After a decade-long bull run and global pandemic-induced investment chaos, valuations are starting to revert to pre-2020 levels. While many look toward these valuation trends as a return to equilibrium, this begs the question of “What was the equilibrium, or was there ever an equilibrium?” During the pandemic, zero interest rates (i.e., treasury yield was nearly zero) and an increase in money supply (i.e., pandemic stipends and exit activity) directed an abundance of capital to fund managers. Present in the private and public markets, this decreased the required return, increased the velocity of investments, lowered the ability or need to conduct thoughtful diligence, and inflated valuations at a historic rate. Retail investors entered the public market in mass and started investing based on memes or Reddit threads.
“Decrease in rates = decrease in required return = decrease in savings = increase in investment capital = increase in buying = increase in price & repeat over and over for 12 years.”
This year, 2023, there is still hyperinflation from 2022/2021 and the most significant percentage increase in interest rates ever. Real estate cap rates are in lockstep with the 30-year treasury yield (as required rates increase, real estate values drop). Not only did the devaluing of bonds kill some of the largest banks (e.g., Silicon Valley Bank had old bonds with low rates that are worth less because new bonds have higher rates), but the devaluing of real estate could also kill banks across the US.
The Fed continues to raise rates as their hands are tied to a slowly decreasing hyperinflation rate, primarily induced by post-pandemic supply chain difficulties (supply is down while demand is the same), the Ukraine war, and a synthetically inflated money supply in 2021. No one has a crystal ball, but it is clear that we are not at the bottom of the downturn. That said, the next 12–24 months will be challenging and opportunistic, depending on who you are. At Redbud VC, we aim to be opportunistic and find founders who share that sentiment in tough times.
By the end of 2022, nearly 60% of private companies with actively traded shares in the secondary market were trading at a 50% or more discount compared to their 52-week highs [Based on Caplight MarketPrice historical values, which track the price of private shares in the secondary market]. Caplight’s data showed that the top 20 private companies were trading at a 27% average discount to their last primary round valuations, deviating from previous trends of trading at premiums [Data is based on Caplight Marketprice].
Down rounds have become increasingly common since 2021, with over $20 billion raised. This trend is worrisome for unicorn companies, as only 23% secured primary funding last year, leaving the remaining 77% reliant on cash reserves [Based on primary funding rounds listed on Pitchbook Data]. In 2023, defending previous valuations may prove challenging.
Although structured financing may help companies avoid down rounds, they often come with complex terms that can be detrimental in the long term. Down rounds can negatively impact equity returns and make hiring difficult, but they can also reset valuations and provide time for growth and IPO preparation. That said, the constant pressure of raising an up round can influence overpromising from the early stages, creating a domino effect of inflated valuations until exit.
Another push to inflated valuations is the trend of later-stage funds shifting towards a multi-stage fund model. For example, Tiger Global has a war chest of billions with institutional LPs with lower IRR targets; therefore, they are willing to take risks at a higher price to win early-stage deals. These are a small percentage of AUM but could turn into downstream deal flow. Their ability to outprice early-stage investors will set founders up for failure as they struggle to grow into the valuations.
The increase in SPACs provided liquidity to many investors who reinvested into new funds at the expense of retail investors, which are now ending in bankruptcies and fire sales. The increase in SPACs also influenced inflated valuations at the growth stage. At the end of 2022, exits went below $10B for the first time since 2013, and IPOs were at the lowest level since 2009 — less than 10% of where they were in 2021 [Pitchbook NVCA Monitor 2022]. In addition, SaaS multiples dropped from 16x to 7x revenue between 2021 and 2023.
An analysis of unicorn companies that went public between 2021 and 2022 revealed an average return of a 38% loss in the first six months after their IPO [Based on Caplight’s analysis of unicorn company performance over the 6 months following their IPOs. Available here with data sourced from Yahoo! Finance, Pitchbook Data, and Microsoft]. Only 13% appreciated, suggesting that private assets were previously overvalued. Since 2020, more than 140 VC-backed companies that went public in the US have market capitalizations that are less than the amount of venture funding they raised. In addition, companies like Klarna have seen valuations drop 80%+. That said, Klarna’s valuation was nearly double what it is now before the pandemic, which indicates hyper valuation inflation pre-pandemic. Unicorn startup valuation cuts question the solidity of the broader unicorn board. For example, in June 2021, cumulatively, unicorns were worth $3T, and 12 months later were worth $4.6T.
