Public Vs. Private Tech Valuations: What's Driving the Divide?

It is not uncommon to see private companies valued as high as 100 times revenue in late-stage funding. Unicorns, which have become synonymous with tech companies valued over $1 billion, are now receiving blowback after the former Silicon Valley darlings lost their luster on the public market. Just this past year, a number of companies and boundless unicorns saw their values slashed leading up to going public. Before its IPO, Square Inc. (SQ Square Inc 36.89 +2.27% ) was valued in the private market around $6 billion. As we know, the payment company IPO’d at slightly more than half its private value and has watched the stock plunge over 20% in its relatively short existence. Unfortunately, determining value can be difficult with the recent glut of hyper growth start-ups. A valuation for a private or public company follows similar mathematical procedures, but private companies often do not disclose key financial information. That said, the mind-boggling valuations over the past five years are more indicative of the markets than the true value of the company itself.

The Process of Valuing Companies

Many of the techniques used to value private companies are not that different from those used for public companies. The simplest methods of valuing a private company are comparable company analysis and estimate discounted cash flow. Comparable company analysis uses actual transaction multiples and premiums paid in comparable transactions to value target private company. This approach observes transactions with similar attributes such as, industry group, recent timing, business offerings, and capital structure. That said, precedent transactions are rarely directly comparable to the true value of a target company. Since value is not always tied to revenue, comparable analysis will often fail to incorporate other key metrics Taking comparable analysis one step further, investors often make valuations based on discounted future cash flow. The first and most important step in estimating future cash flow is estimating revenue growth. For private companies in early stage funding, it can be difficult to make an accurate estimate of future revenue.

Typically, over valuations in the private market occur at the earliest stage of a company’s existence. Uber, for example, has been deemed to have high potential revenue growth and is now valued over $60 billion despite reportedly losing millions of dollars per year. Besides revenue multiples, a cash flow model will look at EBITDA to evaluate a company’s profitability. In the first few years of a startup’s existence, it will often lose money as they attempt to reconcile debt. As a result, EBITDA becomes an attractive metric since it masks costs and is thought to be indicative of profitability.

Where’s the Divide?

Since public and private valuations follow the same mathematical procedures, there is a fundamental discrepancy on why companies fall flat when they hit the public market. Private company valuations are often discounted based on several risk factors pertaining to the private sector, which reflects marked difference from publicly traded corporations. Public company financial statements are officially audited and overseen by official regulators where private firms are not accountable to a regulating organization. Moreover, private companies do not report to shareholders and haven’t managed its operations in the shareholder's best interest. Sometimes, private companies will manipulate its financial statements to show lower profits, which effectively minimize tax liabilities. As a result, a firm’s historical financial information can lead to a stark undervaluation when compared to a public company. However, more often than not, private company valuations are bloated to reflect high potential revenue growth. In this case, a valuation multiple is used which simply expresses the market value relative to a key metric, like revenue. For example, a revenue multiple of 10 claims the company is worth ten times its revenue. In the early stages of a hyper-growth startup, it is not abnormal to come across companies valued at 100 times revenue. That said, almost no company has achieved a forward revenue multiple higher than ten times besides Facebook (FB FB Facebook Inc 178.92 0.00% ). Even though venture capitalists and private investors are aware of this, they will still take on unprecedented levels of risk for fear of missing out on the next Facebook. For today’s private companies, there are a number of important factors which help determine revenue multiples. Due to the interconnectedness of the world economy, pre-IPO valuations must measure growth on a global scale. These numbers can grow very large as we now converge to a truly global economy. What this means for a tech company is potential for hundreds of million of users or to investors, potential sources of revenue. One of the most compelling factors private companies show investors are a growing user base. High engagement typically translates into more cash.

The Bottom Line

Far too often, companies will fall flat when they transition from privately held to publicly traded. The recent glut in IPO’s has driven this home as lofty valuations have failed to live up to expectations. Just this past year, Etsy Inc. (ETSY ETSY Etsy Inc 16.59 +0.55% ), Box Inc. (BOX BOX Box Inc 21.91 -0.95% ) and Square all reported $5 billion plus private valuations, just to plunge in the days leading up to their IPOs. The difference between public and private valuations are evident when evaluating key metrics, including market liquidity, profit measurements, capital structure, risk profile, and operational control amongst several other factors. These gross overvaluations are said to be more indicative of the market than the company itself. That said, many experts have begun to question whether the surge in IPOs is inflating a bubble on the verge of bursting.

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