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From Bloomberg:
Startups achieve astronomical valuations in exchange for protecting new investors
Snapchat, the photo-messaging app raising cash at a $15 billion valuation, probably isn't actually worth more than Clorox or Campbell Soup. So where did investors come up with that enormous headline number?
Here's the secret to how Silicon Valley calculates the value of its hottest companies: The numbers are sort of made-up. For the most mature startups, investors agree to grant higher valuations, which help the companies with recruitment and building credibility, in exchange for guarantees that they'll get their money back first if the company goes public or sells. They can also negotiate to receive additional free shares if a subsequent round's valuation is less favorable. Interviews with more than a dozen founders, venture capitalists, and the attorneys who draw up investment contracts reveal the most common financial provisions used in private-market technology deals today.
The backroom agreements are becoming more common as tech companies stay private longer, according to the interviews and financial documents obtained by Bloomberg Business. The practice obfuscates the meaning of a valuation, which can become dangerous down the road because private investors aren't taking the same risks a public-market shareholder would. By the time a company does go public, the valuation it got from VCs may not align with its balance sheet. Just ask Box.
Some VCs defend the practice by saying valuations are just a placeholder number, part of an equation fueled by other, more important factors. Those can include market share, growth projections, and a founder's ego. The number is typically set by the company and negotiated alongside various provisions designed to protect a new backer's money. That often comes at the expense of employee shareholders and earlier investors, whose holdings are diluted to make room for new entrants. If you've seen the movie The Social Network, you have an idea of how that works.
"These big numbers almost don't matter," says Randy Komisar, a partner at venture firm Kleiner Perkins Caufield & Byers. "Those numbers are just a middling shot at a valuation, and then it's adjusted later" through various legal techniques, if an earlier valuation was too high, he says.
For Uber to get to $40 billion or Airbnb to $20 billion, you'd need to get a little creative with the variables underlying that logic. Since private tech companies often lack earnings or enough historical data to inform projections—or, in the case of Snapchat, any significant revenue—investors can't rely on the metrics available for public companies. If there were a math problem for determining a tech startup's valuation (for the record, there isn't), it might look like this:
Founder's hopes and dreams
A founder often starts off with a number in mind, based on the startup's last valuation, the valuations of competitors, and, for good measure, the valuation of the company's neighbor down the street. It can become a sort of arms race. When Slack Technologies founder Stewart Butterfield decided to raise $120 million, his goal was to crack a $1 billion valuation for his corporate software startup. The other appealing thing about a big number: It means founders don't have to give away as many of their shares to raise a lot of capital.
Billion-dollar companies join a club of "unicorns," a term used to explain how rare they are. But there are more than 50 of them now. There's a new buzzword, "decacorn," for those over $10 billion, which includes Airbnb, Dropbox, Pinterest, Snapchat, and Uber. It's a made-up word based on a creature that doesn't exist. “If you wake up in a room full of unicorns, you are dreaming," Todd Dagres, a founding partner at Spark Capital, recently told Bloomberg News....MORE
