The third aspect of the valuation of tech companies often misunderstood is private valuations set by venture capitalists and other private investors. This topic was recently explored by @Jessicalessin in this excellent article.

A private company in which a sophisticated investor has bought a minority stake for $X/share is not actually worth $X * total number of shares.

First, the entire company has not traded hands, just a small slice of it. So we don’t actually know what the whole company is worth. Second, most financing rounds are for preferred shares, which have special rights. Other shares don’t have those rights and are worth less. Smart VCs think about startup shares less as stock than as options — options with limited (1x) downside and unlimited (1,000x+) upside.

A share of preferred startup stock ~= A long-dated out-of-the-money call option, paired with a long-dated contingent put option. The contingent put option is the liquidation preference in preferred stock. It increases the odds of getting cash back in a downside sale of the company. Plus, in some high-valuation late-stage rounds, there are additional downside protections like ratchets, which can be highly valuable and preferred stock brings with it governance rights and access to information not available to normal investors. Those have value too.

So you can’t extrapolate the value of an entire company from a minority sale of preferred stock. It’s better just to focus on cash raised. In my view, there is WAY too much discussion of private valuations in tech. Fuzzy numbers matter way less than real company substance.

The best book to read as a followup to this post is Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld.

Source Tweets: 1,2,3,4,5,6,7,8,9,10,11,12,13

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