utility in my skis over a $200 pair. So, what's the value of the expensive pair of skis? Well, to me it's at least $1000. To the beginner, it's no more than $200.

The same holds true for companies. DCFs and multiples are useful hints at understanding the value of a company, but ultimately, they are insufficient. Companies can see strategic value in acquisitions differently, including the value of shutting it down (either because of concerns of competition or to acqui-hire the team).

On the public market, shares will more closely represent a discounted cash flow view of the future, but not always. The author's point about different share classes is also valid on public markets where control does not always go to common shareholders. That said, it's extremely hard to fool the market, as you've suggested. There's a ton of data to confirm that the market is exceptionally good at pricing the value (probability weighted against tons of factors) of future cash flows based on all current market information. There is a ton of data to support this, and very little to dispel it.

Yes, you are correct - value can be a vague term (Future value? Book value? Estimated value? etc). I think I should have clarified as you did.

FMV defined from my textbook recollection: Highest price at which property will change hands between a willing and able buyer and a willing and able seller, acting at arm's length and under no compulsion to transact, in an open and unrestricted market and with full knowledge of the relevant facts.

Check all those boxes off and you can say: "YES, I'VE CALCULATED THE FMV!" but the truth is you can never be sure that you've determined the ONE TRUE FMV(c).


There should be only once price at which the property will change hands. Any less, and there would be competing buyers. Any more, and the buyer may have more attractive purchase options. This assumes that it's not a fire-sale, and that the property isn't a unique must-have asset, i.e. that your 'no compulsion to transact' condition is satisfied.

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.

> 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.


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

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

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.

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.

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'.

Maybe... but nobody really thinks of it that way, any more than they bother to worry about what fair market value of the assets (the other part of the purchase price) is for an early-stage tech company. They just care about the overall price, and they leave splitting that into FMV and goodwill as an exercise for the accountants after the deal is done.

A service company (i.e., a law firm) being acquired would almost exclusively depend on goodwill for the accounting of the transaction. There are few fixed assets beyond desks and chairs and possibly a property lease to include as assets. Accounts receivable and cash would of course play a role, but that is likely a fraction of the overall value paid. The difference between book value and the price paid is accounted for through book value.

Even in a steady-state in which Snapchat is earning serious money, were it to be acquired, the acquirer would likely need to account for it predominantly through goodwill. What tangible assets does snapchat have? Data center/infrastructure is likely the only area where a company like snapchat could invest in a way that would increase its book value... but snapchat is more likely to stay on the cloud...

The typical tech startup has few tangible assets, hence the necessity to account through book value.

Interesting analysis, but isn't goodwill a fudge-factor in the balance sheet? ie, its not a flow but a stock. This makes its estimation implicitly data-starved, because with a DCF at leat you are getting a time series of independent measurements.

No. Few companies are worth their exact book value. Accounting a balance sheet in of itself does little to tell you the true value of the company. For example, Google's book value is roughly 100B while its market cap (the implied value of the company) is 360B. Why the discrepancy? Accounting rules are strict on how assets are valued and don't (nor are they meant) to represent the future cashflow that can be derived from them. Future growth, intellectual property and brands are basically not included in the book value. When a company gets acquired, this difference is made up through goodwill. This is simply a representation that book value is not a good measure of true value.

Actually, in the case of a change of control (e.g.: acquisition), you will recognize fair value for brands and other identifiable intangible assets on the balance sheet. The Goodwill becomes the remaining difference between the consideration (purchase price) and the FV of the net assets.

Funny thing is that I'm actually working on a purchase price allocation right now.

...This difference is made up through goodwill is exactly why its a fudge factor, by definition.

Sorry if my point wasn't clear.

>> This makes its estimation implicitly data-starved, because with a DCF at leat you are getting a time series of independent measurements.

It isn't a data-starved number. It is often as simple as DCF calculation of value - the book value. DCF isn't used to calculate book value. Book value is simply the sum of the tangible parts.


Then goodwill isn't the right word for it, because goodwill has a precise definition that isn't fudged.

Additionally, the author made a good point in that many investors are not buying straight common shares. You can't simply value those shares by doing a DCF. You need to value each component of the instrument (an option, equity, debt,etc.) to get to a final number. He's right that extrapolating out that number is incorrect, but it's also incorrect to then deduce that anything beyond DCF is 'fudged'.

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?

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.

"it's all upside and no downside."

If you ignore the cost of doing the deal, any further investment of time and expertise into the company, and the opportunity cost.

