The key issue is that a lot of startups use various contractual terms --
things like options on exit, liquidation preferences and others -- to take money into into the business at high nominal valuations, while still offering downside protection (optionality) to investors. The public at large usually just quotes the nominal valuation and goes from there. However, the optionality of those terms has substantial financial value, so the nominal valuation is often far from the truth.
These authors have developed a system to tease out the optionality using standard financial methods (using methods like Black-Scholes, for example), which can give us all a better understanding of the true worth of these companies. Far overdue in my opinion.
I totally agree. A startup founder has to spend so much time and energy understanding these preferential downside protections. Raising money is so time consuming solely for this reason. If everyone were to just stick to the fundamentals of simple accounting, the startup world would be a far better place. I really appreciate what these professors have done.
FWIW, this is what a 409A valuation is supposed to do. But that is often done long after a funding round is closed. The PR people and journos need a simple number to report on the story as the deal is announced. I would argue nobody really knows what the company is worth at that point (with the exception of the new lead investor, who may have a model for it).
Interestingly, the authors look at 409A valuations, which funnily enough have the opposite problem. From the article: "Low values reduce taxes; coincidentally, 409A valuations commonly use questionable assumptions that
significantly deflate values." (p. 8)
Optionality basically just means that there isn't a straightforward linear relationship between the price of something and how much you earn out of it. It's a very general term.
With preferred shares, investors have the option of taking either some percent of the company, or of instead taking a flat payment equal to their original investment (or more). For example, if a venture investor invested $100 into your lemonade stand, they could choose either to get the first $100 when you sold the stand, or to get 20% of the sale price. As long as you sold it under $500, they would take their $100 back, but if you sold it over $500 they would take 20%. If you sold it under $100, they would get all of it. That's the downside protection, since you'd be left with less than 80% of the proceeds even though nominally you own 80% of the business.
The optionality in startup investing has mainly to do with the "limited liability" in Limited Liability Corporation (other types of corporations and partnerships also have limited liability). That is, if you invest a dollar in a corporation, your losses are capped at a dollar. But, your gains are potentially infinite. Another instrument that has that characteristic--limited downside and infinite upside--is an option. The startup equity isn't actually an option, but it is useful to discuss its "optionality" because it does have some similar characteristics.
A related question I have then is would RSUs be considered as providing downside risk(but no upside) for employees then as the value is independent of the companies actual performance?
I'm far from an expect, but unless I'm misunderstanding your question, no, that's not it. RSUs negate some of the downside risk for an employee (vs an option), but have similar upside. With an RSU, it has value as long as the company has value, with an option, it has no value unless the sell price is above the strike price.
I probably didn't articulate that as well as I could have. You answered my question though thanks. I actually don't hear about RSUs as much except for some unicorns that seem to be staying private for longer and longer.
Yes, I think that RSUs are the most common form of stock grants for publicly traded companies. I think FB might hae been one the first SV companies to use it for employees pre-IPO.
> The average unicorn, the researchers note, has eight stock classes for different types of investors, including founders, employees, venture capitalists, mutual funds, and others.
As an aside, this is why I think that any effort of a prospective employee to divine the value of a stock option package is likely in vain. Without a detailed accounting of the ins and outs of the preferred stock that is senior to your common shares, it is nigh impossible to tell how much the common shares (and options thereon) are worth.
This is why I always recommend to individuals that when a startup offers equity in lieu of cash compensation to ask every financial/equity question imaginable. (what are you valued at today? how much investment have you taken? what's been diluted? etc etc)
People don't like to have that conversation because they think it's inappropriate. However, it's more inappropriate for a founder to tell you that you're getting equity in lieu of compensation and explain nothing about the value of that equity and potential future value of that equity based on the current state and future state assumptions.
90% of my engineer/designer friends have no clue what every financial/equity question imaginable even look like, and even if they had a list of them, they'd have no clue about how to interpret any of the results, or how to tell if the company is feeding you BS.
I mean, I was the first employee at a startup, involved with fund raising, and then founder at a startup, and even I would have a hard time with that.
Not to mention that even if you have a very solid understanding of what things are like when you get hired, it can all change dramatically in subsequent fundraising.
This is just one of many instances where the employee/employer relationship is heavily biased against the employee. And unless clear disclosure requirements understandable by the average worker are put in place, it'll stay that way. As an employee, your options are inscrutable lottery tickets which value can be redefined in many ways at many points in time, and there's not much you can do against that.
> 90% of my engineer/designer friends have no clue what every financial/equity question imaginable even look like
Totally - I've been thinking about actually putting on a "equity master class for engineers looking to join startups" type seminar in the bay area if people are interested.
