You might think that a study demonstrating that venture capital-funded “unicorns” are overvalued, and by a stunning 48 percent on average, would shake up the industry. Yet “Squaring Venture Capital Valuations With Reality,” a paper announcing just that finding by Will Gornall and Ilya A. Strebulaev (professors at the Sauder School of Business at the University of British Columbia and the Stanford Graduate School of Business, respectively), received only a perfunctory round of coverage from some important investment and tech publications when it was published.
It’s no surprise that a study casting doubt on the worth of darlings like Lyft and Cloudflare didn’t move investors or change the venture capital industry. Trade press reporters don’t have much of a future if they take to biting the hands that feed them, and the investors with overpriced wares don’t want to admit they’ve been had, or, worse, that they’re part of the problem. But write-ups of this important paper, with its sensational finding, missed that the authors’ analysis is deadly for the venture capital industry as a whole.
The median venture capital fund loses money. Only the top 5 percent of funds earn enough to justify the risks of investing in venture capital. The nature of venture capital is that the performance of those few successful funds in turn rests on the spectacular results of a small fraction of the investments in a particular fund. Gornall and Strebulaev’s finding that the performance of the winners — and even the also-rans — is overstated further undermines the already strained case for investing in venture capital. If you are Joe Retail and think this isn’t your problem, think twice. If you invested in high-growth mutual funds, your holdings probably include shares in large venture-capital-backed private companies.
How does this pervasive overvaluation come about in the first place? Once you understand it, it’s breathtakingly simple. Venture capital-backed companies are money pits. Even if they manage to become profitable in accounting terms, they almost always need more funding to support their growth, typically every 12 to 24 months. The tech stars profiled in the paper, 135 U.S. “unicorns” (i.e., companies with a valuation of $1 billion or more) had undergone an average of eight rounds of fundraising.
But all these investment rounds are not equal. While the common shares of a public company are fungible, the shares issued in each money round for these venture capital-sponsored companies are unique, as reflected in the naming conventions: Series A, Series B, etc. More important, each share class has its own set of rights, including control rights, conversion, preferred payments, and downside protection, such as ratchet rights that allow for the issuance of additional shares if an IPO price falls below a certain level. These complicated mechanisms are designed to assure investors a minimum level of return.
But muddying this picture, and the valuation exercise, is the fact that each newly issued class of stock has better rights to the company’s cash flow than its predecessors. That might seem counterintuitive; isn’t a more seasoned new venture less risky, and wouldn’t its investors therefore be more willing to accept a lower return than the earlier investors? In fact, almost without exception, the later stage investors pay a higher price for their shares, which sets them up to realize a lower return than earlier investors. The newcomers compensate for that by getting various option rights to improve their returns and protect them against specific risks, such as the founders and earlier investors selling or IPO-ing the company at a price that would lose the newcomers money.
The pervasive overvaluation results from the widespread use — by analysts, the press, the media, and often the companies themselves — of “post-money valuation.” They take the price per share realized in the latest funding round and use it to revalue the older classes using the higher price of the latest class of shares, even though each new round of funding effectively sucks value out of the previous ones via its superior rights. As the authors stated: “Overvaluation arises because the reported valuations assume all of a company’s shares have the same price as the most recently issued shares.”
Why does this practice persist, particularly given the fact that finance professionals ought to know better? One factor is that it’s a lot of work to value every class of stock. Gornall and Strebulaev had three lawyers and three law students doing the first pass of interpreting the rights of each class of stock, which was then reviewed by at least one of the profs. That step alone took as much as 12 hours per class. The authors then used an options-based approach to extract the value of common shares from preferred shares, which typically had embedded options, as well as assigning value to contractual rights like vetoes.
But likely an even bigger factor in the use of this bad metric is that lots of players benefit from it. Private companies get to report ever-rising valuations, and at a faster clip than the actual increase in “fair value,” making them seem like more desirable candidates for investment. It even enables them to dress up what would otherwise be a “down round” by giving enough goodies to the latest investors to show a nominally higher share price, and hence a rising valuation using the misleading “post-money” calculation, when its fair value has fallen. Gornall and Strebulaev use the example of Elon Musk’s SpaceX venture, whose Series D Preferred Share issuance produced a gain of 37 percent in post-money valuation terms, but a decline of 67 percent when properly measured.
This sort of overvaluation is endemic across the venture capital industry. Even though the authors quoted venture capital firm Andreessen Horowitz as stating specifically that it does not base its valuations on the result of the latest fundraising and does take into account the value of contractual terms, the fact that the firm’s limited partners say that its valuations are lower than that of other industry players shows that it is in a minority. Another piece of evidence is how major unicorn investors avoid giving straight answers. For instance, in a Barron’s article last year on unicorn valuations, Sequoia partner Pat Grady conceded that there had been an increase in “financial engineering” to get “that big headline valuation.” However, he was silent on Sequoia’s valuation approach and simply said that the firm tried to steer clear of that type of situation. Yet the firm hold stakes in seven companies in Gornall and Strebulaev’s “overvalued unicorn” analysis: Houzz, Unity Software (which is elsewhere called Unity Technologies), Qualtrics, Carbon3D, Thumbtack, Medalia, and MarkLogic. Qualtrics is a case study of complex terms: participation, seniority, IPO obstruction, and an IPO ratchet. (Sequoia did not respond to a request for a comment.)
