The math behind jaw-dropping mega-round valuations

I know I've been silent (at least blogging-wise) for a while. This is mostly due to my 20-day trip to Hong Kong, Shenzhen, Dongguan and Taiwan in which I visited universities, labs and local partners for manufacturing, logistics and funding. Especially during the week in Shenzhen and Dongguan, I felt an immense disconnect from my usual world of internet due to the VPN crackdown led by the Chinese government in January. Since my writings require lots of fact-checking on the internet, I lost desire to write anything after coming back to the hotel from a heavy day of meetings only to find that I couldn't even get Baidu to give me the proper definition a random tech term.

That, of course, is no excuse for my no-show during the ensuing week in Taipei, equally filled with dense meetings. I'll blame it on the world-famous Taiwanese food then — too good to pass by for the sake of writing blog posts.

Anyway, I'm now back to Paris and back to my weekly routine, so it's time to torture the innocent minds of the readers of this blog. And what else better to start than the hot topic of valuation given the recent frenzy of jaw-dropping valuation of late-stage fundings?

Before we get started, let's take a look at the latest Unicorn (>$1B) list at this convenient WSJ website:

I listed only the Unicorns that are valued at more than $5B and it's already a fairly long list. We're in an unprecedented era of private valuations which is a result of money-chasing-deals and VC-looking-to-pocket-more-returns-before-IPOs. In fact, a new term has been coined to describe startups valued at more than $10 billion: "deca-corns". We have to hope that Xiaomi and Uber don't linger on too long in the private land so that the alarmingly weird term "cent-corns" has to be invented.

But are these late-stage valuations really what the companies are worth?

The short answer is: no, they are not. A long answer could be found in a recent Bloomberg article "The Fuzzy, Insane Math That's Creating So Many Billion-Dollar Tech Companies". However, this article requires some basic understanding of financial theories to fully grasp the implications.

I will hereby use a step-by-step approach here to build some basic understanding of valuation before I use my own (simple) language to explain why late-stage valuations are not really valuations.


What does VALUATION mean?

While VALUATION could apply to any part of a firm, in the startup world it usually means the valuation of the equity part of the firm and it usually comes in a very simple math called post-money.

For example, if the startup raises a round of $50M in cash and the new shares issued will account for 20% of the firm after the round, then the post-money firm valuation is simply $50M / 20% = $250M. In other words, the startup's shares are now worth (at least in the eyes of the latest investors) a total of $250M.

This is, however, assuming that the newly issued shares are normal common shares with no conditions. While this might be the case for early stages, it's usually not the case in the recent mega-rounds of late stages.


Enterprise Value

The textbook definition of Enterprise Value (EV) is "the present value of all future free cash flows generated from the firm's operating activities".

The firm's operating activities could be sponsored by two genres of capital: equities and debts. In financial theories, this means that the present value of the operating activities should be equal to the present values of the equities and debts.

  • EV = MVE + MVD

where MVE stands for Market Value of Equities and MVD stands for Market Value of Debts.

Note that EV represents the real value of a firm's real business, stripping all other components that are not representative of what the firm really does. For this reason, marketable securities and excess cash for non-financial firms are usually subtracted from the firms total values.

This concerns particularly public companies where MVE usually includes the values of the excess cash and marketable securities.

For example, public company A might have the following numbers:

  • current market cap = $1B
  • remaining long-term debt = $150M
  • excess cash on the book = $45M
  • current values of marketable securities = $52M

EV will then be calculated in this way:

  • EV = $1B + $150M – ($45M + $52M) = $1053M

The rationale behind this is that excess cash just sits on the book and doesn't participate in operating activities (think Apple in this case). Marketable securities are similar except that their values fluctuate with the market.

EV is the best approach to evaluate the real values of a firm, which is no more than a going-concern comprising meaningful operating activities. For this reason, a public firm could raise a certain amount of money at the market rate by issuing new shares. If they have no use for the cash, the EV will remain the same as before the issuance despite the apparent increase of market cap.