According to a recent publication called “Initial Public Offerings: VC-backed IPO Statistics Through 2022” by Jay R. Ritter of the University of Florida, VC-backed IPOs have underperformed non-VC-backed IPOs between 1980–2021. Over an average 3-year buy-and-hold return period, the returns for VC-backed IPOs were 18.5% compared to 19.6% for all IPOs. This doesn’t include the worst period for VC-backed IPOs, 2022 and 2023, as they have lost 50%+ of their market cap. Looking at these returns from a risk perspective, VC-backed IPOs are generally riskier due to the expected growth and profitability at the time of the IPO. Therefore, the risk-adjusted return would be much lower for VC-backed IPOs.
Even though the hike in 2021 valuations was heavily event-induced (e.g., rates, pandemic, etc.), venture capital startup valuations are historically overvalued. Especially when it comes to breaking down a cap table and valuing equity tranches exclusive of each other, not all equity is treated the same. What is inevitable is the constant push from VCs to founders to raise more capital and increase valuations, often based on something other than practical fundamentals. A study by Will Gornall and Ilya A. Strebulaev called “Squaring Venture Capital Valuations with Reality” provides an in-depth examination of how venture capital (VC) valuations often diverge from actual company values.
The authors argue that these discrepancies result from the unique methods and structures used to calculate VC valuations. By analyzing 135 US unicorns (privately-held startups valued at $1 billion or more), with information sourced from venture capital databases like Crunchbase, PitchBook, and Capital IQ, as well as company filings and other financial documents, they created a model that accounts for the various financial instruments involved in a VC funding round, including preferred shares, common shares, and convertible debt. This model, dubbed the “Gornall-Strebulaev Model,” aims to provide a more accurate representation of a company’s true value by considering the different securities’ preferences and conversion terms.
Figure caption: distribution of overvaluation of the total value, ∆V, for the unicorns. ∆V is the percentage that the post–money valuation overstates the company’s fair value.This work shed light on the limitations of traditional valuation methodologies and developed a more accurate framework for evaluating venture capital-backed companies. Using their model, they assessed the value of unicorns from legal filings and found that the reported unicorn post–money valuations averaged 48% above fair value, with 14 being more than 100% above. Traditionally with investments, valuations are calculated assuming all shares are as valuable as the most recently issued preferred shares. Gornall and Strebulaev's new method calculated values for each share class, yielding lower valuations. They attribute the difference in valuations to unicorns giving recent investors significant protections such as initial public offering (IPO) return guarantees (15%), vetoes over down-IPOs (24%), or seniority to all other investors (30%). Common shares lack all such protections and are 56% overvalued. After adjusting for these valuation-inflating terms, almost one-half (65 out of 135) of unicorns lose their unicorn status.
Importantly, they identify the core problem with VC valuations, arguing that traditional valuation methods, based on the most recent financing round, lead to inflated valuations because VC funding rounds involve various types of securities. These features can result in overvalued post-money valuations, as they don’t account for the true value of the securities held by different investors. For example, common stock held by founders and employees has a steep discount to preferred stock due to liquidation preferences and/or other terms, and preferred shares have unique liquidation preferences and conversion terms.
More important than the identification of the problem with valuations is the implication. The authors argue that inflated valuations create misaligned incentives for entrepreneurs, leading to increased risk-taking and potential financial losses. Moreover, the findings suggest that regulatory bodies should consider revising their definitions of accredited investors and reforming the rules surrounding private company investments to protect investors from the consequences of inaccurate valuations. That said, there is a strong argument against their take on accredited investors. A good analogy is that someone earning $150k per year can’t invest in a risky private technology company but can take their paycheck to the casino and lose all of it.
The events of 2020 to 2021 accelerated the pace of valuation inflation and shed light on the loose investing principles that were made a habit during the longest bull market. The consistent influence of founders to raise capital at higher valuations has ingrained unsustainable long-term company-building tactics. Regardless of the VC logos backing founders, the ones who focus on profitability, culture, and customers will be the outliers over the following decades; we at Redbud VC are lucky to have two great examples in our backyard at Zapier and EquipmentShare.
Redbud VC is an early-stage venture capital fund and studio investing monetary and social capital in early-stage tech founders.