When Is a “Mark” Not a Mark? When It’s a Venture Capital Mark

Scott Kupor

Editor’s note: this article previously appeared as a response to misconceptions about the valuation of private companies.

Valuation in VC land is more of an art than a science. That’s because we aren’t continuously trading in private companies – in contrast to what happens with public companies. So, to some extent, valuation is in the eye of the beholder, and different accounting approaches can yield different carrying valuations for private companies. This post is intended to help demystify private company valuations.

The value of what VCs ultimately distribute to their limited partners (LPs) is deterministic – cash and stock that can be converted into cash – not based on some theoretical model about hypothetical returns in 7-10 years (so-called “marks”). Simply put, you can’t game cash.

A “mark” is a point in time accounting estimate that often varies by firm and does nothing to tell an LP what a company’s ultimate value at exit will be. Cash or stock actually realized and distributed to LPs is the only real, non-manipulable measure of a firm’s interim success.

Venture capital firms and other financial companies are required under Generally Accepted Accounting Principles (GAAP) to “mark to market” the value of their underlying company holdings on a quarterly basis. But, unlike a hedge fund, for example — where the mark is based on the actual, marketable value of a public security — venture capital marks are highly variable based on different valuation methods prescribed by different accounting firms and on a venture capital firm’s qualitative assessment of the likely future prospects for that business. That means for every company in our portfolio, there is likely another venture capital firm invested in the same company that “marks it” at a different valuation.

These are the main “mark” valuation methods used by venture firms:

Last round valuation/waterfall

Some venture firms value their companies by taking the last round company valuation in the private market and assigning that value to the firm’s ownership in that company. For example, if a firm owned 10% of a company and the last round valuation was $200 million, a firm that utilized the last round/waterfall method would report the value of its holdings as $20 million (10%*$200 million).

Comparable company analysis

Other venture firms, particularly for companies that have substantive revenue and/or profits, will use a public-company comparables analysis. In this method, the venture firm will devise a set of public “comparables” — companies that have a similar business model or are in a similar industry — and pick a valuation metric (often a revenue multiple) to reflect how the broader public market values this set of companies. That metric is then assigned to the portfolio’s company’s financials.

For example, if a portfolio company is generating $100 million of revenue and its “comparable” set of companies are valued in the public markets at 5x revenue, a venture firm would then value the company at $500 million ($100 million*5x) and reflect its holdings based on whatever percentage of the company the firm owned. If, as in the above example, the firm owned 10% of the company, it would value its holdings at $50 million ($500 million*10%). Often, a firm will then also apply what’s known as a “DLOM” (a discount for lack of marketability) to reduce the carrying value of the company. Basically, this discount says that because the stock is private and can’t be freely traded, it’s worth less than that set of comparable public companies. DLOM’s of at least 20-30% are common; in this case, a DLOM of 30% would reduce the carrying value to $35 million ($50 million*(1-30%)).

Option pricing model (OPM)

This tool in the valuation toolset is the most complicated mathematically and the newest addition to the venture capital valuation ranks – in fact, we use a third-party software tool to help us utilize it.

OPM uses Black-Scholes to value a portfolio company as a set of “call options” whose “strike prices” are the different valuation points at which employee options and preferred shares all convert into common stock.

Perfectly clear, right? Of course – even though OPM valuations may or may not relate at all to waterfall or comparable company valuations!

Here’s a quick example: if our hypothetical company raises a Series C financing at $5.00 per share, the OPM says that all we know for certain is that anyone who holds Series C shares should value them at $5 … simple enough. But, if you own a Series B or a Series A share, the OPM says those are worth some fraction of $5 – why? Well, to really answer that question you’d need to have a Nobel Prize in economics (like Myron Scholes, the co-inventor of Black Scholes), but the not-too-mathematical answer the OPM generates is that those Series A or B shares could be worth many different values based upon a series of probabilistic outcomes if/when the company ultimately gets sold or goes public. So OPM will assign a value to the Series A and B that is a substantial discount to the $5 per share price assigned to the Series C. And then to calculate the value of the whole company, it adds these up.

OK, so then what?

In addition to the different methods above, many firms may combine them and assign different weights to the different methods, ending up with a compatibility matrix of valuation methods that is longer than a typical Chinese restaurant menu.

Let’s look at an example to see how all this impacts marks.

Assume a private company has recently raised capital from investors at a $3.8 billion valuation. Let’s also assume, only for the sake of illustration, that we own about 10% of the company and invested $10 million for that stake.

How could we then “mark” the company based on the differing methods described above?

  • Last round valuation/waterfall — under this method, the value of the company would be $380 million (10%*$3.8 billion). So, on an investment of $10m that is a 38x hypothetical return.
  • Comparable company analysis — this one is tough given the fact that our company (and its growth rate) are not really “comparable” to any set of public companies. But, again using only public data, let’s assume that the company had annual recurring revenue (ARR) of $64 million at the end of the previous year. To make the calculations simple here, assume that the company is growing at 100%, so investors making an investment this year would be forecasting an ARR of $130+ million for that year. Looking at high growth multiples in the public markets, investors might assign a multiple of 10-15x on that ARR, resulting in a $1.3–$2 billion value for the company. If we took the high end of this range to mark the company, we would hold it at $200 million (10%*$2 billion), or a hypothetical return of 20x — which is good, but not as great as the 38x above. And that’s without assigning a DLOM to it.
  • OPM — You’ll have to trust me on this one, since the math does not easily lend itself to a paragraph summary (recall that we purchased a software tool to help us)! But, an OPM with reasonable assumptions on time to exit and volatility would yield about a 16x mark for the company. Very different from 38x and even 20x.

So, which accounting methodology is right?

They are all theoretically “right” in that different accounting firms would likely sign off on each of these as consistent with GAAP. But, at the same time, they are all “wrong” in that none actually tells LPs anything about what this company would ultimately be worth to the fund if it goes public or gets sold and the proceeds of those events are distributed back to LPs.

Here’s some more context to really understand VC valuations:

First, this is such a significant issue in our world that at least half of the conversations we have with our LPs is comparing our unrealized “marks” to those of other venture firms who have the same company in their portfolio. None of the benchmarking firms in the industry adjust valuations based on the differing methods used by firms, so any comparison of results is inherently apples-to-oranges.

Second, “marks” are just that: They reflect theoretical, unrealized gains as of a single point in time. As one of our LPs consistently says, “I can’t spend unrealized gains.” The only thing that matters in this business are actual, realized, and distributed returns to LPs — which is why Sequoia Capital, one of the most respected venture capital firms, specifically tells its LPs to ignore unrealized gains and focus only on the cost of the investments and the actual gains distributed to LPs.

Third, venture capital is a business with a long-gestation period, more aptly depicted by what is known as the “J curve.” That is, returns in the early years of a fund are decidedly negative — because as a firm you are investing money (and thus calling capital from your LPs) in young, immature companies that may not get sold or go public for 10 years from the time of initial investment. In the harvesting phase of a venture capital fund (generally years 7+), cash flow to LPs in the form of realized distributions should be more than positive to make up for all of the early years’ investments. As the time to exit for many private companies continues to elongate – in many cases to 10+ years — the inflection point on the J curve has and may continue to push even further out.

Venture capital is a long game. Calling the outcome on funds that are less than 5 years old, where many of the portfolio companies haven’t even shipped their products, based on non-uniform, point-in-time valuation metrics, is like reporting the Super Bowl winner based on the result of pre-season NFL games or even training camp scrimmages. At best, it’s off the mark.