Billion Dollar Startup Club – The Complex World of Venture Capital Dealmaking Simplified
A unicorn is a magical beast, a horse-like, horned creature that is so rare, that even in mythology, you almost never run into a blessing of unicorns (which, I have learned is what a group of unicorns is called). It was perhaps the rarity (and magic) of private businesses with billion-dollar valuations that led Aileen Lee, founder of Cowboy Ventures, to call them unicorns, in 2013, but as their numbers increase by the month, it may be time to rename them after a species that is more common and less magical. While there are several provocative questions that surround the rise of unicorns, this post is dedicated to a very specific question of how the investor protections that are offered to venture capitalists at the time of their investments can not only affect the measurement of value and make non-unicorns look like unicorns but also skew the behavior of both investors and owners.
One of the best visuals that I have seen on the rise of Unicorns is in Wall Street Journal article, and it not only allowed you to see the rise of individual companies but compare the numbers over time. In June 2015, there were 97 companies that had values that exceeded a billion, with Xaomi and Uber leading the list, with valuations in excess of $40 billion. The breakdown of Unicorns globally is captured in the pie chart below:
Not surprisingly, the vast majority of unicorns are US-based, though the number of Asian entrants into the ranks is increasing. Looking at the sectors across which these unicorns are sprinkled, the WSJ article provides the following breakdown:
The explosion in the numbers of these companies has also given rise to almost as many explanations for the phenomena, some based on rationality and some on the prevalence of a bubble. The rationality-based explanation for the surge in unicorns is that it has become easier to remain a private business, as private capital markets broaden and become more liquid, while it has become more costly to become a public company, with increased disclosure requirements and pressure from investors/analysts. The less benign argument is that investors are being driven by greed to push up the prices of young companies and that this has all the makings of a bubble. I think there is truth in both arguments and that you can have both good reasons for the increased number of large value private businesses and momentum driven froth in the market. However, I will leave that discussion to those who know more about these young companies than I do, and are more confident in their capacity to detect bubbles than I am.
If the conventional definition of a unicorn is a private business with a valuation that exceeds a billion, how do you arrive at the valuation of such a business? While you have no share prices or market capitalizations for these companies, you can extrapolate to the values of private businesses, when they raise fresh capital from venture capitalists or private investors. Thus, if a venture capitalist invests $100 million in a company and gets 10% of the ownership in the company in return, we estimate a value of $1 billion for that company, making it a Unicorn. There are, however, two problems that get in the way of a good estimation. One is that the capital infusion changes the value of the company, creating a distinction between pre-money and post-money values. The other is that the investor’s equity investment generally comes with bells and whistles, designed to protect the investor from downside risk and these protections can skew the value estimate.
1. Pre versus Post Money
In an earlier post on the offers and counter offers that you see on Shark Tank, the show where entrepreneurs pitch business ideas and ask competing venture capitalists for money, I drew the distinction between pre and post money valuations. If the capital raised in an offering is held by the company, rather than used to pay down debt or owners’s cashing out, the value of the company increases by the amount of the new capital raised, leading to the following distinction between pre-money and post-money values.
Post-money valuation = Investor’s capital infusion/ Percentage ownership received in exchange
Pre-money valuation = Post-money valuation – Investor capital infusion
In the example above (where an investor invests $100 million for 10% of a firm), the post-money value is $1 billion but the pre-money value is only $900 million. Thus, companies that are smaller than a billion can make themselves look like billion dollar companies, if they are willing to give up enough ownership in the company and can find investors with deep pockets.
While it is unlikely that you will be able to find an investor to offer $950 million in capital for a business with a $50 million valuation, it does illustrate why post money valuations may not always be comparable across businesses.
2. Investor Optionality
While the difference between pre and post money valuations is easy to handle, there is another aspect of venture capital investing that is more messy. Many venture capital investors are offered protection against downside risk on their investments, though the degree of protection can vary across deals. What type of protection? Consider the investor who invested $100 million to get 10% of the company in the example above. That investor’s biggest risk is that the value of the business will drop and that investors in subsequent rounds of capital raising or in an initial public offering will be able to get much better deals for their investments. To protect against this loss, the investor may seek (and get) a provision that allows his or her ownership stake to be adjusted for the lower value. With full protection, for instance, if the value of the business drops to $500 million on a subsequent capital event, the original investor’s ownership stake will be adjusted up to 20% (reflecting the lower value). This is termed a full ratchet. Alternatively, in the weighted-average approach, the original investor will receive partial protection, resulting in an ownership stake between 10% and 20% if the value drops to $500 million, depending on how the weighted average ownership stake is computed. The key, though, is that this provision is protection against a value drop, but only if the company seeks out capital, and is thus contingent on a capital event occurring.
The protection is usually stated in terms of price per share, where the price per share of the investor’s original investment is adjusted to reflect the price per share in the new round of capital, but it is effectively a protection of your original dollar investment and it is easiest to think of this protection as a put option on your investment. In the full ratchet case, assuming a capital event occurs, you are effectively protecting your initial dollar investment, at least until the value of the business hits $100 million (at which point you would be entitled to 100% of the business). Once the value of the business drops below $100 million, the protection can no longer be complete and the pay off diagram for this investment, as a function of the value of the business, is below:
Note that the protection works fully when the value of the business is between $100 million and $ 1 billion and only if there is a capital event to trigger it. To value this option, you need three more pieces of information:
Probability of capital event: Since a capital event is the trigger for the protection, there will be no protection if no capital event occurs, a scenario that will unfold if the business unravels quickly. Put differently, the protection is useless if the business never raises any additional capital. (Since the probability of accessing new capital will decrease as the value of the business drops, especially if the drop occurs quickly, the option value is likely to be overstated.
Expected time to capital event: The timing of the capital event may not be known with certainty, but to the extent that it can be forecast, you need an expected value. If the protection covers multiple capital events, it is the expected time to the last one.