Breaking Down the Mystery of the Start-Up Valuation
We all read the headlines about the latest valuation assigned to a glossy start up or venture backed firm. These valuations are helpful in our understanding of just how large a company may be, but they leave a lot to be imagined for the rest of us about the overall health of a firm. WeWork is a great example, once valued at $47 billion, but as of this publication’s posting, its investors are seeking to delay its IPO because existing investors fear they will not achieve a $20 billion valuation in the public markets.
WeWork’s example is a great illustration of why real estate companies should be weary of venture capital valuations. The Venture Capital Valuation method is not conducted with the same rigor or methodology as is common in public companies, so we feel it is worth reviewing the venture capital valuation method and exploring the implications for commercial real estate companies.
What is the Venture Capital Valuation Method?
Companies that are backed by venture capital often cite two different valuations: pre-money and post-money valuations. A pre-money valuation is the value of a company prior to a pending investment from a venture capital firm. A post-money valuation is the value of a company expected by the venture capital firm after it makes an investment in a start-up
company. Interestingly, the pre-money valuation is dependent on the post money valuation. Let us explain with an example.
When a venture capital firm invests in a company, it has a certain amount of money it is willing to invest and the company will have a certain amount of money it is looking to raise. The company and the venture capital firm will determine a reasonable exit value, and the venture capital firm will have an expected return on investment. The post-money valuation is:
Post-Money Valuation = Exit Value ÷ ROI
Pre-Money Valuation = Post-Money Valuation – Investment Amount
The formulas above assume no dilution of shares and incorporate significant assumptions on behalf of both a company’s management and the venture capitalist. Thus, the valuations are particularly flimsy from any other stakeholders’ perspective.
For comparison, public markets take into account the intrinsic value of future cash flows of a company and perceived risks to forecast a present value of all future cash flows from the business to arrive at a value. That approach still takes into account many assumptions, but it has a significantly more rigorous valuation methodology that means more to the real estate community.
Why should you be skeptical of valuations as a real estate professional?
One of the significant concerns for any commercial real estate professional leasing or acquiring space with venture backed firms is mitigation against credit losses. Investors enjoy in their upside, but commercial real estate firms must protect against the downside. Valuations are subject to ongoing changes in valuation assumptions. This is no more apparent than in our WeWork example. A tenant’s equity or enterprise value is not meaningless to a real estate professional, but it does not signal a tenant’s strength. It simply indicates what a company is worth to its investors. Landlord’s are effectively lenders, and thus should be more focused on credit risk, and there is not necessarily a direct correlation between equity or enterprise value and credit risk.
Reach out to TRA if you have questions about a venture backed tenant that keeps you up at night. We can highlight the risks and help you secure the lease with dynamic security structures that protect you against the unique risks these companies pose.