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Wed,Dec022015.0235AMIST

Makingsenseofhyperfundedstartupvaluations
KashyapDeorahtriestodecodethecrypticalvaluationdynamicsofstartupfirms
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Preferredliquidationhasbeenpartofventurecapital(VC)andprivate
equity(PE)investorstermsheetsworldwideforlongerthanthe
Internethasbeenaround.Itgivesinvestorstherighttofirstgettheir
moneybackwithaninterestormultipleincasethecompanyfailsto
delivertheexpectedmultiplesatthetimeofexit.

Atthetimeofinvestment,entrepreneursareaudaciouslyoptimistic
andfocusedontheupside.Investorsareprofessionalmoney
managerspartingwithcashandwanttoprotecttheirdownside.That
seemsfair.However,takentoitsextreme,preferredliquidationcreates
theillusionofanequityinvestmentatinsanevaluationswhilethe
hyperfundedstartupisgettingburiedindebt.Hereshow.

Inthepastfewyears,thisconstructhasbeenturnedonitsheadby
globalfundswritinglargechequestoprivatecompanies.Moneythat
wasearlierfocusedonpublicmarketstocksisnowbeinglenttotech
startupsatprogressivelyearlierstages,givingthemheftyvaluations.
Therearenow162privatecompaniesintheworldvaluedatoverabilliondollars,alsoknownasunicorns.Iamnotaloneintryingtodecode
thisphenomenon.

Lastmonth,inacolumntitledThesubprimeunicornsdonotlookabilliondollars,thelegendarySequoiapartnerMikeMoritzwrote,...agood
number(ofunicorns)seemtheflimsiestofedifices.Forgetthefactthatsomeofthesevaluationsareillusorybecausethemostrecentinvestors
havestructuredtheirinvestmentsasdebtinallbutname,meaningthattheywillstandtoprofitevenifthecompanyisworthfarless.Laterthat
month,IwaschattingwithafriendwhoisapartneratamajorPEfirmconsideringaninvestmentinanIndianstartuplookingtoraiselarge
money.Intheduediligence,hewassurprisedtoseethedebtlikepreferredliquidationstructureburiedunderillusoryvaluations.Preferred
liquidationhasbeenaroundfordecadesnow,Ithought.Sowhatwasdifferentnow?

Finally,thepennydroppedlastweek.IwasintheaudienceduringapanelattheInvestorSummitinDublin,Ireland.ThepanelincludedPhil
Libin,cofounderofoneoftheearlyunicornsEvernoteandnowpartnerataVCfirm,andTomStafford,partnerattheglobalinvestmentfirm
DST,whichisaninvestorinFlipkartandOla.EvernotesLibinexplainedhowfinancialjournalismhasmisunderstoodunicornvaluationsand
largefundingrounds.Asaresult,therearestrongreactionstoheftyvaluations.DSTsStaffordexplainedthatlatestageinvestorscaninvestin
acementfactoryinKenyaandget1015%internalrateofreturn(IRR)ortheycaninvestinatechstartuptargetinganIRRover20%.

Hepickedtheultimateunicorn,Uber,asanexample.WhileUberisvaluedat$51billion,ithasraisedabout$5billion.IfUberexitsatanything
over$5billion,theinvestorsarewholeandsecureduetoliquidationpreference.Anythingabovethatisupside.Latestageinvestorsarenot
stupid.DoanyofusthinkUberisnotgoingtobeworth$5billionatexit?heasked.Ifthecapitalisreasonablyprotected,andyouhavea
chanceofmakingover20%IRRonalargebase,itisagoodbet.Thevaluationnumbersdonotmatter.

Forthefirsttime,itoccurredtomethatraisinglargeamountsofmoneywithpreferredliquidationislikedrawingaloansecuredwiththeentire
companyascollateral.Asforvaluations,thehigherthatnumber,thetallerthemountainthattheentrepreneurandemployeesneedtoclimbin
ordertorealizethenotionalvalueoftheirholdings.Itisalesserconcernforglobalfunds.

IrememberedtheoldIndiansayingaboutanelephantsteethonesettoshowandanothersettoeat.

Fromtheinvestorsperspective,illusoryvaluationsseemtobetheteeththatappearlargetointimidateotheranimalsinthejungle.Deployed
capitalaretherealteeththatneedtochewoffenoughnourishmentsothattheexitisatavaluationhigherthanthefundingraised.

Nowlookatthe$3.2billioninvestedinFlipkart,$1.9billioninSnapdealand$900millioninOla.AsStaffordsaid,thequestiontoaskis
whetherthesecompaniesgetanexitthatvaluesthemhigherthantheinvestedcapital.Ifso,theglobalfundsaresecure.

Infact,theyareevenmoresecureinthecaseofstartupsthatsurviveonfundingandhavenooptionbuttokeepraisingmore.Globalfunds
haveatieredstructureofliquidationpreferenceswheretheygetthemoneybeforeearlierinvestors.

Thelastinvestorneedstoonlybeconcernedaboutthecompanybeingasvaluableastheinvestmentmadeinthelastround.Whileall
shareholderswantthestartuptoultimatelybevaluedhigherthantheirunicornvaluationsgrantedtothem,ifthingsdonotpanoutthatway,
shareholderswillbehitinthefollowingorder(leastfirst):VCs,angelinvestors,entrepreneurs,employees.

Inotherwords,everyoneisworkingtowardsreturningthelatestageinvestorsmoneyfirst.

Thehigherthegapbetweenthedelusionalvaluationsandtherealityofexitoptions,thelessertheseshareholdersarelikelytovaluetheirown
equityandwouldwanttomaximizeshorttermoutcomes.

IdontknowaboutyoubutthispanelputalotofthingsinperspectiveaboutthehyperfundedIndianscenarioasIsippedonmyfreshpintof
Guinness.

KashyapDeorahistheauthorofTheGoldenTap,theinsidestoryofhyperfundedIndianstartups.Heisaserialentrepreneurwhohasspent
thepast15yearsinIndiaandtheSiliconValley.Duringthistimehehasstartedandsoldthreecompanies.Heisalsoanangelinvestorinover
20companiesinIndiaandtheSiliconValley.DeorahfoundedChalo,apaymentsappwhichwasacquiredbyOpenTablein2013.Priortothat
hefoundedChaupaati,aphonecommercemarketplace,soldtoFutureGroupin2010.HeservedFutureBazaaraspresidentfornearlytwo
years.Hetweetsat@righthalf.