You mean biased agains the employee? Anyway, I guess the obvious thought is that situations of information asymmetry like this are not really biased against anyone but just lead to worse outcomes for everyone. Startups would prefer to compensate in equity, but the value of their equity is depressed because potential employees can't tell how much it is worth. I suspect the obvious thought is right although maybe it could be bad for employees if they systematically tend to overvalue equity. (And then it would work against even the rare employee who can tell how much it is worth because he or she will have to compete against a bunch of suckers.)
I completely agree. An employee should be optimizing for maximum salary, the equity should just be considered a token reward.
If founders and investors really want to align their goals with employees, then start handing out rev share, otherwise, the employee is just deluding themselves.
I just don't accept equity in lieu of compensation. There's far too many ways to screw you over.
The only thing I would value is participation in a trust designed to make it as difficult as possible for the founder to receive cash from their ownership stake without paying out to all minor participants. "If he's worth $1B, I'm worth $1M" is something I can value.
Commonly set up? Depends on what you mean by "like this" - for this exact purpose, probably not at all. Enforceable? Absolutely. The entire point of a trust is to give out flows of cash to beneficiaries while restricting certain rights you may not want those beneficiaries to have. Usually this is more along the lines of "can't use the assets to pay down debts" than ensuring that the wealth generated from founding a start-up gets distributed fairly.
I remember one time negotiating an offer with StartupXYZ and they claimed a bunch of things about their stock options (company valuation, overall stock package value, etc). When I asked them various questions about the options, in particular the total amount of shares available, about class, etc, they told me "we can't share that information".
The last time I was interviewing was my first experience at evaluating non-public company offers. My recruiter at Docker setup a 30+ minute phone call just to explain what each of the terms meant, and helped me research and understand the offer much better.
And to add to this, it's impossible to predict the future. Even if you are privy to all relevant details to come up with an accurate "value" to attach to your shares, you have no idea what sort of deals will be made in the future (stock-backed loans or later equity rounds come to mind). All it takes is one bad-for-common deal and you're wiped out, and common is usually the first to get the short end of the stick (and the last to find out).
This is part of what makes cryptocurrency "ICOs" appealing. Depending on how the token sale is set up, you can usually be sure of exactly what portion of the equity you are getting. Whether or not it will be worth anything in the future is another question of course.
I completely agree with this. While I could (and have) done due diligence into a valuation of privately held companies in order to understand the value of a stock option, once you get to the later rounds there can be so much change to make any previous valuation calculation moot.
I really enjoyed the TL;DR stock option visualization earlier but for unicorns it would be a really interesting exercise to walk through various 'liquidity events' and their value and see the various percentages that went to which investors.
In theory, an external 409A valuation should serve this purpose: determine the FMV of common stock options, while accounting for all the nuances of existing preferred stock, liabilities, cash flows, and comparables.
I think when a model is presented like this, it should also show the examples where it fails. In the article, they show Square (Series E valuation at 6 B, pre-IPO 2.66 B) where the "fair valuation" correctly models closer to pre-IPO at 2.2 B.
However, let's look at another example. Take Nutanix (Series E valuation at 2 B, pre-IPO at 2.1 B). This model values it at 0.8 B on their table, almost a third of the IPO price.
There is no explanation forthcoming in this article as to why that's the case. This makes it seem like the Square example was cherry-picked.
I picked NTNX at random, so I don't know if it's the one exception. I'm not going to exhaustively check every result, however. I expect them to do that for me and not sell me a story without pointing out the terrible exceptions.
This is why the myth of "market capitalization" is so persistent. Often what you have at an IPO is a conversion of preferred shares to common shares. So effectively the 8 classes of preferred shares do become the same as the common, and the "simple" market capitalization number becomes real.
However.
How many startups never IPO? 99%? 99.9%? In acquisition or liquidation scenarios, those common shares are often worth a lot less than preferred. And because these scenarios make up a large proportion of the probability distribution, it means the expected value of common shares is a lot lower.
Even unicorns that are far more likely to IPO can raise bridge rounds that cause major dilution for the common shares, rendering previous market capitalization numbers useless.
The deal terms for unicorn investment rounds are less about company fundamentals, and more about the scarcity of great startups.
There's more money than there are good deals in Silicon Valley, so later stage investors are forced to offer more money for less equity in order to beat other term sheets. This ends up looking like sky-high valuations, since investors that offer fair-market-valuations are unlikely to get picked. Founders naturally gravitate towards minimizing dilution.
Or more generally, "welcome to the over-valuation of every asset class". Cryptocurrencies, housing, various kinds of stocks - there's more money than ever in the world, all of it chasing a return.
More complex packaging is part of it (think confusopoly of mobile plans applied to investing) and I think the paper has useful advice for "non preferential" investors, but it's not the whole story.