Skeptics might say, “But Qualtrics was just sold at a big premium to its valuation. So why should we worry?” Venture capital-backed companies are staying put longer. The average time to exit, even for high-performing companies, is over six years. Even though entrepreneurs and investors have taken to complaining about the regulatory burden of being public, if anything, the requirements have been weakened in recent years, thanks to the JOBS Act and an SEC that seems interested only in pursuing insider trading. What this suggests is that investors in these private companies aren’t keen about what they’d fetch if they tried selling these ventures in the public market, with full disclosure, or to another company. Remember that what matters to investors in the long run is realized gains, not paper profits. Longer holding periods require even greater gains in order to produce attractive returns. Professor Strebulaev concurs that the widespread overvaluation of venture-capital-backed companies plays a role, and probably a large one, in the lengthening of the average time to exit.
Revaluing unicorns alone would have a dramatic impact on the entire venture capital industry, particularly on the top-5-percent firms, as well as eliminating nearly half of the supposed unicorns from their over-$1-billion club. But they are far from the only venture capital companies that are widely overvalued. Professor Strebulaev points out that it isn’t just companies that have undergone many rounds of fundraising that are likely to be overvalued. As he wrote, “Earlier-stage companies are likely to raise more rounds of funding in the future, and so any valuation method also needs to take that into account. Our modeling on that issue suggests that earlier stage companies are substantially overvalued.”
And what about mutual funds? The SEC permits them to hold as much as 15 percent of their assets in illiquid securities like unlisted shares. Many large fund managers, such as Fidelity, Vanguard, T. Rowe Price, and insurers like John Hancock that sell investment products, hold shares in companies like Uber, Dropbox, BuzzFeed, and GitHub. Yet some funds hold large enough stakes in these companies that they’ve been able to tarnish overall fund performance.
For instance, a Reuters story last June described how writing down the prices of the unicorn Pinterest took nine basis points off the performance of the $114 billion Contrafund in the first half of 2017. A Fidelity spokesperson had been willing to set up a call to discuss its unicorn holdings, but stopped responding after I indicated I wanted to discuss the Gornall-Strebulaev paper.
Professor Strebulaev said that his team’s investigations indicated that over 90 percent of mutual funds used inflated post-money valuations. For instance, funds holding different classes of stock in the same company, which clearly should have different prices, would show the same figure. And even the funds that did show lower prices due to illiquidity or “scratch and dent” — the way some funds cut their prices of Uber shares as it was becoming apparent that Japanese investor SoftBank would not meet the price of the last round of funding — were still adjusting them relative to an inflated post-money valuation, not a fair-money valuation.
Could the SEC step in and remove some of those unicorns’ horns? Don’t hold your breath. While Dodd-Frank reforms gave the agency oversight over private equity funds with over $150 million in assets, the venture capital industry has enough clout in D.C. to have gotten itself exempted. The SEC could still pursue venture capital firms under anti-fraud statutes, but the commission has traditionally used those powers only to pursue egregious abuses, like Ponzi schemes. On top of that, the agency has long taken the position that “accredited investors,” as in the ones who are wealthy and sophisticated enough to be allowed to invest in venture capital funds in the first place, are adults capable of taking care of themselves. The SEC has more oversight over mutual funds (and professes to care about easily-preyed-upon retail investors), but until there is a blow-up that puts illiquid mutual fund holdings in the headlines in a bad way, it looks like it will continue to defer to the big mutual-fund families.
There is still a threat on the horizon to venture capitalists astride their fake unicorns — in Kentucky, of all places, where a fiduciary duty lawsuit against three deep-pocketed hedge fund sponsors (KKR/Prisma, Blackstone, and PAAMCO) has the potential to shake up the fund management industry. The beneficiaries of deeply underwater public pension funds run by incompetents or crooks make for sympathetic plaintiffs like the ones in this case, Mayberry v. KKR. Public pension funds have also been enthusiastic investors in the “hopium” known as venture capital. Securities laws take a very dim view of misrepresentations made when selling funds. Venture capital funds typically raise a new fund four or five years after their last one. At that point, they would still own the overwhelming majority of the companies they’d invested in. That means their “returns” are based on their own valuation of those stakes, and for almost all players, significantly overvalued. If the Kentucky lawsuit against the three fund-management giants looks to be going well for the plaintiffs, the venture capital industry might find some saber-rattling securities lawyers on its doorstep.