David S. Bennahum, Venture Partner @alphavp
Much has been written this summer about unicorns– private companies valued at a billion dollars or more– and the “privatization” of technology IPOs. Unicorns live in a world where most of the upside from successful technology investing occurs well before a public offering.
Less well understood is that every unicorn is valued with two prices– a glitzy well-publicized price, and an unpublicized discounted price. Take Uber as an example. The headline price is $51 billion. The alternative price is $5 billion. 90% off!
The rise of secondary market transactions has driven much of the anxiety around unicorn valuations (anxiety that you have no way to get into these markets, anxiety that if you can get in, it’s because you’re a sucker “adversely selected,” anxiety that someone else got in early, and that if you got in, you overpaid to get in). But less well understood is that there are effectively two markets for every unicorn: the secondary market and the primary market. And with these two markets come two valuations: a primary valuation and a secondary valuation. The difference between the two can be an order of 20x or more.
Let’s take a closer look at Uber. This summer, the company raised $1 billion on a reported valuation of $50 billion. This brings the total amount of money raised by Uber since inception to $5 billion (not inclusive of the $1.2bn raised by Uber’s China subsidiary or debt financing). For investors who participated in those primary financings, all of which were purchases of preferred securities, they received a liquidation preference, meaning that the first $5 billion that comes in from a sale or public offering of Uber goes to the preferred shareholders (if more than the last round’s post-money valuation comes in, then the benefits are spread proportionately between the preferred shareholders and the common shareholders).
From a preferred shareholder’s perspective in Uber, they are guaranteed to get their money back in any sale over $5 billion. They won’t be losing money on their investment.
Not true for the secondary market investor– this person is typically purchasing common stock from an employee or an early investor. Employees have to sell stock from time to time on private markets because the delayed time to IPO means employees are expected to hold on to stock for much, much longer. Getting them some liquidity must be addressed in order to retain key people (especially if the company is “crushing it” performance-wise). Early investors have a somewhat similar “problem”: They may already have made 100x on their investment on paper based on the latest primary financing, and they’d like to return capital to their limited partners (bank a win, and get paid as general partners as well); much like employees, early stage investors also can’t always wait for ever-longer time horizons to IPO (the average time to IPO was four years for tech companies in 1999; now it’s 11 years). This convergence of early-investor and employee need for liquidity has led companies to organize increasingly systematic “company authorized” sales of either common stock or junior preferred securities, such as Series A, held by early investors.
This of course leads to more investor anxiety– what do the employees or early investors know that might be compelling them to sell?– none of which can be mitigated by getting access to truly definitive company information, as these are necessarily guarded as core company secrets that shouldn’t be leaked to any number of current and future competitors. The benefit of participating in primary financings is access to these crown jewels as part of the due diligence.
In Uber’s case, the stock trades on secondary markets at a slight discount (5% to 15%) from the $50 billion valuation of their latest round. For secondary market purchasers, this means they’ve paid a different price, effectively, than the preferred market purchasers, all of whom are ahead of them in line to receive proceeds from a sale. For Uber, today, there are two prices:
- A preferred price, valuing the company at $5 billion.
- A secondary price, valuing the company at $50 billion.
That’s a variance of 10x!
When looking at a company’s valuation– in particular unicorns– it’s important to note the implied valuation for preferred shareholders, which is the total amount of capital raised to date, vs. the “company valuation” in the last round, which is the secondary– call it “aspirational valuation” that may or may not turn out to be above or below the ultimate liquidity event down the road (hopefully a sale or public offering for more than the last round’s valuation).
In this sense, the talk of unicorns and over-valuation needs to be recalibrated to fully take into account the dual price structure on all unicorns. Is Uber over-valued at $5 billion? Or is it fairly priced? Here are the rumored numbers for 2015:
- Uber collects $10bn in gross revenue (preferred valuation is .5x gross).
- Uber keeps $2bn and pays $8bn to drivers (valuation is 2.5x net revenue)
- Uber is spending intensely on capturing markets; net income is a loss.
- But revenues grew 10x in two years.
At a $5bn valuation– the de-facto preferred price to break even for primary investors– Uber is likely a buy.
The only time that the value between preferred and common (secondary) valuations converge is when the company is private and profitable. Such unicorns do exist– we have investments in several– and in those cases secondary buyers are on much steadier ground. The “liquidation preference” for preferred shareholders becomes increasingly irrelevant to the equation, as the company has sufficient operating cash-flows to be priced like a comparable public company.
The ongoing “privatization of IPOs” will make this kind of math– and thinking– increasingly important when it comes to understanding the true value of an investment.
This is the first of a series on the rise of the private IPO market.
PS Priced out of secondary markets? Amazon has an alternative.
About @dbennahum
Venture Partner / @alphavp. Co-Founder CEO / @Kandu. Co-Founder CEO / Punch. Founder / The American Independent News Network. Director & Advisor / DailyCandy, MediaBistro. Founding Writer / Wired. Analyst / McKinsey & Co. BA / Harvard College. First computer: Atari 800. First programming language: BASIC. LinkedIn