The Pitfalls of Venture Capital Valuations

Have you ever wondered how WeWork, valued at $47 billion in January 2019, fell to $12 billion in September of the same year when they planned to IPO? As tech unicorns–privately held companies with an initial valuation over $1 billion–become more and more commonplace, it is important to ask if these valuations are accurate or if they are artificially inflated without regard to their intrinsic value.

Venture capitalists are not looking to invest in companies and run them into perpetuity. Their business model is to invest in numerous companies, double down on companies that do well, and sell them for a big payday. The only way this model works is when their portfolio companies are successful in raising capital at higher valuations in each subsequent funding round.  

If a venture capital firm invests $40 million across 20 companies ($2 million per company), 80 percent of the 20 portfolio companies will not raise another round of capital; the VC firm loses its original $32 million investment in those 16 companies.

Ten percent of the 20 portfolio companies will raise additional capital but not give the VC firm a blockbuster return. At best they may get their original $4 million investment back from those two companies.

The remaining 10 percent of the portfolio companies have to increase their valuation sufficiently to cover the losses from the 80 percent that did not provide any return on investment. For two companies with an original investment of $4 million to not only return their original investment, but also cover $32 million in losses from other companies, it requires an 800 percent return just to break even. If the VCs want any significant profit from their investment, they need a minimum of 10- to 20-times return on those two companies.

How can a VC firm guarantee that the profitable 10 percent of the portfolio companies give them 10- to 20-times returns sufficient to cover the losses from the other 90 percent?

The first step is to encourage their fellow VCs to form a syndicate of co-investors for the profitable 10 percent of the portfolio companies. In each subsequent round, the valuation of the company increases by three- to five-times of the previous round. After four to five rounds of raising capital and further investment, the VC syndicate is finally in a position to recover its losses, and make a positive return for themselves and their limited partners–who are expecting a minimum 100 percent return after three to five years of investment.

Increasing these valuations is much easier said than done. If the remaining two portfolio companies don’t have the intrinsic value required to provide a sufficient return on investment, VC firms still need the perceived value to increase such that they will recoup their losses and make a profit. Externally, this appears the same as raising the valuation for any other company. However, behind the scenes, the intrinsic value is not always there.

You may be asking yourself, “How can the value of something be worth anything other than what someone will pay for it in an open market?” Most of the time, the market value reflects the intrinsic value of a product. However, when the market doesn’t have all the information regarding a product, a divide between market value and intrinsic value can appear.

Intrinsic value of a company is based on an economic benefit analysis and cash flows of the company, which rely on transparent accounting records of a company and collected financial statements: the balance sheet, profit and loss statement, statement of cash flows, etc. When a company is public, these records are open for the public to see via quarterly and annual filings.

In contrast, a company that is not public–for example, a VC portfolio company–is not required to, and often does not, share its accounting records with the public. Without complete knowledge of the company’s financial status, the public determines the market valuation based on predictions of the company’s potential future value. Sometimes, these predictions cause the hype around a company to explode.

Venture capital firms are not in the business of running companies long-term. They are great at growing companies, increasing the valuations, and selling them for a blockbuster exit. Once they have increased the valuation of a company to a level where they want to sell it, they also need to find a buyer. Generally there are two possibilities: The portfolio company is either purchased by a larger public company or it has an IPO.

It is important to remember that the VCs are not necessarily concerned if the intrinsic valuation of the company matches the perceived valuation. The most important factor is how much they can sell it for. As such, they are not opposed to selling a portfolio company for a valuation higher than its intrinsic value.

Retail investors aren’t always as versed in the business as VCs, so they trust the public valuation to reflect the intrinsic value of a company. Furthermore, public investors can get carried away with predicting a company’s potential future value, which can cause a market bubble if the anticipated future value exceeds the intrinsic value of the company. This allows VCs to sell a company for more than its intrinsic value if necessary.

No matter if a large public corporation buys the portfolio company or its IPOs, when a company’s valuation is artificially inflated, as it was with WeWork, retail investors can end up holding the bag for the VC payouts without getting the returns they expected.