Surprise: Tech Company Valuations Are Completely Made Up

Tyler Durden's picture

Talk of a massive bubble in the red hot world of private tech companies is getting louder of late. As we noted last week, Prem Watsa recently highlighted what he called excessive “speculation” in tech stocks and predicted that at the end of the day, habitually slapping billion-dollar valuations on unproven companies that often have little more than an app and a dream will end “very badly.” This comes on the heels of Mark Cuban’s warning that stretched valuations in private tech companies are far more dangerous than any perceived Nasdaq bubble 2.0, as at least with overvalued publicly traded firms there’s liquidity. 

Well, now that everyone is jumping on the “there’s no way that app is worth $50 billion” bandwagon, Bloomberg is out with a startling revelation: “Snapchat, the photo-messaging app raising cash at a $15 billion valuation, probably isn't actually worth more than Clorox.” 

No, probably not, but it sure is more fun than doing laundry, which is why it absolutely makes sense that the number VCs are putting on the app makes absolutely no sense. Here’s Bloomberg:

Here's the secret to how Silicon Valley calculates the value of its hottest companies: The numbers are sort of made-up. For the most mature startups, investors agree to grant higher valuations, which help the companies with recruitment and building credibility, in exchange for guarantees that they'll get their money back first if the company goes public or sells. They can also negotiate to receive additional free shares if a subsequent round's valuation is less favorable.

Ok so it’s all completely made up, which is what we suspected, but as Bloomberg discovered when they spoke to some of the billionaires involved in funding early stage tech companies, the term “valuation” doesn’t actually mean what sane people think it means. In fact, having to equate the amount of money one throws at something with an assessment of how much the business is actually worth turns out to be really inconvenient when it comes to fleecing employee shareholders and people who got in earlier which is why VCs would rather just not talk about it, but when pressed, here’s what they’ll say: 

“These big numbers almost don't matter," says Randy Komisar, a partner at venture firm Kleiner Perkins Caufield & Byers. "Those numbers are just a middling shot at a valuation, and then it's adjusted later" 

Got it. So while we thought “valuations” were numbers that indicate how much something is worth, what they actually are are complete shots in the dark which, if necessary, can be “adjusted” later to reflect economic realities. The reason this makes sense is because these companies often command huge market shares in markets they made up and also because their founders are arrogant. Here’s Bloomberg again: 

Some VCs defend the practice by saying valuations are just a placeholder number, part of an equation fueled by other, more important factors. Those can include market share, growth projections, and a founder's ego. 

If those are the “more important factors,” what are the less important factors? 

“A tech startup's cash flow is less important than you might think. It's something investors look at for a sense of how quickly a startup is growing its revenue, if the company has any.” 

So just as the term “valuation” does not, as we mistakenly thought, indicate what something is worth, a business’s ability to generate cash flow is “less important” than we might have suspected, and it’s a good thing, because a lot of these business don’t make any money at all:

Financiers also look to find the number of people using the product, regardless of whether they pay for it. 

Another mistake the market often makes when thinking about valuing these companies revolves around the bad habit of factoring in costs, and especially operating costs, which, like cash flow, actually don’t matter:

Costs, especially operations costs, are largely ignored for fast-growing companies.

All of this makes complete sense of course, but it does lead us to wonder how valuations for the next Facebook are determined because ultimately, you’re still left with the annoying task of having to get a funding round done, and even if it’s just a “middling shot,” it’s still a shot you have to take. Fortunately, there’s one completely unbiased party who is always willing to step in and tell you how much the business is really worth: 

The number is typically set by the company…

 

A founder often starts off with a number in mind, based on the startup's last valuation, the valuations of competitors, and, for good measure, the valuation of the company's neighbor down the street.

The punchline to the whole thing is that when this highly scientific process ends up spitting out a number that doesn’t make any sense (so like when Snapchat is supposedly as valuable as Campbell’s Soup for instance), the VCs never get hurt because, in consultation with the founder, they make sure to put in ironclad “downside protection.” 

Buried in their corporate filings, startups tuck away all sorts of provisions that reward investors for accepting these mega-valuations. The practice is more regular and egregious in financing rounds for mature companies. Their capital requirements tend to be much larger, so they must turn to more sophisticated investment firms that demand these kinds of terms. Startups that are generous with these guarantees can garner much higher valuations.

