Squaring venture capital valuations with reality

Venture capital (VC) is an important driver of economic growth and an increasingly important asset class. Of all the companies that have gone public in the US since the late 1970s, a third had venture capital backing.¹ Historically, most successful VC-backed companies went public within three to eight years of their initial VC funding. More recently, many successful VC-backed companies have opted to remain private for substantial periods and have grown to enormous size without a public offering. Companies such as Uber, Airbnb, and Pinterest have been valued in the tens of billions of dollars, fueled by investor expectations that these companies could become the next Google or Facebook. The growth of these companies spawned the term “unicorn,” which denotes a VC-backed company with a reported valuation above $1 billion. Once thought to be rare, as of mid-2017, there are more than one hundred unicorns in the US and another one hundred in other countries.²

With the reported valuation of these unicorns totaling more than $700 billion, the interest in VC as an asset class has increased substantially. A number of the largest US mutual fund families, such as Fidelity Investments and T. Rowe Price, have begun investing directly in unicorns. In addition, third-party equity marketplaces, such as EquityZen, allow individual investors to gain direct exposure to these unicorns. While the total present VC exposure of mutual funds, at around $7 billion, is small compared with the size of the mutual fund industry, a tenfold increase has taken place in just three years. In 2015, Fidelity invested more than $1.3 billion into unicorns, more than any US VC fund invested that year.³

Despite the growing importance and accessibility of VC investments, the valuation of these companies has remained a black box. This is due in part to the difficulty of valuing high-growth companies. But, to a large extent, it is due to the extreme complexity of these companies’ financial structures. These financial structures and their valuation implications can be confusing and are grossly misunderstood not just by outsiders, but also by sophisticated insiders.

Unlike public companies, which generally have a single class of common equity, VC-backed companies typically create a new class of equity every 12–24 months when they raise money. The average unicorn in our sample has eight share classes, where different classes can be owned by the founders, employees, VC funds, mutual funds, sovereign wealth funds, strategic investors, and others.

Deciphering the financial structure of these companies is difficult for two reasons. First, the shares they issue are profoundly different from the debt, common stock, and preferred equity securities that are commonly traded in financial markets. Instead, investors in these companies are given convertible preferred shares that have both downside protection (via seniority) and upside potential (via an option to convert into common shares). Second, shares issued to investors differ substantially not just between companies but also between the different financing rounds of a single company, with different share classes generally having different cash flow and control rights.

Determining cash flow rights in downside scenarios is critical to much of corporate finance, and the different classes of shares issued by VC-backed companies generally have dramatically different payoffs in downside scenarios. Each class has a different guaranteed return, and those returns are ordered into a seniority ranking, with common shares (typically held by founders and employees, either as shares or stock options) being junior to preferred shares and with preferred shares that were issued early frequently junior to preferred shares issued more recently.

As a motivating example, consider Square Inc.’s October 2014 Series E financing round in which the company raised $150 million by issuing 9.7 million Series E Preferred Shares for $15.46 per share to a variety of investors.⁴ These shares had the same payoff as common shares if the company did well but additional protections if the company did poorly. The Series E investors were promised at least $15.46 per share in a liquidation or acquisition and at least $18.56 per share in an initial public offering (IPO), with both of those claims senior to all other shareholders. These Series E shares joined Square’s existing common shares and Series A, B-1, B-2, C, and D Preferred Shares. Each of these classes of shares has different cash flow, liquidation, control, and voting rights.

After this round, Square was assigned a so-called post-money valuation, the main valuation metric used in the VC industry. This post-money valuation is calculated by multiplying the per share price of the most recent round by the fully diluted number of common shares (with convertible preferred shares and both issued and unissued stock options counted based on the number of common shares they convert into). After its Series E round financing, Square had 253 million common shares and options and 135 million preferred shares, for a total of 388 million shares on a fully-diluted basis. Multiplying total shares by the Series E share price of $15.46 yields a post-money valuation of $6 billion for Square:$\$6\text{billion}=\underset{\text{Series}\text{E}\text{price}}{\underbrace{\$15.46}}\times \underset{\genfrac{}{}{0.0pt}{}{\text{Total}\text{number}\text{of}}{\text{shares}\text{in}\text{all}\text{classes}}}{\underbrace{388\text{million}.}}$

