Down is the new up in 2022 in the stock market, especially for once high-flying growth stocks.
Yet private company valuations have taken their sweet time to adjust to the new reality.
This includes crowdfunded shares on platforms like Seedrs* and Crowdcube, as well as the unlisted holdings of some investment trusts.
Despite a deep bear market in publicly-traded growth shares, I’ve seen some private ones raise money in 2022 at higher valuations. Perhaps even more than they achieved in the 2020-2021 euphoria.
Sure, the companies may have made solid progress since their last funding.
More users, higher revenues, and/or their products have new features.
But such valuations still seem fanciful, given that the multiples paid by public stock market investors – where, crucially, everyone can see what everyone else is paying – have crashed.
A fast-growing unlisted fintech that valued itself at, say, 80-100x revenues in mid-2021 should not expect the same valuation multiple in 2022.
Possibly not even the same order of magnitude.
Road to nowhere
I don’t begrudge their management teams if they can still raise money at high valuations, mind you.
Most such start-ups – and even some of the unlisted growth holdings of specialist investment trusts – are loss-making.
That’s often by design, especially in the (fin)tech sector.
Instead of tuning their operations for profits, they aim to scale fast.
Their business plans anticipate they’ll tap easy money to fuel this expansion.
Until recently, the deal had been that if you can show sufficiently fast growth, investors will show you the money.
Often these start-ups have less than 12 months of funding in the tank – as calculated via the aptly-named ‘burn rate’ – before they run out of road. Hence their need for regular injections of cash.
So it’s generally good for a company and its shareholders to sell precious equity at the highest valuation possible. Especially now market turbulence is seeping into the real economy, making growth and future funding even more uncertain.
It’s not about being greedy. A higher valuation gets more money in the door today. That buys more time for growth, while giving up less equity – much of which will be needed to sell in future rounds.
Yet an unrealistically high valuation probably isn’t great for the firm’s new investors.
I know this might seem stupendously obvious.
But there’s a contrasting school of thought that – within reason – it doesn’t matter too much what you pay for seed-stage investments.
Most of them are destined to more or less go to zero, anyway.
In light of this, even new investors might prefer to put money into a start-up that raises money at an inflated valuation, if by doing so the firm greatly extends its runway and hence its odds of finding success. (Or even just survival.)
You’ll likely lose money either way, whether you invest at a grossly high valuation or something more realistic.
But if you don’t lose, it will be because the firm is one of the minority that finds and wins its market and multi-bags1.
With such winners, you won’t care too much that you paid 20-30% over the odds when you bought in.
Our biggest ever sale
I understand this logic – which has driven even professional venture capital (VC) in recent years – but I don’t entirely buy it.
Not least because we’re probably not talking about a 25% overvaluation, given comparable valuations in the public markets.
The vast majority of listed high-growth/tech stocks are down 50-90% from their peaks – thanks to the regime change we’re going through due to higher interest rates and inflation.
Below are a few random examples of just the year-to-date falls.
I’ve definitely not cherry-picked rare duds here. And many such companies were already well down as 2022 began:
In light of such declines, an unlisted fintech that has raised new money at 25% above its last round could be in the order of 150% to 1,000% or more overvalued.
And indeed we are starting to see this now in some high-profile valuation adjustments.
Take the Swedish ‘Buy Now Pay Later’ firm Klarna.
Klarna just raised $800m at a valuation of $6.7bn. Which sounds like a decent chunk of change, until you remember it got money from Japan’s SoftBank last year at a valuation of nearly $46bn.
On Monday Klarna’s CEO took to Twitter to express sentiments similar to my points above:
Today Klarna announces an $800m financing round during the worst stock downturn and challenging macro in decades.
We are not immune to public peers being down 75-90% and hence our valuation is down on par.
The CEO doesn’t want his company’s valuation plunge to be seen as a Klarna-specific problem. Nor even as a blight on Buy Now Pay Later space.
Fair enough, I haven’t got a strong view except in that I passed on the chance (as a lah-dee-dah ‘sophisticated investor’) to invest in Klarna myself at that higher valuation, when a private holder offered a tranche of shares last year.