 

Each provision covers different ways to make sure new investors get paid back, even if disaster strikes, if an initial public offering gives the company a market cap far less than its private number, or, more commonly, if the startup has to raise money again at a lower valuation. One stipulation, called senior liquidation preference, ensures that a certain group gets its money back before anyone else, including employees. Another class, called downside protection or ratchets, automatically grants additional shares in the event of a declining valuation, removing a great deal of risk that the stake will ever lose value.

 

And while company founders and VCs are busy making up numbers, employees (who may or may not have been lured into working for the companies with promises of stock option riches), get the short end of the stick because unlike the VCs, the value of their stake is based on real numbers: 

The valuation based on common stock, which is generally what employees receive, and it's calculated by professional auditors. That figure usually isn't anywhere close to the headline number.

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Temporalist's picture

"Financiers also look to find the number of people using the product, regardless of whether they pay for it. "

Haha paying for stuff is so Pre-Obomber

DirtyWilly's picture

Great, now I have the invisible schween song stuck in my head.  Strikingly, the song fits if you imagine tech companies singing it.

TruthInSunshine's picture

So, make sure you're a "ground floor" investor, with ironclad return of investment clauses, rather than a post-IPO shareholder/bagholder of any "oh, give it a valuation of whatever the fuck" tech companies in dot.com bubble v2.0 (which is remarkably similar to James Cramer's "valuations & revenues don't matter" diaTRIBE during his Winners of the New World garbage circa-1999).

Got it.

RABBIT HOLE AGAIN.

BKbroiler's picture

So the valuations are just made up?  That probably wasn't included in the investor sales pitch...

twh99's picture

It is always better if you get into the pyramid at the start of the scheme, rather than later.

Blankenstein's picture

Wonder who Eric Lefkofsky's, the co-founder of Groupon, bagholders are now?  They were shareholders in Ha-Lo Industries back in 2000.   

 

"Lets start having fun… lets get funky… let’s announce everything… let’s be WILDLY positive in our forecasts… lets take this thing to the extreme… if we get wacked [sic] on the ride down-who gives a shit… THE TIME TO GET RADICAL IS NOW… WE HAVE NOTHING TO LOSE…"  

"It was written in an email by the co-founder of a company called Starbelly.com, which labeled itself a B2B provider — back when people greeted that phrase with a straight face."

 

"In early 2000, Starbelly sold itself to another company called Ha-Lo Industries for $240 million, much of which went to the author of those words, a man named Eric Lefkofsky. Not long after that transaction, Ha-Lo declared bankruptcy. Shareholders and others blamed the Starbelly deal, and a series of lawsuits ensued.

Eric Lefkofsky is the co-founder and chairman of Groupon, which filed last week for an IPO valuing the company at $30 billion,"

 

http://fortune.com/2011/06/10/the-checkered-past-of-groupons-chairman/

konputa's picture

You know it's a slow news day when we're reposting day old MSM pieces.

 

I guess we're just killing time before 14:00 ET.

Philo Beddoe's picture

Watch oil for the next 3-5 trading sessions IMO.  Yellen is a transitory issue at this point. 

ILLILLILLI's picture

Think I'll take a few lazy laps around the pool...nice day that it is.

asierguti's picture

It's worth watching Peter Schiff on the .COM bubble once again.

 

http://www.youtube.com/watch?v=MUhOxS-F-Zk

Atomizer's picture

This article won't meet the new Fuckface terms and conditions. Good job in exposing this shit. 

Kirk2NCC1701's picture

That's actually FANTASTIC news!

Now all you have to do, is to get into the "In" crowd, and Ben's your uncle.

Oh, be sure to BTFD and tell everyone about it.

Winston Churchill's picture

The rice business is always underwater.

Jethro's picture

Yet Zuckerberg attends meetings with Obama. However, the intelligence gathered from the sheeple self-reporting can't be underestimated I suppose.

czarangelus's picture

Whenever I go over the Hill to Silicon Valley I see and hear the most unbelievable shit you could possibly imagine. These people live in a separate reality from you and me; Hell, they live in a separate reality from the laws of physics.

Philo Beddoe's picture

Your observation applies to most hills that overlook most any city these days. 

Consuelo's picture

Speaking of VC's - (and KPCB) What happened to the two horny Heebs that wanted a hot side of Ellen (Kung) Pao...?

 

 

vote_libertarian_party's picture

What?  You mean companies with no revenue aren't worth billions???

 

I am shocked!!!

Atomizer's picture

Enron investors were a kite flying on MSM hype. 