Many finance professionals, both inside and outside of the VC industry, think of the post-money valuation as a fair valuation of the company. Both mutual funds and VC funds typically mark up the value of their investments to the price of the most recent funding round. The $6 billion assessment of Square was reported as its fair valuation by the financial media, from the Wall Street Journal to Fortune to Forbes to Bloomberg to the Economist.⁵

The post-money valuation formula in Eq. (1) works well for public companies with one class of share, as it yields the market capitalization of the company’s equity. The mistake made by even some very sophisticated observers is to assume that this same formula works for VC-backed companies and that a post-money valuation equals the company’s equity value. It does not. Most public companies issue primarily fungible common shares, without distinct cash flow rights. VC-backed companies issue a variety of shares with different terms, which means that these shares have different values and a formula like Eq. (1), where all classes are assumed to have the same value, cannot be used. In many cases, the most recent VC investors have been given what is essentially a put option, a right that transfers substantial value to them at a direct cost to the unprotected shareholders.

For example, the price of Square’s November 2015 IPO was $9 per share, 42% below the Series E price. However, Series E investors were contractually protected and received extra shares until they got $18.56 worth of common shares. Series E shares must have been worth more than other shares, because they paid out more than other shares in downside scenarios and at least as much in upside scenarios. This difference in value is ignored in the post-money valuation formula. Equating post-money valuation with fair valuation overlooks the option-like nature of convertible preferred shares and overstates the value of common equity, previously issued preferred shares, and the entire company.

In this paper, we develop a modeling framework to derive the fair value of VC-backed companies and of each class of share they issue, taking into account the intricacies of contractual cash flow terms. Our model shows that Square’s fair valuation after the company’s Series E financing round was $2.2 billion, not $6 billion as implied by the post-money valuation. Square’s reported post-money valuation overvalued the company by 171%. Square is not a unique case. We apply our model to a sample of 135 US unicorns and find that post-money valuations overstate company values in all cases, with the degree of overvaluation ranging from 5% to a staggering 188%. To do so, we extract contractual terms of unicorns from certificates of incorporation (COI) and develop a methodology to reconstruct their capital structure. We find that IPO guarantees and other previously unexplored terms, such as automatic conversion vetoes, are both common and quantitatively important. Section 4 contains the core of the paper’s findings, showing the overvaluation of all US unicorns in our sample, as of the time of their most recent round (see Tables 6 and 7).

Our results show that equating post-money valuations and fair values is inappropriate. Although valuation practices are secretive and idiosyncratic, several limited partners (LPs) have informed us that most venture capital funds mark all of their investments to the most recent round’s price. An informal survey of VCs we conducted also suggests that many of them mark up their investments after subsequent successful rounds in their reports to LPs. This is consistent with a memo written for one of the major venture capital firms, Andreessen Horowitz, in which its partner Scott Kupor argues that “[s]ome venture firms value their companies by taking the last round company valuation in the private market and assigning that value to the firm’s ownership in that company.” Moreover, because Andreessen Horowitz uses a valuation methodology that takes into account contractual terms, its “marks are deliberately more conservative and according to our LPs are lower than other firms who use different methods”. Our survey is also consistent with an industry report by the data provider Sandhill Econometrics, which asserts that “in reporting company value, [VC investors] ignore preferences and report all shares at the same value.”⁶ We can get better disclosure from venture capital vehicles that market themselves to the public in Europe. Two of the largest such vehicles explicitly note that they mark their values to the price of the most recent round.⁷ Marking unicorns to their most recent round’s price leads some venture capitalists to overstate their fund’s unrealized value. As unrealized asset values are an important determinant of future fund-raising (Barber and Yasuda, 2017), this could lead the investors in venture capital funds to misallocate capital.