EV for startups

While large and mature public firms usually fund their activities with a combination of equities and debts, startups usually do not have this luxury due to its high-risk/low-physical-asset nature. This means that the operating activities of startups are usually funded solely through equities.

Startups are also constantly running out of cash, which means excess cash does not exist for startups. Even for a startup that just raised a big round, that cash sitting on the book is necessary for growing the business and therefore not excess.

Therefore, in general EV of a startup will be the same of its MVE.

  • EV = MVE

As a result, when talking about a startup's valuation, the number implies also the enterprise value and therefore the whole worthiness of the startup's operational activities.

As a contrast, large airline firms usually fund their activities with a lot of debt, which means that their MVEs on the stock market only tell half of the story regarding the whole worthiness (or worthlessness in this particular industry) of its operating activities.


Late-stage valuation that is NOT

Throughout the early stages of a startup's life, common stocks are the main funding sources, despite the fact that they sometimes come in the form of convertible preferred shares.

As a successful startup moves to later stages, things get more complicated:

  • Pure debt kicks in from banks and asset management firms if needed
  • Equities with various provisions beyond normal common stocks surface

The pure debt part, valued at MVD, is easy to figure into the equation and in theory doesn't affect the MVE. The EV will increase by the same amount of MVD.

The special late-stage equities with provisions, however, render the valuation less obvious. In particular, late-stage equities with liquidation preference result in valuation that is NOT.

Liquidation preference is nothing but a guarantee to a group of investors that in the case of a lower valuation in a subsequent fund-raising event, whether it's IPO or another private round (in this case it'd be called DOWN ROUND), this group of investors will at least get their money back before anyone else.

For example, assuming in a Series E a group of liquidation-preferred invested $1B of cash at a valuation of $10B (giving them 10% of the deca-corn startup).

If everything goes well and in 1 year the startup successfully IPOs at $11B market cap (assuming no debt on the book), this group of investors will receive $1.1B for their investment and therefore a 10% return, annualized. Not bad for a growth-fund type of investment. The other previous investors will have 90% of the value which is $9.9B and fully 

However, if things do not go as expected and the firm IPOs at a valuation of $9B, which is lower than its Series E valuation of $10B, the liquidation preference will kick in and guarantee that the Series E investors get their full $1B of original investment back. Previous investors will be left with $8B.

Note that sans liquidation preference, Series E investors will have 10% * $9B = $0.9B while the other investors have $8.1B. With liquidation preference, Series E investors have their downside protected at the expense of previous investors.

Essentially Series E investors own the following two things at the same time:

  • Common shares accounting for 10% of the firm
  • A put option to sell all its common shares for $1B

The 2nd item, the put option, is an implicit cost to the previous investors. A standard way would be using a Black-Scholes formula (or any of its derivations) to estimate the price (and therefore the cost to the previous investors) of this option. The real pre-money valuation for the previous investors at the moment of the Series E valuation will then be:

  • (Post-money – Series E cash) – Put option cost
    = $9B – Put option cost

An option's value is always positive, therefore the pre-money for Series E will be lower than the $9B suggested by the news headline of deca-corn valuation.


Why all the fuss?

The Bloomberg article mentioned some motivations for such high-valuation fundraising that is NOT, such as founders' ego. Bottom line is late-stage investors have to put their money to work given the abundance of liquidity in the system. As long as they deem their downsides protected, they're willing to accept a symbolically high valuation if it makes the founders and less-finance-savvy employees happy.

While the firm accountants will give a more reasonable valuation to existing employees (supposedly using the aforementioned Black-Scholes formula method), for outsiders it's not too much of a stretch to put a significant mental discount on the mega-round valuations, as recounted by the Bloomberg article:

It may be 30 percent less; it may be 50 percent less. They don’t necessarily disclose that to the public until the time of their IPO.

I hope this helps the readers understand the nature of the exciting mega-round valuations.

Regarding structural VC investments

The new world is flat and hot in the eyes of the Hardware Club