Making sense of hyper-funded start-up valuations

Kashyap Deorah tries to decode the cryptical valuation dynamics of start-up firms

Preferred liquidation has been part of venture capital (VC) and private equity (PE) investors’ term sheets worldwide for longer than the Internet has been around. It gives investors the right to first get their money back with an interest or multiple in case the company fails to deliver the expected multiples at the time of exit.

At the time of investment, entrepreneurs are audaciously optimistic and focused on the upside. Investors are professional money managers parting with cash and want to protect their downside. That seems fair. However, taken to its extreme, preferred liquidation creates the illusion of an equity investment at insane valuations while the hyper-funded start-up is getting buried in debt. Here’s how.

In the past few years, this construct has been turned on its head by global funds writing large cheques to private companies. Money that was earlier focused on public market stocks is now being lent to tech start-ups at progressively earlier stages, giving them hefty valuations. There are now 162 private companies in the world valued at over a billion dollars, also known as unicorns. I am not alone in trying to decode this phenomenon.

Last month, in a column titled The sub-prime unicorns do not look a billion dollars, the legendary Sequoia partner Mike Moritz wrote, “...a good number (of unicorns) seem the flimsiest of edifices. Forget the fact that some of these valuations are illusory because the most recent investors have structured their investments as debt in all but name, meaning that they will stand to profit even if the company is worth far less." Later that month, I was chatting with a friend who is a partner at a major PE firm considering an investment in an Indian start-up looking to raise large money. In the due diligence, he was surprised to see the debt-like preferred liquidation structure buried under illusory valuations. Preferred liquidation has been around for decades now, I thought. So what was different now?

Finally, the penny dropped last week. I was in the audience during a panel at the Investor Summit in Dublin, Ireland. The panel included Phil Libin, co-founder of one of the early unicorns Evernote and now partner at a VC firm, and Tom Stafford, partner at the global investment firm DST, which is an investor in Flipkart and Ola. Evernote’s Libin explained how financial journalism has misunderstood unicorn valuations and large funding rounds. As a result, there are strong reactions to hefty valuations. DST’s Stafford explained that late-stage investors can invest in a cement factory in Kenya and get 10-15% internal rate of return (IRR) or they can invest in a tech start-up targeting an IRR over 20%.

He picked the ultimate unicorn, Uber, as an example. While Uber is valued at $51 billion, it has raised about $5 billion. If Uber exits at anything over $5 billion, the investors are whole and secure due to liquidation preference. Anything above that is upside. “Late-stage investors are not stupid. Do any of us think Uber is not going to be worth $5 billion at exit?" he asked. If the capital is reasonably protected, and you have a chance of making over 20% IRR on a large base, it is a good bet. The valuation numbers do not matter.

For the first time, it occurred to me that raising large amounts of money with preferred liquidation is like drawing a loan secured with the entire company as collateral. As for valuations, the higher that number, the taller the mountain that the entrepreneur and employees need to climb in order to realize the notional value of their holdings. It is a lesser concern for global funds.

I remembered the old Indian saying about an elephant’s teeth—one set to show and another set to eat.

From the investor’s perspective, illusory valuations seem to be the teeth that appear large to intimidate other animals in the jungle. Deployed capital are the real teeth that need to chew off enough nourishment so that the exit is at a valuation higher than the funding raised.

Now look at the $3.2 billion invested in Flipkart, $1.9 billion in Snapdeal and $900 million in Ola. As Stafford said, the question to ask is whether these companies get an exit that values them higher than the invested capital. If so, the global funds are secure.

In fact, they are even more secure in the case of start-ups that survive on funding and have no option but to keep raising more. Global funds have a tiered structure of liquidation preferences where they get the money before earlier investors.

The last investor needs to only be concerned about the company being as valuable as the investment made in the last round. While all shareholders want the start-up to ultimately be valued higher than their unicorn valuations granted to them, if things do not pan out that way, shareholders will be hit in the following order (least first): VCs, angel investors, entrepreneurs, employees.

In other words, everyone is working towards returning the late-stage investors’ money first.

The higher the gap between the delusional valuations and the reality of exit options, the lesser these shareholders are likely to value their own equity and would want to maximize short-term outcomes.

I don’t know about you but this panel put a lot of things in perspective about the hyper-funded Indian scenario as I sipped on my fresh pint of Guinness.

Kashyap Deorah is the author of The Golden Tap, the inside story of hyper-funded Indian start-ups. He is a serial entrepreneur who has spent the past 15 years in India and the Silicon Valley. During this time he has started and sold three companies. He is also an angel investor in over 20 companies in India and the Silicon Valley. Deorah founded Chalo, a payments app which was acquired by OpenTable in 2013. Prior to that he founded Chaupaati, a phone commerce marketplace, sold to Future Group in 2010. He served Future Bazaar as president for nearly two years. He tweets at @righthalf.

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