Companies like Square are what Silicon Valley is meant to be all about. Co-founded by Jack Dorsey, the boss of Twitter, the payments company has been backed by some of the Valley’s most prominent investors. Now, six years after its founding, it is preparing to list on public markets.
But something funny happened on the way to the IPO. The preliminary price range — an indication of what Square expects to sell its shares for in the coming days — is far below what investors who funded the company just a year ago were anticipating. Square is projected to go public with a valuation around $6bn, with a share price that is one-third less than that promised to its most recent investors in October 2014.
Keith Rabois, the company’s former chief operating officer, summed up the mood in Silicon Valley as investors and workers come to terms with a changing reality. “The steroid era of start-ups is over,” he tweeted after the price range was announced last week.
For some of Square’s employees, it has been a particularly rude awakening. As recently as September, the company handed out stock options to staff — one of the main perks of jobs in the Valley — valuing it at $15.39 a share, or more than 50 per cent above what the shares were deemed to be worth only six months earlier. But less than two months later, a more sombre picture is sinking in. Square’s assessment of what its shares are now worth is closer to $12 each.
These shifting share prices for one of the Valley’s most prominent companies have called into question the headline valuations that have become synonymous with the present tech era. Uber valued at $50bn, Airbnb at $24bn, Snapchat at $15bn — these numbers have become a symbol of the outsized ambitions of this generation of start-ups. But these private market valuations are also one of the most misunderstood traits of the tech boom. The headline figures are not all they seem.
Sitting behind the valuations is often a complex structure of investor guarantees and multiple share classes that disguises the real value of common shares. Headline valuations — widely reported by the media — often have little relationship to actual enterprise value.
“Valuation setting in private markets is such a challenging process that we don’t really believe whatever number is set,” says Eric Goldman, assistant law professor at Santa Clara University. “There’s no real discipline to it.”
More dotcom boom and bust?
As a wave of tech companies prepare to launch IPOs over the next two years, these headline valuations are starting to intersect with reality — a process likely to be both painful and disappointing.
Today’s tech bubble may not burst violently, like the dotcom boom in 2000. But many observers expect that headline valuations, along with private share prices, will deflate over the next 18 months. “It’s going to be a slow-motion ooze,” says one private equity investor.
One reason is the overinflated expectations for some of these companies. As with other tech booms, many start-ups will disappoint, even as a handful go on to become household names.
But this time around another, less well-known factor has come into play, inflating the value of truly disruptive and mediocre companies alike. Many of the investments in the more mature start-ups are structured: in effect giving investors guaranteed returns and a degree of protection against any losses.
Financial experts refer to these headline valuations as “marketing numbers”, highlighting that they are a function of image as much as anything else: the greater the degree of guaranteed return a company is prepared to give, the higher the hypothetical value that investors place on the company.
While structured deals are not a new phenomenon, the size and scale of the investor protections granted has grown dramatically. “It does create an artificiality in the headline value,” says Stu Francis, senior managing director at investment bank Evercore. The terms that protect investors “have become more onerous for companies”, he notes. “It is not a new innovation, but the magnitude . . . has changed.”
Even some of the best-regarded tech companies have used these methods. At Uber, a major investor received a guaranteed 25 per cent return during an early investment round. Investors also received significant protections during Airbnb’s $10bn round last year.
Square, the most prominent of the current generation of start-ups to have so far opted for a public listing, is typical of this trend. In its most recent private fundraising investors paid $15.46 per share, generating headlines about a $6bn valuation. Those who bought in were guaranteed a 20 per cent share price bump in an IPO. Their compensation, if Square fails to hit this: extra shares to make up the difference, potentially diluting the value for earlier investors and many employees.
These new investors may have paid a higher price for their shares, giving them less upside if the company does well. But they also have a degree of insurance unavailable to other investors if the company falls short of expectations — as, in the case of Square, looks likely.
These multi-share class structures, along with the lack of a liquid market for private shares, have made it almost impossible to calculate an accurate valuation for many start-ups. Even investment professionals whose job it is to assess the value of private shares in their portfolios admit that they cannot do this with 100 per cent certainty.