Mutual fund filings show even more clearly the prevalence of treating post-money valuations as fair values. Almost all mutual funds hold all of their stock of VC-backed companies at the same price. For example, after DraftKings’ Series D-1 round, John Hancock reported holding DraftKings’ 2015 Series D-1 and common shares at the same price.⁸ We find the D-1 shares were worth 43% more. Along the same lines, most mutual funds write up all of their share holdings of a given unicorn to the price of its most recent round of funding, regardless of the type of stock. For example, in 2015, when AppDynamics issued a Series F round with an IPO ratchet, a provision offering a 20% bonus in down-IPOs, Legg Mason wrote up its Series E shares to the Series F price despite not being eligible for the 20% bonus.⁹ These examples are representative of common industry practices. Mutual funds have earned large mark-to-market returns on their venture capital investments [see, e.g., Agarwal et al. (2017)]. These returns would be lower with more appropriate valuation methodologies.

Although EquityZen provides nine pages of analysis on Wish, the fact that the valuation is set using preferred stock and that investors are buying common stock is not clearly mentioned. The preferred stock that Digital Sky Technologies purchased here has strong preferences, including the right to its money back in exits other than IPO and a right to keep its preferred liquidation preference in an IPO, unless that IPO provides a 150% return. These can lead to stark differences in payout. If Wish is acquired for $750 million, all of the preferred equity investors get their money back while the common shares that EquityZen is selling get nothing.

The rank and file employees of VC-backed companies often receive much of their pay as stock options. Many employees use post-money valuation as a reference when valuing their common stock or option grants, which can lead them to dramatically overestimate their wealth. For example, many of the stock options Square issued around the time of its October 2014 Series E funding round had a strike price of $9.11.¹¹ Fig. 1 shows the value of these options as a function of the strike price under three possible valuation scenarios. The first scenario is the fair value produced by our model, which says that options with a strike price of $9.11 are worth $2.85. The second scenario ignores the capital structure complications and calculates the fair value of the option under the assumption that one common share is worth $15.46. Being unaware of Square’s complex capital structure would lead one to estimate the value of those options as $10.32, a 262% overvaluation. The third scenario shows the value under a rule of thumb approximation used by many employees, which estimates the value of a stock option as the difference between the most recent round’s value and the option’s strike price. That naïve approach values the stock options at $6.34, for a 123% overvaluation.

Even if a company’s fair value is falling, it can report an increasing post-money valuation if it issues a new round with sufficiently generous terms. For example, Space Exploration Technologies, better known as SpaceX, issued Series D Preferred Shares in August 2008, during the early stages of the recent financial crisis. Despite the troubled economic times and several failed launch attempts, SpaceX managed to increase its post-money valuation by 36% from the previous round by promising buyers of Series D shares twice their investment back. Our model shows that SpaceX’s reported valuation was four times its fair value and, despite the reported valuation increasing by 36%, its fair value had fallen by 67%. These generous terms are not necessarily evidence of active post-money valuation manipulation and could simply be due to a difficult fund-raising environment. Irrespective of the company’s intentions, the post-money valuation painted an overly rosy picture.

In this paper, we develop a contingent claim valuation framework for valuing of VC-backed companies. Beginning with Black and Scholes (1973) and Merton (1974), researchers have used share prices to value warrants, options, bonds, and other contracts. We reverse this process and use the price of option-rich preferred shares to value common shares. Our approach is close to the common practice of option-adjusting corporate bonds or mortgage-backed securities to determine underlying risk prices. Similar to our method, in this approach, risk-neutral valuation is used to account for the embedded call options in debt contracts to recover underlying default risk (Kupiec, Kah, 1999, Stroebel, Taylor, 2009).

The 409A tax valuations of VC-backed companies often rely on similar techniques. The primary goal of these valuations is tax compliance, not strategic insight. Many companies push their 409A providers for lower valuations as this allows them greater freedom in setting option strike prices. This pressure leads to the use of assumptions that produce conservative valuations.¹² The 409A valuation provider eShares finds that common equity is overvalued by approximately 186% for the median Series C company, far above our median overvaluation of 37%.¹³ As another example, Economics Partners, which provides both strategic and tax valuations, indicated to us that 409A valuations of VC-backed companies with at least three rounds of preferred funding have common shares worth an average of 35% of the value of preferred shares, which implies average overvaluation of at least 185% for common shares.

Metrick and Yasuda (2010b) provide a textbook treatment of the venture capital industry. In particular, in chapters 13–15 and 17–18 they discuss the nature of post-money valuation and its difference from fair value and describe the contingent claims approach to post-money valuation. They also analyze the pricing implications of a number of contractual features, such as liquidation preferences, for the most important securities used in the VC-backed transactions. We apply the contingent claims framework to analyze quantitatively the relation between fair value and post-money valuation and value specific VC-backed companies. In doing so, we also value many additional contractual features, such as IPO ratchets.