And the fact that you still might lose all the money. Preference puts you (jointly) first in line for whatever is left, if anything.

I think a good way to describe it is a package deal containing one stock and one american sell option. So basically you value the sell option at $50, which is stupid, since the profit from exercising it can never be over $50.

EDIT: What I mean is, the absolute best possible case for the option is that the stock drops to zero. In that best case you get your money back: $50

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.

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

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.

True, but the risk profile for a late-state venture investor and an investor in public markets are very different. Let's say a company's valuation starts at 2 billion and drops to 200 million at some later date. If someone invested 100 million at 2 billion valuation, their losses from that value drop are very different. The private investor with downside protection due to liquidation preference gets their 100 million back, while the investor in public markets would get back only about 10 million. Late stage investments, such as those in Snapchat, are essentially bets that the value of the company at exit will not be below the value of the round in which they are investing.

No, it's not quite that simple, which is exactly the point of the article.

If I own 1% of a company that raises a round at a $2B valuation, my shares are worth $20M, in theory. But does that mean I can sell my shares for $20M? No, it does not.

Even if I can find a buyer for them, they won't fetch the same price that the latest investors paid, because of the liquidation preference. (If they do, either I've found a sucker, or the company got suckered in the latest round.)

If I can't sell my shares for $20M, then they aren't really worth that much. Twenty million is a convenient estimate, but there's a reason we sometimes talk about people being rich "on paper."

> 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.

"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

"'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

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

And now you both owe $100 Million in sales tax ;)

> "Price is What You Pay, Value is What You Get".

Yes, the real estate people at the supermarket must have decided that the plot has a value of more than $1M. They might be wrong or even foolish to think so, but they must clearly think that is the case, otherwise they'd be fools to pay it.

This is why those kinds of plans are kept secret as long as possible, because the supermarket hopes to pick up the plot at much closer to $100K than $1M.

What Buffet means, quite sensibly, is that you should only buy an asset when (your assessment of) its value is a lot higher than its price, not when its price accurately reflects its value.

There's two definitions of "worth" being used here. The investment definition and the laymen's definition. The layman probably adds up all the IP, assets, even the chairs the programmers sit on and comes up with some number << $3b. A more sophisticated layman might even look at revenue and growth and project out 4-5 years and still come up with some number << $3b.

The investor does some other kind of magic math and whatever because it's worth whatever somebody's willing to pay for it anyways so why bother?

He's not talking about the FB acquisition, he's talking about the rumored funding round. If there were an ac on the table, it was, at least until they turned it down, worth at least the price of the ac of course. He makes that distinction clear at the beginning of the post, just doesn't connect those dots directly.

Except no one has paid $3 billion for Snapchat. They've only bought a slice at that valuation.

I thought the offer from facebook was 3B all-cash for everything?


Maybe, but that's a rumor of a failed acquisition attempt. They will almost certainly raise money at that valuation or higher though. Just as soon as their current investors can find some dumb investors to pump the valuation sky high.


Most people own a fraction of their home, and hold a mortgage that is largely backed by the value of the home.

When you buy a house you agree to pay 100% of the agreed upon valuation. Investors in Snapchat are only buying a few percent at this valuation.

This is what it looks like to me:

Step 1) Buy 30% of a company at a $5 million valuation.

Step 2) Buy (or hopefully convince dumber investors to buy) 5% at a $3 billion valuation.

Step 3) Tell Yahoo to acquire you for at least $5 billion since your last raise was at $3 billion and you want your dumb investors to be happy.

Step 4) Cash your billion dollar check.

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.

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...

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.

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?

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.

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.]

Yeah, I had the same question. If there are 2 investors each investing 50M, and they're equally senior, they both get half of the sale value if it's < 100M. They get 50M + 8%/y if it's sold for 100M-3B. And they get 1/60 each if it's sold for >= 3B.

That sounds like a good deal even if you think SnapChat is only worth 200M...

Ok, so the main thing I missed is the preferential terms that investors get in the event of a sale, namely that they will be the first money out.

I think he's saying the total investment is $100m. So if it sells for $100m, each individual investor gets his money back.

Hmmm, he does say "If I put a hundred million dollars into Snapchat today at a 3 billion dollar valuation, three things can happen:". Doesn't that roughly mean he owns 3.3% of the company, so would be entitled to only 3.3% of the return? Or in an IPO would he be one of the only ones selling his stock so he would get his cash out?

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).

"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).

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

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.

>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?


> 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.

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.

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.

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.

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.

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.

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.

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.

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.

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

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