However the markdown is a wake-up call to investors in private companies deluding themselves about the current value of their portfolios, due to them not being marked-to-market or even liquid.
A butterfly flapping back to earth
One investor in private companies who has had to take notice of Klarna’s valuation collapse is the London-listed investment trust Chrysalis Holdings.
This fund came to wider attention in January. Back then its owner – the giant Jupiter – disclosed the trust’s managers were to be paid an eye-watering £60.5m after blistering returns in 2021.
As CityAM reported:
[the managers] generated stellar returns for the firm in the past year with a 57 per cent increase in net asset value per share, after backing firms including fintech darlings Wise and Starling Bank.
Nice work if you can get it, but questions were asked about how these performance fees had been structured to allow such a colossal payout to two employees.
That particular potato is even hotter given Chrysalis’s share price slump in 2022:
What has happened here is largely that the market no longer believes Chrysalis’ unlisted holdings are worth as much as they are being carried for on its books.
And given that its biggest holding was Klarna – whose valuation has just been slashed by 85% remember – we can only applaud Mr Market’s foresight.
Until recently, Chrysalis’ official net asset value (NAV) had only declined modestly in 2022.
But the share price predicted different.
I’m not familiar with exactly how the trust calculates its NAV. Typically though, NAVs are based on the most recent valuations achieved by all the different portfolio companies.
(Sometimes – and especially controversially – even when it’s an existing investor that is putting more money in at a higher valuation – thus marking up their existing holdings).
On Monday Chrysalis reported that:
As announced on 23 May 2022, the Company’s net asset value (“NAV”) per ordinary share was 211.76p as of 31 March 2022.
It is estimated that the revised valuation of the Company’s investment in Klarna due to this funding round, along with the movement of listed assets and FX post-period end, would result in a decrease in the NAV per ordinary share of approximately 32p as compared to the Company’s last reported NAV per ordinary share.
The resulting NAV would therefore be 179.50p
Note that 45% of the portfolio is currently profitable and 51% of the portfolio is now either profitable or has sufficient cash to reach profitability. The remaining 44% of the portfolio, excluding cash, has approximately 15 months of runway without raising further capital.
This trust is therefore currently valued at roughly half its latest NAV – a very large discount.
Perhaps the magnitude of this discount is unwarranted. Or perhaps as the market clearly fears more of the portfolio will be revalued down in the months ahead.
Either way, if you own investment trusts with holdings of unlisted companies that are trading at big discounts to stale NAVs, I wouldn’t go ranting about the ‘irrational market’ right now.
Chrysalis is a striking example of a delayed NAV decline, made more contentious by the fee controversy.
But there are plenty of other investors in unlisted companies – whether directly or via funds – who are in denial about valuation adjustments.
At least with investment trusts, the canny stock market can knock down share prices to anticipate declines in the value of the underlying holdings.
Seeing your shares plunge to a steep discount is no fun for existing shareholders. But it is better for anyone pondering a purchase.
I’d argue it leads to better functioning capital markets, too.
In contrast, VC and private equity funds that are not listed – and so not marked-to-market – may continue to comfort their investors with yesterday’s valuations for illiquid holdings.
At least they can until new funding rounds for their holdings put the boot of realism in.
Even the ever-popular Scottish Mortgage trust is trading at a discount, reflecting in part uncertainty about its unlisted holdings.
Not a big enough discount in my view, incidentally, given that some other tech trusts that invest purely in the public markets – where prices and hence valuations are nailed-on – are on even greater discounts.
(This illustrates that discounts aren’t just about uncertainty over private valuations. Fearful investor sentiment is also in the mix, and is quite capable of fostering a widening discount.)
Don’t go down on us
Intriguingly, professionals operating in the venture capital sector may be among the strongest voices urging the companies they’ve backed to keep reaching for higher valuations.
Venture capitalists in general abhor what they call a ‘down round’ – fund raising at a valuation lower than the last one achieved.
There are some pertinent reasons for this.
VC managers don’t want to tell their backers that their investments have been marked down but are still going concerns.
It looks bad for one thing.