Consuelo's picture

“These big numbers almost don't matter," says Randy Komisar, a partner at venture firm Kleiner Perkins Caufield & Byers. "Those numbers are just a middling shot at a valuation, and then it's adjusted later" 

Alles Klar, herr 'Komisar'...?

prudent_investor's picture

Here you can find more detailed reserches on some of the tech stocks mentioned in this article:

http://prudentvalueinvestor.blogspot.com/2015/01/sell-short-dexcom-inc-d...

Bell's 2 hearted's picture

 

"Financiers also look to find the number of people using the product, regardless of whether they pay for it"

 

i'll have to look for it ... but i cut out a comic from the late 90's ... showed a twenty something sitting at a computer working on a website about cats ... with a couple of dudes in suits standing behind him with fist fulls of cash ... asking him to name his price

 

i forget ... how did those times turn out??

Winston Churchill's picture

Depends when you got out, as always.

Atomizer's picture

Dipshits above need to visit Palm Springs, CA and ask how the wind farm taxpayer investment benefits the city. While visiting last year, they where vile. Ask a taxpayer who lives in Palm Springs or Rancho Las Palmas. The fraud is spreading. Not directed to you Mr. Churchill. 

NoDebt's picture

I feel like I already learned this lesson sometime around 1999-2000 or so.  Back then it was web hits and "eyeballs".  Now it's Apps and "users".  Remind me again how much those "users" pay for the service?  Oh, that's right, NOTHING, just like they did when they "hit" your website 15 years ago.

Chuck Knoblauch's picture

Hide the salami.

Someone has to sit on it.

Will it be you?

JRobby's picture

Well, we were thinking that something will probably happen. Not sure when. But we are pretty sure it will.

headhunt's picture

So basically; take off all your clothes, bend over that barrel and trust us.

Downtoolong's picture

It’s another dimension of the new normal, where everything online and imaginary is priceless, and everything real is worthless.

Refi you're house if you must, just, don't miss out on the Oil/BABA pair trade.

mastersnark's picture

So our stock market is just like high school, the more popular you are, the more attention you get, and no one cares what you are like on the inside.

unionbroker's picture

when i was in the Philippines everyone i met had a cell phone and a internet connection i wonder how many of these users of facebook etc just own a phone and the clothes on their back

Bioscale's picture

Maybe having a cell phone with internet is the crucial thing to find the best one day job for tomorrow.

redux2redux's picture

Selling dog food via FedEx, is not a business model.

The only asset they had was that sock puppet.

Atomizer's picture

Amazon can drone deliver one nibbles at a time. Have to make sure your dog or cat doesn't get obese. Our new online restocking appliance program will alert you if you need more food under Obamacare provisions health code laws. 

/sarc 

Max Cynical's picture

Anyone catch Naja Lingerie on Shark Tank last Friday?

https://www.youtube.com/watch?v=yL11e1eJ2mk

$147K in total sales.

Silicon Valley investor gave her $850K based on $5M back of a napkin valuation (after a conversation in a bar).

She was asking for $500K for 5% of the company...a $10M valuation.

How does she justify the valuation? Because "I have a Stanford MBA" and "I'm from Silicon Valley."

Atomizer's picture

Didn't see it. But, Mrs. Atomizer was flipping through channels the other night and landed on CNBC. They are so dull in creativity. They were copying a food network show using Shark Tank theme. 

That gay agenda is losing broadcast viewership. Last night, was watching Beach TV. Almost fell out of the bed laughing. They're using British speaking women to sell attractions in Myrtle Beach, SC. It's hilarious. 

Never One Roach's picture

99.999% = Good Will

 

00.001% = Hard Assets (Cap equipment, bank accounts, etc)

Fun Facts's picture

One side effect of CB market levitation is that all boats sink or float together.

It doesn't matter what business they're in, how profitable they are or how fast they're growing. Fundamental analysis has been destroyed.

It's a carnival market of widgets now. Get a monkey to throw darts or put a blindfold on to point at a symbol.

Better yet, take your chances at the MGM Grand market in Vegas on red or black.

Colonel Klink's picture

I'm sorry, where's the surprise?

la cebolla's picture

"Surprise: Tech Company Valuations Are Completely Made Up".    To that I say, not shit.  Then Tyler says  "Well did you know that, words really can hurt you?" https://www.youtube.com/watch?v=kCysb4_-4jU

 

 

 

 

malek's picture

Such an "Irrational exuberance" arcticle on Bloomberg of all places will only serve another doubling of "valuations" within the next 12 months.

q99x2's picture

When Harvard is teaching FRAUD and FRAUD is everywhere and the United States of America has no government it is every person for themselves. It can't be much longer now.

dynomutt's picture

Ken Lerer, is that you?!

combatsnoopy's picture

The neo-tech bubble is kind of a scam using VC/M&A start up fields to rob others to make only the friends of "investors" rich.  And I'm making comments from yesterday's bloomberg article. http://www.bloomberg.com/news/articles/2015-03-17/the-fuzzy-insane-math-...