In a private company, unlike in public markets, each class of share commands a different price because of the protections that come with it. In Square’s case, the headline valuation figure of $6bn assumes wrongly that all shares could command the highest share price.
The dotcom bubble of the 1990s saw companies rushing to go public to raise money, but the opposite has been the case in 2015. Many fast-growing start-ups seek to raise as much money privately as possible, and offer investor protections to secure it.
This phenomenon has been closely linked with the rise of the “unicorns” — the term given to private tech companies that claim valuations of $1bn or more. When the term was coined in 2013 by venture capitalist Aileen Lee, she counted 14 private companies in the category. Today, there are more than 10 times that number.
The urge to join this exclusive club has driven some founders to grant investor guarantees and protections in exchange for the headline valuation they seek. Reaching mythical status helps the companies recruit employees, attract publicity and raise their profile.
The increase in protections has also been driven by investors such as mutual funds, private equity groups and hedge funds moving into markets that were once the preserve of venture capitalists. These so-called “non-traditional” investors contributed roughly 15 per cent of funds invested in start-ups in the US in 2012: this has risen to 30 per cent today, according to the National Venture Capital Association and PwC.
Many of these new investors “are playing a bit of a different game than the classic venture one”, says John Backus, co-founder at New Atlantic Ventures, a venture capital group. VCs focus on getting a big upside — the “home runs”, as Mr Backus puts it. However the newer investors have a different goal. “They are focused on not having much downside at all, and are willing to trade off modest upside,” he says.
Investors such as mutual funds must value their portfolios to market, a process that results in widely divergent reported share prices because of the various share classes they hold. In cases where there is little or no downside protection, that has led to some steep cuts. Over the past two months, a skittish atmosphere in the Valley as well as the weak share price performance of comparable public companies have forced major funds to write down the value of their shares in Snapchat and Dropbox by 25 per cent or more.
There are those in Silicon Valley who argue that giving special rights to some classes of investor is good for the companies if it helps to raise capital more cheaply and grow faster.
“I don’t see an issue with it,” says Shervin Pishevar, an early investor at Uber. “There is a trade-off between being able to scale companies fast in a compressed space of time, and being able to grow a company that makes many billions in revenues within five years.”
These convoluted capital structures have a limited shelf-life. Once companies return to raise more money, they are forced to issue even more generous terms to later rounds of investors, running into restrictions imposed by earlier investors or provoking complaints. Eventually, a stock market listing may be the only way to clear the decks.
“In the private market companies won’t be able to keep layering on terms,” says Geoff Yang, a partner at venture capital firm Redpoint Ventures. “You’ll see the floodgates open [to IPOs].”
Full IPO pipeline
Bankers are eyeing a string of tech companies that are likely to go public within the next two years. But many expect their valuations to fall when that happens. “I think a lot of these companies in the $1bn-$5bn valuation range are going to have trouble meeting their valuations when they go public,” says one senior banker.
While most of the convoluted capital structures used by tech start-ups have yet to be unwound, it is apparent who the winners and losers are likely to be. At the bottom of the heap: early investors who have no protections and may have believed that the headline figures ascribed to start-ups represented their “real” valuations.
“The main people that lose out are the entrepreneurs, the early employees,” says Olav Sorenson, a management professor at Yale School of Management who studies employee compensation at start-ups. “The level at which employees are getting diluted is much higher than it has been in the past. In the short term there is a real risk that employees just don’t understand how little their shares are going to be worth by the time an exit event occurs.”
As the next wave of tech IPOs begins, these headline valuations will be put to the test. If the markets do not bear up the private valuations, as has been the case for recent floats, this will eventually be reflected in private markets.
“I don’t think we are in a bubble, but I think we have a number of those unicorns that are overvalued and some will correct negatively in the next 12-18 months,” says Mr Backus. The process may be a bit “lumpy”, he suggests, as private markets take time to react.
Additional reporting by Richard Waters and Murad Ahmed
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