Worse, flailing investments may well call on additional funding and still end up getting nowhere.
Given the structure of VC returns, you’d probably rather cut bait on losers and double down on winners than back a kennel of declining dogs.
Hence some VCs may prefer to put extra money into a company at a higher valuation – and mark-up their existing holding – rather than get more shares at a lower price. (Otherwise known as a bargain to you and me.)
If the capital markets recover then the higher valuation may become credible again. No harm done!
There can be operational issues with a down round, too. For instance, if you’ve granted options or restricted equity to employees at a higher valuation, then a down round is at the least a headache.
But I think it’s mostly a reputational concern for VCs.
Share options and other incentives can be repriced, after all.
And at the seed stage even the founders (and hence major shareholders) of many of these start-ups live at best a middle-class life, despite owning and running companies valued in the millions.
I knew one who was living in a flatshare despite an (illiquid) multi-million pound shareholding, for example.
The point being that the valuation doesn’t affect the founders’ day-to-day life much, nor their businesses. So if a down round is needed to get money in to keep it going, then I say so be it.
But VCs have different concerns. This sets up some interesting conflicts of interest.
At the least I’d urge any start-up CEOs that read Monevator to cut extraneous headcount and non-core outgoings, in order to reduce your burn rate and extend your runway.
It’s possible the risk aversion we’ve seen in 2022 will abate. And there is still lots of cash sloshing around in the bank accounts of rich people (and some funds for that matter) seeking high returns.
But if you don’t survive until such better times then all that’s moot.
Startup founders smelling the coffee
The good news is there has been more evidence of realism recently, even in the frothy crowdfunding space.
Besides job cuts and hiring freezes, I’m seeing cap table restructuring and the like. This may involve tidying up the crowdfunded investors into less unwieldy or onerous structures.
Doing so could make it easier to raise money in the future from professional investors. It can also cut management cost and hassle by easing communication and decision making.
I suppose there will be cases where small investors give up rights in these restructurings, and it comes back to bite us.
But overall I think it’s a sign that the better management teams are getting their ducks in a line.
Another option some start-ups are pursuing are so-called Convertible rounds.
This article is long enough already, so I won’t go into the mechanics here.
But to over-simplify it’s a way of raising money today without establishing a new valuation. Instead investors get a potential discount on a future conventional raise. (The exact terms vary widely).
Convertibles are appealing to founders and shareholders in a weak market, because they sidestep the drawbacks of a down round.
But there’s a Wiley Coyote running off the cliff element to them.
The convertible has a limited amount of time to, well, convert. At that point money handed over by investors becomes equity. It’s a moment of truth where a valuation is established.
Perhaps the climate for fund raising will look better in six to 12 months. But at the moment it seems to me more likely to be worse.
Inflation is still running rampant, roiling share prices, and increasing the odds for more near-term interest rate hikes – even despite a shifting consensus towards a recession as a consequence.
Don’t fool yourself
Of course much of this gloom depends on whether you believe what the public markets have been saying about valuations for the past year.
If you think the stock market sell-off of growth companies is overdone, maybe you can be more optimistic about unlisted company valuations too.
And the turmoil certainly throws up opportunities, as ever.
For instance last month I was able to grab shares in the fintech investment trust Augmentum, which had briefly plunged far below NAV despite a very cash-heavy portfolio.
And as crowdfunded valuations are adjusted down, more attractive options will emerge there, too.
But right now I am more cautious and pessimistic about private valuations than public ones, for all the reasons we’ve discussed above.
Indeed I’ve applied an additional discount to how I value my existing crowdfunded investments.
This is the opposite of what a professional VC fund would do, as I’ve noted.
And at the other extreme, I know even some readers who crowdfund and angel invest themselves who assume their investments are worthless until they see an exit for cash.
But I’m only answerable to myself.
I don’t see the point of self-delusion by pretending I own assets valued at more than they’re worth.
Equally, I don’t believe they are worthless. (Not least because of the tax benefits.)
I’ll run through this markdown in a future post. Subscribe if you’re interested to ensure you see it!
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- That is, its valuation at least doubles and possibly many times more than that [↩]