We also develop methodology to reconstruct the capital structure of unicorns based on contractual terms from certificates of incorporation. Our analysis, based on these extracted contractual terms, shows that previously ignored terms, such as IPO ratchets and automatic conversion vetoes, are extremely important.

Our paper is related to several branches of the literature on venture capital. Cochrane (2005), Harris, Jenkinson, Kaplan, 2014, Harris, Jenkinson, Kaplan, 2016, Kaplan and Schoar (2005), Korteweg and Sorensen (2010), and Korteweg and Nagel (2016) analyze the returns and the risk of VC as an asset class. Importantly, many papers that look at project-level returns [including Cochrane (2005) and Korteweg and Sorensen (2010)] take post-money valuations at face value and use them as a proxy for fair value, a practice that we caution against. Chung et al. (2012), Litvak (2009), Metrick and Yasuda (2010a), and Robinson and Sensoy (2013) look at the role and impact of VC compensation provisions. Barber and Yasuda (2017), Brown et al. (2019), and Chakraborty and Ewens (2018) examine how venture capitalists report the value of their stakes to their investors. Agarwal et al. (2017) and Kwon et al. (2017) explore the way that mutual funds mark their VC investments and their exit performance. Cumming (2008), Hsu (2004), and Kaplan, Strömberg, 2003, Kaplan, Strömberg, 2004 explore VC contracting and the economics behind contractual terms. Our findings of significant overvaluation are not inconsistent with the views of VCs themselves. A survey of VCs by Gompers et al. (2019) shows that 91% of VCs think that unicorns are overvalued.

As our paper argues these securities are reported at incorrect values, our work is also related to classic literatures on mispricing and misreporting. Anomalies papers such as Lamont and Thaler (2003), French and Poterba (1991), Bondt and Thaler (1985) and Ritter (1991) [see Schwert (2003) for a survey] argue for occasional mispriced stocks. Papers such as Barth (1994), Carroll et al. (2003), and Plantin et al. (2008) discuss the effect and importance of mark-to-market accounting. To the extent that freedom in setting contractual terms allows arbitrary valuations to be hit, our paper is related to earnings management papers such as Dechow et al. (1995), Healy (1985), and DeFond and Jiambalvo (1994).

Valuation model of a VC-backed company

In this section, we develop a valuation model of a VC-backed company and apply it to the contractual terms frequently used in the VC industry. We first build a contingent claims model, in Section 2.1. We then detail how we apply this model to common contractual terms in Section 2.2. We discuss our model implementation in Subsection 2.3 and the parameters we use in Section 2.4.

Data

In this section, we construct a sample of US unicorns and gather their financial structure data. We first discuss the commercial data sets and legal filings used in our analysis (Section 3.1). We then describe how we construct our sample of unicorns (Section 3.2). Finally, we discuss how we derive the capital structure inputs our model needs from legal filings and commercial data sets (Section 3.3).

Unicorns are overvalued

In this section, we estimate the value of unicorns and their common shares as of the date of their most recent unicorn funding round (as of February 1, 2017). We first describe the prevalence of special financial terms among unicorns (Section 4.1). We then apply our valuation model to the sample, taking into account these valuation terms (Section 4.2). Finally, we show that these overvaluation results are robust to different specifications (Section 4.3).

Discussion

The value of unicorns and their shares is extremely sensitive to the contractual terms given to investors. This speaks to the importance of information availability for investors, limited partners, and employees. While a small group of privileged investors are aware of these terms and, in fact, negotiated them, many other stakeholders cannot easily view them and certainly cannot understand the valuation implications.

This lack of information is particularly troublesome because of the large

Conclusion

Valuation of real and financial assets is at the core of finance. In this paper, we develop a valuation model to assess unicorns: young, innovative, and highly valued companies backed by venture capitalists. Our model applies the contingent claims option framework to valuing venture-backed companies, following the lead of Metrick and Yasuda (2010b). We apply our model to value 135 unicorns at the time of their funding rounds. We determine the fair value of these companies, as well as the value