I think the difference is that inflation also involves goods that are consumed or desired for their direct utility. Not just "stuff I can resell for more later."
There's more money than there are good deals in Silicon Valley, ...
Is that true? VCs aren't acting the way they would if they really believed it. If they did, they would refuse funds from potential LPs, since they really can't find professionally responsible places to invest it. But that's not what they do. Alternately, they might take the LPs' money, warn them carefully that they could be investing in some real longshots, and then be willing to invest on fairly generous terms in any number of startups that look to be competently run and pursuing plausible opportunities. But that's not what they do, either.
The VCs of course need to maintain return but they are under some pressure to push money out the door and invest, as their fee is a percentage of funds invested.
There are many funds structured in a way where it's better for the fund (not necessarily for the investor) to invest 2x in questionable companies, than just 1x in great companies, lest they lose fees on the remainder.
I was fundraising last year for the company I work at and one of the investors asked me if I'd consider doing XYZ. I said, well that would put our share price to such that you would create a massive valuation on the business, so no. They seemed confused and said but wouldn't you want to make the company that valuable. I smiled and ended the meeting. What they wanted would introduce an enormous amount of risk to the business because Valuation != valuable. I would imagine this type of conversation is how founders end up on that list. I think our business is great, but I'm not delusional.
No, fundraising for DO wasn't like I've ever seen before as the revenue growth and customer growth was straight up and to the right when I joined (~employee 15). This was for the startup I founded after I left DO: https://techcrunch.com/2017/05/24/stae-helps-cities-take-adv...
The key thing here isn't about the fact that they are overvalued. It's more important to discuss the repercussions and what anyone is doing about it. It's not just Sillicon Valley, it's the startup scene all over the world.
How much is something really worth. Well how much is the next person willing to pay, that's really what this is all about. I've been down the road of VCs, exits etc... before and to be honest most of it is just fluff people make up, loop holes in the way things are valued, forget basic business and accounting they literally are making this up as they go.
Most VCs I feel have a detrimental effect on startups, the only thing a lot of them provide is money, which isn't always what a startup needs. It doesn't matter to the VCs that they are mostly wrong, they just have to be right once.
The question we need to ask here is what happens when it all crumbles down, due to the fact that all this is going on. How valuable something is ultimately depends on how many lives it improves. Whether something is valuable or not is measured by the amount of pain inflicted on society if the startup didn't exist, and ultimately if something is not needed, it wont survive anyway. The market is cruel like that, and having VC money shields entrepreneurs away from that crucial factor. All this fluffed up valuation has nothing to do with the survival of a business anyway.
> The question we need to ask here is what happens when it all crumbles down, due to the fact that all this is going on.
The problem there is that anyone riding right up until the very end has a pretty substantial return advantage over the folks who stepped off early and turtled up.
Which gives a perverse incentive to stay all in, which gives everyone an incentive to keep the wheel spinning for as long as possible, which is probably why crashes only tend to happen with an external spark.
I respectfully disagree. Functionalism isn't really the ultimate value: our world would look different if it was.
The ultimate value is instead rather circular: how much something is worth, is how much you can make people think it's worth. As we head towards general AI, we can generalize this: how valuable something is depends on how much people and AIs/systems think it's worth. Whether it improves anything at all, is very much optional.
If you've been an employee at a unicorn and have common shares/options, check out table 8 (page 48) that lists common share valuations according to their model.
AIUI, the common share FMV they list should be comparable to the 409A common share valuations you may have gotten. Roughly speaking, assuming the funding round in the table is close in time to the 409A valuation.
Perhaps this is the beginning of the end of what is essentially a new IT bubble? After all, it bears all the traits of the last bubble so all that's missing is a trigger.
Will be probably happen. I guess the trigger will be something like Twitter going down under and not getting VC the payment that they WILL WANT in some close future. I guess then comes a few years of VC being a lot more cautious where it's going to be harder to sell your company idea to them. It's phases all the time and we're on a high right now.
Although right now money is so cheap and there isn't really any alternative if you want ROI. That said, US interest rates are on the rise more so than those in Europe so perhaps the end might come sooner than most people think.
TL;DR it is not fair to take the per-share valuation at the last round of funding and apply it to all stock if the newly issued stock has preferential rights.
10 apples are worth $100. 90 oranges are not therefore worth $900.
you know how Nigerian scammers write bad English on purpose so they don't draw smart people by mistake and waste time dealing with them?
unicorn valuation is the same mechanism.
do it so obviously wrong that you only draw dumb people who think they are the only ones smart enough to see the valuation is off so they buy thinking they can profit from their clever and unique insight. and the scam is complete.
These authors have developed a system to tease out the optionality using standard financial methods (using methods like Black-Scholes, for example), which can give us all a better understanding of the true worth of these companies. Far overdue in my opinion.