People often say valuation is more an “art” than a science. Are start-ups’ true valuations in line with media quotations, or what owners believe to be their value? It’s high time to increase scrutiny on valuations and utilize a robust methodology to make valuations more accurate and consistent.
Unicorns exist in both the fantasies of children and in the business world of grown-ups. Hong Kong-based travel start-up Klook announced in April that it raised US$225 million round led by the Softbank Vision Fund, the world’s largest technology investment fund, with participation from existing investors. The Hong Kong media then widely reported that Klook’s valuation reached US$1 billion. Is Klook’s “true value” in line with this value quoted?
Why private company valuations matter
Companies usually release information on the price paid and the percentage of the company that investors purchased after closing a fundraising round. The media then calculate the value of the company, known as the post-money valuation, by multiplying the last round price with the total number of shares issued. In fact, the media often ignore the complexity inherent in calculating an accurate valuation, as the stocks issued by start-ups often have different rights and seniority. According to recent research in the United States, these values were on average, 50 percent higher than fair value of the 135 unicorns studied.
In view of the high risks and illiquidity associated with start-ups, venture capital (VC) and private equity investors typically seek downside protection and certain controls over the portfolio companies’ activities. Hence, they may receive preferred stock conveying various rights and enhanced seniority on liquidation. As a result, VC-backed and private equity-backed start-ups often have complex capital structures with various classes of stock with different rights, dividends, participations and conversion ratios.
Issues with post-money valuation
In reality, the majority of VC-backed start-ups fail and are eventually liquidated. Post-money valuation only holds true if the company can go public at that price, or if someone is willing to buy the entire company at that valuation. Venture capitalists who quote the post-money valuation usually assume their investment will go public soon, and that the shares will convert to common stock. This is often a clause in the Memorandum and Articles of Association, which details the terms of securities, rights and preferences of shareholders of different classes.
Post-money valuation disregards the rights and preferences of preferred stocks and sometimes oversimplifies the valuation, which results in a misstatement. While many finance professionals are aware that post-money valuations do not truly reflect the value of the company, it is not uncommon to report post-money valuation as fair value. A survey conducted in a valuation event by IHS Markit in Singapore recently revealed that 75 percent of participants use post-money valuation to value their portfolio companies.
Using post-money valuation is appropriate when market participants expect the preferred stocks to convert to common stock, which may be the case when an initial public offering (IPO) is imminent or when latter rounds have additional preference but early rounds investors have control on the timing to exit. If the IPO plan is remote or uncertain, a full scenario analysis or a “backsolve” can be used to value the company.
A backsolve is a valuation approach based on an option pricing model. When using a backsolve, the enterprise value is solved as a variable in an option pricing model with the latest transaction price.
Challenges of start-up valuations
Due to the disruptive nature of start-ups, truly comparable guideline public companies, at a similar stage of development with similar growth and risk expectations, do not usually exist. With little revenue and often no profit, it is sometimes impossible to come up with a reasonable valuation using comparable companies.
The revised Fund Manager Code of Conduct and the implementation of HKFRS 9 Financial Instruments last year called for more scrutiny on the fair value of private companies’ valuation. Despite an improved awareness of the need for a higher level of quality in valuations over the past years, there is still a gap between the actual market valuations, and the auditor’s expectation.
The issues are two-fold. Some VC funds do not have the expertise, or indeed the resources to value their own investment. To make matters worse, start-ups cannot usually produce reliable operational metrics or financial forecasts. Chief financial officers in venture capital in Hong Kong not only face pressure in meeting accounting standards, but also when it comes to managing volatility in valuations.
The road ahead
HKFRS 9 or IFRS 9 do not provide detailed requirements of the valuation methodology for private companies. Finance professionals may refer to other resources such as the International Private Equity and Venture Capital Valuation Guidelines, or the Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies by the American Institute of CPAs for best practice.
Valuation is indeed more of an art than a science. Finance professionals in Hong Kong need to make this art more accurate and consistent to enable stakeholders to make better asset allocation decisions and to make meaningful comparisons. The finance team in VC funds may not be large enough to allow for a segregation of duties. As the guardian of the financial statements, the CFO should challenge the investment team regarding their valuation and the methodology they use to create it. Understanding the rights and preferences of the securities of their investments and the different valuation methodologies available would be the first step to more effective control.
