A shorter version of this post was originally published in the International Business Times.
In most cases, the price of a product is determined based on supply and demand, which is the basic premise of a free economy. But when it comes to the world of private investments, the pricing of companies is sometimes determined by factors that impact on it ‘artificially’, rather than by traditional principles of supply and demand. Unfortunately, even professional investors sometimes accept “artificial valuations” as the “new truth” and get swept away by Irrational Exuberance, when what they should be doing is analyzing whether these valuations are based on real economic considerations or “other” interests that they should be discouraging.
Based on recent patterns in the world of private investments, I have observed several factors that directly divert/tilt the “real price” of a fundraising company into an “artificial” one. Here are just a few:
1) The increasing participation of strategic investors as leaders in financing rounds.
These are not the veteran “corporate VCs” who usually join a round as co-investors with a small check and without having priced the round themselves. Rather, they are large corporations, whom we’ve recently seen making very large investments in companies (of several dozens of millions of dollars) for 2 main reasons: Either they are interested in being closer to the company’s innovation so that they can understand the industry’s trends or use the innovation for their own products, and/or they are exploring the option of a potential acquisition in the future, and “on the way”, lowering their overall buying ticket price (especially if they create a dependency on them). They are not particularly concerned with valuations, and for them it doesn’t really matter whether they pay a 10-15% premium (or even more).
2) The increasing presence of huge VCs and growth funds.
Specifically, these are billion-dollar funds that have recently joined the game with massive amounts of capital that need to be deployed over a reasonable period. Insight Venture Partners, for example, invests from a $4.75 billion fund raised in 2015; Softbank raised a $100 billion fund and is on its way to raising a few hundred billion more, etc. Given their sizes, those funds are less “valuation-sensitive” and are eager to deploy their capital. They are also considered a high-value investor, thus companies are very happy to receive their financing.
3) Prior valuations set the minimum bar for future ones, and if the last round was done in the past 2 years, the bar is most likely high.
Markets go through cycles that affect valuations and alter valuation multiples depending on a company’s specific industry or market, so the circumstances that might have affected its valuation 2-3 years ago may not necessarily still apply today. For example, based on our own research at Viola Growth, we have seen a decline of 75% over the past 2 years in valuation multiples affecting the market of one of our portfolio companies. Other markets have suffered as well, though to a lesser degree.
A new investor looking to join an already funded company usually isn’t “emotionally” attached to the prior valuation so it is guided by prudent financial considerations rather than an artificially inflated ‘outward appearance’, but if it’s an over-valued company whose founders are already “in love” with its existing valuation, they are often reluctant to do a “down round”, especially if the company has progressed since the last financing round. This leaves the potential new investor in a deadlock, which pushes the company to seek other financing alternatives.
There are 2 common “artificial”ways to overcome this deadlock:
Internal rounds. Understandably, it’s not only the company’s founders but also the existing investors who prefer to avoid a down round, even when they know the last valuation was too high. A down round can deflate the company’s ‘mojo’ and significantly dilute the existing shareholders (in most cases), so a good solution is to continue their financing internally. In the really good companies, existing investors are happy to continue betting on their winning horses, especially if the company increases its value along the way. If it is difficult to justify an up-round internally, shareholders may choose a CLA (Convertible Loan Agreement), or in other word, financing the company through a bridge-loan without determining a specific valuation, thus postponing the valuation “problem” to a later stage.
Structured deals. This is an old practice that smart companies, or those that have other options, have learned to avoid. In most cases, structured deals mitigate the high valuation by giving much higher preferred returns to the over-paying investor such as: “2x or more participating preferred”, “guaranteed return” and so on. While this method may solve the valuation deadlock, we have observed that companies that add these structures on top of their over-priced valuations, are often unable to move forward later on.
Although “artificial valuations” work for some companies (even until the expected exit) – and it can be tempting to follow suit and bask in the glory of an envious (albeit misguided) valuation. It’s usually risky, and savvy investors are aware of this, opting instead to be cautious and to cling to benchmarks and industry comps valuations when determining what a company is worth. In some cases, a premium price may be attached to an excellent team or a company in a hyper-growth situation, but this is usually only done in unique cases.
Overpaying may be harmful not only to the investors who will find it difficult to achieve their targeted ROI, but may also impact badly on the company itself: Many “unicorns” – who raise more and more capital at higher and higher valuations – are a great example of this, because when (and if) the time comes for their IPO, it’s highly likely that they may not be able to live up to their inflated valuation.
There are many other risks associated with inflated valuations. The best way to avoid them is to let the market determine a company’s real valuation through good old-fashioned competition and based on valuations multiples methodology. This is sustainable and defensible in any scenario, and minimizes the chance that Irrational Exuberance will affect not only the company itself, but will also create a snow ball effect with many other implications.
It will be particularly interesting to see what happens to company valuations in the near future. It remains to be seen whether those investors that stand against Irrational Exuberance, will reap the benefits of their patience.