 

First bit of braindead VC blathering:

"For Uber to get to $40 billion or Airbnb to $20 billion, you'd need to get a little creative with the variables underlying that logic. Since private tech companies often lack earnings or enough historical data to inform projections—or, in the case of Snapchat, any significant revenue—investors can't rely on the metrics available for public companies. " 

 

No ***SOBER*** PE (private equity) company in the right mind is going to pick up these at these valuations with their own money and tight lending from banks when the start up founder has no history, credit or experience then look for a bank who would pick this up with "debt" to replace equity and lose the initial investors' money back plus capital gains. THe PEs "hate hot money" (NOT!)-these Hahvahd grads don't even like to pay people to do their dirty work of opening up spreadsheets and doodling a few numbers on a home grown Financial Model for WACC.   
 

"For Uber to get to $40 billion or Airbnb to $20 billion, you'd need to get a little creative with the variables underlying that logic."                                                                  

 

What logic? Deacorn and Unicorn are logical to Unique and Monique.  

 

"...investors fear missing out on the next Google or Facebook."

-Google and Facebook are just two examples of SUBSIDIZED companies. Their guaranteed clients are the government. 
Read up on the New Trade Theory (mercantalism) or Strategic Trade Policy... Sheryl Sandberg's spot on Facebook's management team makes it too obvious that there's a revolving door between the US government and Facebook ... both Google and Facebook have some sort of contract with the US government for profits. They didn't do it through free market principles all alone. Esp not this fast in lieu of US Triffin's Paradox and only cash flow into the US from US Treasuries (foreign government ownership and federal reserve).

Investors should be made aware of deals with the government before deciding to buy or not buy stocks; and it should definately be a consideration in "valuation" in a thinly traded market. 

 

There's another article out stating how the S&P is underperforming the rest of the world.  No big surprise here.  ECB cheap loans + London Tech + tax breaks up to 10,000 sterlings (appx. $15,000 in USD until the Fed raises that greenback amount).... as long as their tech products hits a high note in the market, it at least looks good.  China, you can hedge stocks with RMB bonds?  Unfortuantely there are taxes and barriers.  

And yes, Apple tech is outdated.  U.S. tech is outdated.  Thank you special interest lobbied for monopolies.  
Compare Samsung's 4K to the new Apple TV.....just go shopping on Chinavision.

 Seriously, if Apple has so much cash-can't they just buy GM?  

B* puhleeese.  U.S. tech venture is like Jim Cramer on Hardcore Pawn.   Still safer than the subprime bubble (some firms can always go for an M&A to liquidiate- which they all do anyways...I wonder if the FMU and rehypothicated repoed petrodollars make way for continued mirage.)

(EDITED FOR SPELLING) 

Downtoolong's picture

I was involved in a dot com startup once (wasn't everybody?). The product and service was actually good. The financing, planning, and marketing were pure bullshit. The market had barely even formed. Therefore, the logic went, it had to grow at least 25% per year in the foreseeable future. Even worse, we sat in a sea of 100 startups just like us all claiming they would get at least a 10% share of the market when it did materialize. Complete Lunacy.

Six months later the original investors pulled the plug and sent everyone that got in behind them down the toilet. The employees got the worst of it. Even when it was obvious the game was over, the company management had the gall to hand us more shares for our annual  bonus. We retaliated by setting up an OTKC (over the kitchen counter) market in the lunchroom to trade the shares. We were zero bid at $0.20 per share before a twenty something VP caught us in the act and told us to knock it off.   

Clowns on Acid's picture

Illegals don't have to legal and no earnings don't have to be earnings. Don't you guys understand yet..? Feckin old white morons. All the young and non white "peoples" have all this sheet figured out.

Just ask Zuckerberg or Schmidt at Google. It's easy and fun. All you have to do it create the image, have people click onto your site and presto ! ...a thriving eco system Dude..! It's all aout the eco-system.... any minority worth their special status knows this.  

Rootin' for Putin's picture

As far a i am concerned a tech companies value is best estimated as what i can get from selling their desks, servers and fake office plants when they go bust. Anything else is just bs.