The problem of over-valuation of startups is well-known. They defy conventional valuation approaches and demand several assumptions which leaves open room for optimism and other biases. There are fundamental incentive problems that contribute to it. This is a good paper on the problems with entrepreneurial finance.
Will Gornal and Ilya Strebulaev have a paper which exposes the institutionalised nature of over valuation among startups and unicorns arising from the varying nature of shares issued by a VC-backed startup.
We develop a valuation model for venture capital–backed companies and apply it to 135 US unicorns, that is, private companies with reported valuations above $1 billion. We value unicorns using financial terms from legal filings and find that reported unicorn post-money valuations average 48% above fair value, with 14 being more than 100% above. Reported valuations assume that all shares are as valuable as the most recently issued preferred shares. We calculate values for each share class, which yields lower valuations because most unicorns gave recent investors major protections such as initial public offering (IPO) return guarantees (15%), vetoes over down-IPOs (24%), or seniority to all other investors (30%). Common shares lack all such protections and are 56% overvalued. After adjusting for these valuation-inflating terms, almost one-half (65 out of 135) of unicorns lose their unicorn status... The average unicorn in our sample is overvalued by 48%. A large variation exists in the degree of overvaluation. While the ten least overvalued companies are overvalued on average only by 13%, the ten most overvalued companies are on average overvalued by 145%.
They illustrate with the example of Space X,
As an illustration of that sentiment, consider SpaceX’s August 2008 Series D round. Despite significant falls in the Nasdaq and the third failed test flight of its satellite launch service, SpaceX’s Series D round was an up round at $3.88 per share, above the March 2007 Series C price of $3.00 per share. We argue that SpaceX’s value fell in 2008 and the reported price increase was due to the preferential treatment offered to Series D investors. The Series D investors were promised twice their money back in the event of a sale, with that claim senior to all other shareholders. That guarantee increased the price those investors were willing to pay for SpaceX shares, which increased the company’s post-money valuation but did not alter its true value... Our model shows that these terms caused SpaceX’s post-money valuation to rise by 36% despite the true value falling by 67%.
The last column indicates the over-valuation on the post-money valuation after the latest round.
This undercuts both entrepreneurs and early investors and benefits only the latest investors, apart from the venture capitalists who walk away with their fees,
IPO ratchets, automatic conversion vetoes, and liquidation preferences have been activated relatively infrequently, as they protect against highly unfavorable scenarios. However, if the valuation of VC-backed companies experiences a dramatic correction, as in the early 2000s, many of these contractual features would be exercised. That would transfer a large amount of value from early investors and common shareholders to the most recent investors in these companies.
It also creates perverse incentives by encouraging struggling entrepreneurs to offer sweeteners to attract investors to keep the game going.
With such skulduggery in headline business valuations happening without even a murmur, it is no surprise that Bridgespan and TPG have sought to undertake an infinitely more complex valuation exercise, the social return on investment, in the context of impact investing. Their elegantly described Impact Multiple of Money (IMM) is certain to reduce impact evaluations to a joke in the years ahead. Each one of the six steps outlined is filled with making assumptions, which given the track record of the industry, is an open invitation to massaging impact numbers.
Nathan Heller in the New Yorker has an article which also discusses a book on the venture capital industry by Tom Nicholas, a HBS Professor. Nicholas does not obviously hold VC industry responsible for many of the seminal innovations of our times,
The war and its aftermath, which saw the growth and reimagining of such companies as I.B.M. and Hewlett-Packard—plus the first programmable digital computers, the jet engine, mass-produced antibiotics, and oodles more—was by most measures a golden age of American innovation. It happened largely on the government’s tab... Many prominent venture capitalists now decry government controls and say they favor market meritocracy. That’s ironic, given that their industry exists as such only because of a sequence of supportive actions taken by the government. Did the government’s investment pay off? Yes, venture capital in the seventies helped bring us Apple, Atari, Genentech, and the like. And, yes, in the nineties it was crucial to the launch of Netscape Navigator, Hotmail, and Google. Now consider a few entities that got off the blocks without a penny from Papa V.C.: Microsoft (Bill Gates sold a five-per-cent share of his already profitable company in 1981, solely to bring an old hand onto the board); the Mosaic browser (federally funded and released free of charge); and Craigslist (which diverted an existing advertising market into its coffers). Subtract venture capital from the landscape of late-twentieth-century innovation, and we would have reached the new millennium with roughly the same technological capacities.
