"Something is only worth what someone is willing to pay for it,” declared Latin writer Publilius Syrus in the 1st century B.C.
Is that really true?
When Blue Apron IPO’d in June 2017, it was worth nearly $2 billion dollars (with a B). As of this writing, its market cap is $40M, or about 2%— roughly equal to its Series B post-money valuation almost seven years ago.
Up to its IPO, investors had put in north of $250M, at increasingly higher valuations, with Blue Apron finally raising a $300M investment at the IPO. There was a general trust that the investors had done their due diligence and that the valuations were therefore fair and reasonable.
These assumptions seemed to work in the private market—but the public market clearly disagreed. In reaction to poor unit economics and disappointing performance, the company lost 98% of its presumed value.
What happened to all that private investment? Well, it was spent—it’s just gone. Some shareholders have certainly reaped the benefit of the increase in value from the company’s inception, but those who have been holding shares at any valuation north of $40M are not exactly happy.
In this scenario, the private investment into Blue Apron was effectively just an inefficient transfer of capital from investors to the company’s suppliers, vendors, and employees. Money in didn’t turn into more money back out, as investors hoped it would. This capital transfer paradigm, justified by consecutively larger valuations at each round, may not constitute a good investment.
If underperforming IPOs keep happening, will institutional investors pour money into VC funds? And would VC funds pour money into risky companies?
- If there are fewer institutional investors, there will be fewer and smaller VC funds;
- Fewer VC funds, fewer Blue Aprons (for better or worse);
- but also:
- Fewer VC funds, fewer Twilios, Shopifys, or PagerDutys, all of which are services that have arguably made life easier for many people and which actually capture value on the public market.
When private company valuations collapse under the scrutiny of public investors, eventually, trust in the VC asset class erodes. When trust erodes and institutional investors (like insurance funds, university endowments, pension funds, and family offices, collectively called limited partners or LPs) pull out of venture capital as a class, there will be economic consequences.
The good news is, VC firms themselves can take the reins. They are the solution. And while it won’t be easy, it could save the VC ecosystem.
To understand what needs to change, we need to start with where we are today, to focus on how investors are reporting the valuation of their portfolio companies.
How portfolio valuations work now
What sets apart the best VCs from every other want-to-be VC and angel investor is that the best VCs can take an honest look at their portfolio companies and say who is doing well, who is not, and everything in between. They have their finger on the pulse. Said differently, they know how they tick up and down, and what are they worth (implicitly and explicitly).
VCs and PEs have to report on the performance of their investments on an ongoing basis. Most report under the Fair Value framework, with guidance set in Account Standard Codification 820 (or ASC 820), and referred to as “portfolio valuation.”
When we interviewed fund controllers and CFOs, they bucketed their valuation into three groups:
- “If the investment was done within a year, we’ll report it at cost.” (i.e. the amount of investment)
- “If there’s a new round of financing, we’ll write it up to that new price per share.” (i.e. If we purchased Series Seed at $1 per share and the Series A is at $5 per share, we’ll “write up” our Series Seed to $5 per share. This is where the 5x value improvement comes into play.) This is sometimes referred to as “paper gains.”
- If neither (A) or (B), we’ll do a fundamental valuation, in other words, look at the portfolio company's revenue, earnings, projections, or some other form of fundamental analysis.
However, some of the folks we spoke with, especially the investors in pre-Series B companies, had a big caveat for (C): “These companies are so young that they lack meaningful data. We’ll usually just keep it at the last round of financing, or we’ll write it up at our fund’s target IRR, or the larger VC market IRR.”
Both (B) and the asterisks on (C) effectively inflate venture capital.
Investors using the above valuation methodology consideration are not acting out of greed or an intention to misdirect, per se. These are traditionally acceptable, audit-defensible techniques.
Unfortunately, so were the credit modeling practices for certain mortgage-back securities that produced AAA rated ratings in the runup to the 2008 recession.
Regardless of what is considered acceptable, this reporting methodology affects not only venture capital and young companies but also the private equity funds, family offices, and other institutional investors (the university endowments, pension funds, insurance funds, and mutual funds) that invest in them.
We’re essentially in a valuation house of cards.
What would help? Institutional investors should demand more transparent valuation documentation. Audit cover reports or GP memos clearly don’t cut it.
And companies and their investors need to implement a comprehensive, holistic valuation strategy and employ it early and often. Public companies adhere to GAAP and report often because it works. It’s time that VCs hold themselves up to higher standards for their portfolio valuations.
In our next piece, we'll explain how VC firms can do the work to preserve investor confidence.