There is little doubt that this year, more than many in the recent past, valuations will be scrutinized by auditors and investors alike, as it is the most subjective and impactful component of a venture capital (VC) fund’s financial statements. The bear market in 2022 has been particularly acute for venture-backed technology companies, many of which have seen values cut 75 percent or more. In 2022, PitchBook’s VC Backed IPO Index was down approximately 60 percent, an indication of how broad-based the pullback has been for previously high-flying recent entrants to the public markets. Unfortunately for venture investors, the bear market has not been exclusive to public markets. One high-profile example is Instacart, which raised capital at a $39 billion valuation in early 2021 and cut that to $10 billion by the end of 2022.
In spite of everything transpiring in the public markets and the market for later-stage VC-backed companies, where the average pre-money value was down 15 percent in 2022, the picture is better for earlier-stage companies. The median pre-money valuation for seed-stage companies increased 16 percent in 2022 to $10.5 million. Similarly, the median pre-money valuation for early-stage companies increased 22 percent to $55.0 million.
The obvious question that arises from this data is why has the market for seed and early-stage companies not followed that of their later-stage peers? One hypothesis would be that early-stage companies have delayed the timing between financings, allowing them more time to create value. However, the median time between rounds of financing actually decreased across the board in 2022. Another hypothesis is that earlier stage companies are still growing at such a rate that declining valuation multiples are more than offset by increases in revenue. Finally, because of the erosion of the IPO market, investors may prefer to invest in companies with a longer time horizon, such that they are positioned to exit concurrent with an upswing in the market. Were this to be the case, it would shift demand from later-stage to earlier-stage companies and help bolster early-stage valuations.
With all of these considerations in mind, we expect to see investments in later-stage companies directionally following the public markets, though possibly not to the same extent if strong performance is sufficient enough to offset plummeting valuation multiples. That said, if valuation multiples are down 50 percent, investee companies would need to double their revenue in order to keep valuations flat, a tall order for later-stage companies.
With respect to equity valuations for earlier stage venture-backed companies, the data appears to be more favorable, with all metrics suggesting that valuations have not followed the public markets. Accordingly, when valuing these companies, it may be necessary to consider private market data, such as that recently published by PitchBook, in conjunction with qualitative factors when selecting valuation assumptions, such that changes in value align with performance as well as market trends for earlier stage investments. This may mean that calibration analyses used to select valuation multiples need to be re-calibrated to align with the dislocation between public markets and early-stage VC markets, even if there is no specific change in performance that would normally be required. Alternatively, it may be necessary to eschew the use of valuation multiples for early-stage VC investments entirely, in favor of less traditional approaches.
“With all of these considerations in mind, we expect to see investments in later-stage companies directionally following the public markets, though possibly not to the same extent if strong performance is sufficient enough to offset plummeting valuation multiples”
Compounding upon the difficulty of valuing privately-held companies are the challenges of valuation of the equity securities that comprise those companies. Venture-backed companies are generally capitalized with multiple rounds of convertible preferred equity that have different rights and preferences. Accounting for these differences is complex, though over the past several years market forces have served to simplify it somewhat. That’s because through the end of 2021, public equity markets generally went in one direction…up, and marking all classes of equity to the most recent round of financing, was a simple, and often supportable valuation approach. However, the significant declines in public equity markets suggest that things this time are different.
The fundamental premise of marking to the recent round is that investors are assigning little value to the liquidation preferences of the preferred securities because they perceive a high probability that all shares will convert (how VC investors realize significant returns). Accordingly, if investors view all preferred shares as effectively common stock, they should be valued accordingly. When a company raises an up round, particularly one where there is a substantial valuation step-up, the increase in price alone suggests an expectation of conversion and fully-diluted exits.
As equity values decline, simply dividing the equity value by shares outstanding ignores the fact that certain investors may not find it advantageous to convert to common stock, as doing so would yield negative returns. Instead, they would look to leverage the rights afforded to them to be paid their liquidation preferences ahead of common stock to preserve their invested capital. The amounts due in liquidation based on their preferences can be determined through the capitalization table aka “waterfall”.
Using the waterfall, while conceptually straightforward, has its own logical pitfalls. Specifically, as equity values decline and the waterfall yields no value for junior securities, where junior securities control the company they will not accede to a liquidation. Better to play the lottery and hope for an unlikely payout, than sell and get nothing. Their shares become more akin to out of the money options and may need to be treated accordingly for valuation purposes.
There is little doubt that this year, more than many in the recent past, valuations will be under heightened scrutiny. Funds continuing to mark solely to the most recent round of financing, especially if that financing was done prior to 2022, will be pushed hard to support that conclusion given the public equity markets. LPs may also push back on GPs suggesting that their funds have not diminished in value. Therefore, being thoughtful about valuations would be crucial, as declining values will introduce considerations that were not relevant previously.