Traditionally, venture capitalists have calculated that about two in ten investments will generate most of a fund’s profits. A strong fund hopes to achieve a twenty-per-cent return, and so those two in ten winning bets must hit between twenty and thirty times the money invested in them. Usually, returns do not come close. As a whole, the venture-capital industry has significantly outperformed the public markets only in the nineties—a decade that, you will remember, ended with the so-called dot-com bubble bursting, a crisis that Nicholas attributes largely to venture-capitalist profligacy. A chastening study by the Ewing Marion Kauffman Foundation in 2012 found that the average venture-capital fund in the previous two decades, far from delivering its promised returns, had scarcely broken even.
This characterisation of the incentives facing the venture capitalists,
If you’re a venture capitalist, you are, like James Bond, playing mostly with other people’s money. Unlike James Bond, you’re taking a fee to do it: the more money you start out with on the table (the larger the fund), the more gets slipped into your pocket—and that’s before you play your hand. Now imagine that there are two ways to turn your chips back into cash: either you can go to the guy at the window, who will carefully tally and value them (like a startup readied for an I.P.O.), or you can rake all your chips into your hat and sell the whole lot to another player, who may overpay a bit to sweeten the deal and get that lucky je ne sais quoi (like a startup’s being acquired). Occasionally, venture capitalists sell shares in a secondary market, too.
Two things should be clear. First, it can be less appealing to cash out at the window: an I.P.O. entails financial scrutiny, regulatory hoops, and other requirements that are designed to protect investors like you and me from the WeWorks of the world. Why go that route if you’ve got other options? (In the case of WeWork, the push to I.P.O. seems to have been a financial necessity.) Startups hoping to be acquired have less incentive to plan for a lifetime as healthy businesses; like the playboy burning through his savings on fast living and gorgeous suits, they have to keep it appealingly together only long enough to seduce a prosperous spouse-patron.Second, if you’re a venture capitalist you know that you will not be the one to go broke. You might lose all your investors’ chips, but you still have fee money pooling in your pocket, and that’s more than most people involved in the deal get. Startup founders make big money only if their efforts succeed. End investors get rich—or richer—if the funds in which they have invested yield a good return. Venture capitalists, on the other hand, now make good money regardless, and some firms purporting to prosper through their “carries”—their share of returns—are swelling up mostly on fees. A few successful venture capitalists get ribbed for their grandstanding, dubious blog pontifications, and general “Shark Tank”-ing. But who can blame them? If your business depends on bringing in more and more investment, isn’t your first priority burnishing your public image for having special skills and insight?
So why do entrepreneurs and investors play by the venture capital model,
They do it in part from competitive pressure: if your rivals are growing wildly at an early stage, and with good hookups, you’re obliged to play the game in order to keep up. But they also do it for the chance at the lottery. Jackpots have only become bigger as venture capital has grown overcapitalized; last year exit values, the proceeds from selling shares, topped two hundred billion dollars for the first time.
Alongside valuation, the other big problem with venture capital is its obsession with scaling. Eric Paley has a very good article which argues that the biggest problem facing start ups may well be the incentive distortions caused by venture capitalists' push for them to scale quickly.
Capital is a multiplier of the good and bad at a startup. A startup can use capital to compound activities that are working or compound activities that are not working. Unfortunately, venture capital often drives founders to do that later. It is incredibly difficult to fix the multiplication of bad mistakes. This is why VC is so dangerous: venture capital incentivizes companies with good vanity metrics to start scaling bad experiments.
Underlining this point, in another article, Paley and Joseph Flaherty looked at 71 VC-funded startups which had IPOs. They found that startups which raised less money returned more money to their investors, had much greater public market appreciation, and were better companies.
Our hypothesis is that too much capital over time creates a culture that substitutes cash for creativity and operational discipline. Big balance sheets allow companies to grow inefficiently, to paper over problems with headcount and spend, rather than confronting the core engine of value creation. Having less money forces a management team to make hard decisions early on and to cut off potentially wasteful problems that otherwise could linger indefinitely. This efficient ethos becomes part of the long term culture of productive performance that is difficult to infuse in the enriched companies that never operated in a constrained way.
Foremost, building good companies demands financial discipline. And venture capital as it exists currently is a market failure in this regard.
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