An excerpt from one of the lessons
Innovative equity-based approach to determining a startup valuation
Often referred to as private tech unicorns, most of the Silicon Valley darlings grant their common stock as part of their compensation package for their employees (regardless of the form — whether it’s restricted stock units, option stock or additional options). If you amongst the proud shareholders of a Unicorn, you definitely hope that the company’s valuation will grow over time — along with the value of the stock you hold — due to your team and personal efforts and contributions to its success. However, the bad news is that even if you achieve this success leading the company to an IPO or M&A, there is actually a chance that you will not benefit much from your share in the company, if you benefit at all.
Rather than utilizing common metrics for determining a valuation, such as users or revenue growth, professors at the University of British Columbia and Stanford University actually discovered an equity-based approach to calculate the fair value of private companies. They proved in the course of their research that different types and classes of company’s shares may be critically different in value. Unfortunately, this fact often remains ignored by founders and investors until it’s too late to deal with it appropriately. Not only does it lead to a company being overvalued, but, even if it is acquired or goes public, it can also drop the value of the employees’ shares dramatically. They calculated, as examples, that the common stock of Solar City, Good Technology and Nutanix was was overvalued more than twicewhat their company valuations showed at their most recent private financing round (before IPO or M&A). Common stock holders of JustFab, which is still held privately, was in a bit better position at the last round in 2014, with their shares being overvalued at 192%. Furthermore, the owners of common stock of Box should have been much more aware of their stock being overvalued by a staggering 269% (This, eventually, did not go well for the employees!)
Silicon Valley definitely doesn’t like drawing attention to such failures — when founders and employees are left with little to zero return, while the investors receive at least partial return for their investments. How does this happen, and more importantly, how can we stop it from occurring?
Let’s take a moment to refresh our memories. Shares can be what is known as common (which are usually issued to founders, employees and early stage investors) or preferred (which are generally issued to investors in later rounds), where preferred owners possess special rights and preferences that protect them from losing their investment in its entirety if the company fails. Therefore, the more money an investor decides to invest in the company, the more protection they will typically request. If the investor in question feels as if the company is asking for too much, overvaluing itself, the investor can still agree to pay the requested price, or a price close to the original amount, but in exchange for the security of absolute bulletproof protection.
What can such protection be?
To begin with, regardless of whether the company fails or not, most investors want the exact amount of their original investment back at the exit (liquidation preference). Some investors actually want their funds returned with a premium, which can often be as high as 100%. If, due to the protection right of seniority, such an investor is set to be paid off before all of the other shareholders, then they will receive 200% of their investment back, and the leftovers — if any — will then be distributed among the remaining shareholders.
Can it get any worse? Sadly, yes, there are even more volatile circumstances. After the initial investment amount (with any additional premiums) is returned to the senior investor, this same investor may also request the right to participate in the distribution of the remaining proceeds as a common shareholder, along with others (participation), acquiring even a little more for additional pocket expenses. These protection rights are most relevant for an M&A scenario. Yet, even if a company decides to go public, later stage investors can make the decision to block the IPO, get additional share compensation or save their preferential rights in the instance that the IPO doesn’t provide an acceptable return.
Now, when you read in the news that new investors decided to back your employer at a price per share that is significantly more than the price in the previous round, you can imagine what they are paying for. You can probably start to recognize this as the point where things begin to go wrong.
These shares will, in effect, guarantee investors certain rights that will not be guaranteed to other types and classes of shares. However, to publicly announce the most recent valuation of the company, all the shares of the company, including the common shares that will have no protection rights like those described in the paragraphs above, will be multiplied by the exact price paid by the most recent investors. This is exactly the situation in which most of the current private Unicorns instantly jumped to an over $1 billion valuation. However, you can clearly see now why this math is, in fact, incorrect.
Rather than explaining the deal algebra, let me provide you with two other real-life examples to help illustrate how these rights can adversely affect the true value of your employee stock.
In the last financing round (in 2014) before its IPO (in 2015), Square was proclaimed a $6 billion Unicorn, but not without the following strings attached: the investors were guaranteed seniority to other shareholders, with a payout of $15.46 per share at the time of exit, and a 20% return at the IPO. When this news appeared on its employees’ smartphone screens, they rushed to multiply their shares by $15.46. However, as these investors received such guaranteed preferential rights, the above-mentioned professors calculated that the fair value of the common shares at that exact moment was, in reality, closer to merely $5.62 — overvalued by $175%!
Triggering the protection rights of the latest investors, Square went public at $9 per share with a pre-IPO value of only $2.66 billion and had to grant those investors $93 million worth of extra shares, which diluted all of the other shareholders. Surely you can easily see how common stock could drop in value after these two events. Just as recently as February of this year, the shares of the company finally hit the last financing round price of $15.46 per share. Those Square employees, who had purchased employee stock options at $9 strike price, couldn’t have earned much until just recently, and most likely lost the money being not patient enough to wait for more than a year.