Where companies go wrong on valuation

Inflated hopes?
Inflated hopes?
Image: AP Photo/Mark Lennihan
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No matter how you look at it, it’s undeniable—2019 is the year of the tech IPO, for better and sometimes for worse.

So far, we have seen companies blow out by overvaluing their shares and by undervaluing them. Getting the price right is a delicate balance. Investors are increasingly skeptical about prices set by companies and want to know exactly why companies are worth the valuation that they say they have achieved. With more high-valued tech companies than ever making their public debut on the Nasdaq, we have witnessed explosive growth and success. We’ve also weathered some notable disappointments.

Take Uber’s highly anticipated IPO this spring, for example. The rideshare giant was initially deemed a failure when expectations of a $120 billion valuation dwindled to $76 billion after the first day of trading, earning the company the worst dollar losses for a US. The Silicon Valley start-up set its value too high for a company that had previously never had to face the scrutiny of public markets. And recently the company announced a $5.2 billion dollar loss for the quarter – a level of loss that doesn’t engender confidence.

And then there’s WeWork—which tried to boldly assert valuation prominence by announcing a $47 billion valuation—only now to postpone its IPO till the end of the year, once questions about its corporate governance and inflated valuation started to surface.

But undervaluation can be just as bad, if not worse. When social media giant Twitter went public in 2013 and underpriced its IPO at $26 a share instead of the $45 that it closed at, they missed out on over a billion dollars—more money than all of the revenue they had earned at that point.

But given the failure of so many recent IPOs, how exactly does a company get its valuation right?

As the founder and CEO of a business development firm that works with innovative technology companies, I encounter many clients whose main goal is to hit their valuation nail on the head.

Here are some things to pay attention to:

Really, really know your market

Market size is a powerful tool that allows you to determine the valuation of your company before you earn a penny. But if you don’t determine it accurately, by the time you go public it can also be your downfall. Within a few days of debuting, Lyft’s shares declined almost 19%—sending its valuation tumbling.

Angry investors sued the ride-share company, kicking them while they were down and claiming that Lyft misled investors and inflated their IPO share price. As part of the evidence brought against the company, investors cited that the company intentionally exaggerated their control of the ride-sharing market share by claiming 39%. Meanwhile Lyft rival Uber said it owned 65% market share. Something didn’t add up.

While whatever actually happened is not entirely clear, the claim became fodder for disappointed investors searching for a way to regain their losses—and it does not a good look for a company that hopes to leave its IPO woes behind in 2020.

Remember that the market looks at context

It’s really that simple. And while privately held companies have control over the market, public companies are viewed under an ever-present microscope, with stocks rising and falling as the wind blows.

Let’s go back to what happened with Lyft: After its stock recovered, it fell once again upon the news of Uber’s IPO. The assumption was that some investors would sell Lyft stock for Uber stock. Every earnings report, new partnership, and shift in the market sentiment can affect the valuation of a public company. Volatility becomes a new factor that influences the company beyond the control of the founders.

Valuation is important—but it can be overrated

Many of my clients want their companies to be unicorns. While I agree with them that a valuation of over $1 billion is desirable, I remind them that it isn’t everything.

For every unicorn that enters the market, there is another extraordinary company with real staying power that may never reach that coveted status. Valuation is just one metric of gauging current and future business success. Also, given the male-dominated culture of Silicon Valley and explicit biases in funding that result from it, we know it may not always be the best metric anyway.

Christina Stembel, the founder of the San Francisco-based floral delivery service Farmgirl Flowers, experienced this firsthand when she had trouble raising funds despite her trailblazing company being highly profitable and boasting a revenue of $23.4 million last year. Stembel pitched almost 100 venture capital firms with no luck, while similar male-led companies with founding teams with tech experience had no trouble obtaining venture capital funding. Last year, just 2.2% of all venture capital funding went to female founders, leaving companies like Farmgirl Flowers, continuing to bootstrap for funds.

The market is less forgiving of loss

Last year, a record 83% of US tech companies went public without making a profit. Don’t let that fool you; making a profit matters. While investors are willing to stake their bets on money-losing companies that they feel will be successful in the future, the public market is much less willing than venture capitalists to indulge companies that yield perpetual losses.

That’s bad news for the Ubers of the world, which not only have multi-million-dollar losses but do not have a successful revenue model that will lead to profitability. Or, as is the case with Uber, have confessed they actually may never turn a profit.

Compare that to Zoom Video, a company that after its first day of trading became more valuable than any other tech company to go public this year. Zoom’s tremendous success was largely due to the company being one of the rare unicorns to reach profitability before its IPO. After all, how bullish can you really be on a stock that isn’t expected to be profitable ever?

Skipping the IPO, or even staying private, is an option

Going public has its risks. While an IPO offers founders a real chance at raising money that can help a business grow, it can be time-consuming, expensive, and invite an unanticipated spotlight. Being publicly traded comes with a slew of disadvantages, including not being able to choose your investors and who you answer to.

And going public won’t necessarily make you rich. If you’re a typical founder who isn’t looking to cash out right away anyway, the difference for you in doing an IPO or not going public at all is actually very little.

If your brand recognition is big enough, you might consider bypassing the traditional IPO route and going straight to direct listing. By doing this, Spotify and Slack both significantly reduced the number of banks and underwriters involved, as well as the amount they had to pay in fees. For comparison, Slack paid $22 million to just three financial advisors—Goldman Sachs, Morgan Stanley, and Allen & Co, compared to Uber, which paid $106 million to at least 29 different banks for a traditional IPO.

If you are a small company with a billion-dollar idea that is still relatively under the radar, you should think strategically about the long term. Is an IPO and going public the best choice for you right now? If the answer is no, remember that there is nothing wrong with being a fortune 500 company, staying privately held, distributing a serious share of profits, and protecting yourself by staying immune from the volatility of the market.