Startup Values and Financial Marxism
Yesterday the Wall Street Journal wrote an article about how venture capital firm Andreessen Horowitz has returns that are pretty good, but not as good as some other venture capital firms. Andreessen Horowitz's Scott Kupor wrote a response that is basically: well, depends on how you count.
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.
Some people value private companies using what Kupor calls a "last round valuation/waterfall" method, which basically says: If I own 10 percent of a company that just raised a financing round at a $4 billion valuation, then my stake is worth $400 million. Others use an "option pricing model," which starts from the fact that startups tend to raise successive financing rounds in the form of convertible preferred stock with successively higher liquidation preferences. So later rounds are senior to earlier rounds in the capital structure -- they'll get back more money if the company fails -- and the headline valuation of a later round only really applies to the securities sold in that round. So if a company just raised a $400 million Series C convertible preferred at a $4 billion valuation (and with a $400 million liquidation preference), you can go ahead and value that Series C at $400 million. But someone who owns 10 percent of the company in the form of common stock (or Series A preferred with a low liquidation preference) can't just mark her common stock at $400 million. If the company is sold today at $4 billion, sure, she'll get back $400 million. But if it's sold tomorrow at $500 million, the Series C will get paid its $400 million first, and the common shareholder will have to divide the remaining $100 million with the holders of the other 80 percent of the company.
You can sort of math out the different values using a Black-Scholes-based formula, and that's what Andreessen Horowitz does. Which produces a lower valuation for its early-stage investments in successful private companies than would just looking at the headline valuations of those companies. Kupor suggests that some of Andreessen Horowitz's competitors use different methods that make their returns look better.
But there are two more general points here. One is that, when a startup raises a $400 million Series C round at a $4 billion valuation, its own venture capital investors don't think it's worth $4 billion. The buyers of that Series C aren't paying $400 million for a 10 percent stake of the company: They're paying $400 million for a 10 percent stake plus a $400 million senior claim in a downside case. And a Series A shareholder with 10 percent of the company isn't marking its stake at $400 million: Its option pricing model is telling it that the stake is worth less, because it is not as senior as the new money. And since the new money is only a fraction of the total, that means that the company as a whole is worth much less than the headline valuation.
This is pretty well-known, but it bears repeating. Kupor's post hints that Slack, which recently raised money at a $3.8 billion valuation, might "actually" be worth more like $1.6 billion, by Andreessen Horowitz's math.
Another point has to do with how the "option pricing model" is calculated. Frankly I have no idea, and I am a little suspicious of Black-Scholes-ing out values on a non-traded asset. But at a broad conceptual level, if a startup goes public at twice its most recent private valuation, the differences in liquidation preference don't matter; if it goes public at half that valuation, the differences matter a lot. The relative likelihood of those events should affect your valuation. In a world where all startups always do initial public offerings at prices way above their last private round -- or even in a world where all startups either do that or disappear at zero valuations -- the liquidation preferences don't matter, and Series A and Series C shares should be worth the same. In a world where the probability of down rounds, and down-round IPOs, is very high, Series C shares should be worth significantly more than Series A shares, and the gap between last-round headline valuations and "actual" valuations should be wide.
I have not seen Andreessen Horowitz's numbers. But if I were one of their investors, I would be interested in the size of that gap, and how -- if at all -- it's changed over time. A couple of years ago, in the heat of the unicorn boom, did the model think that prices only went up, and so treat early and later rounds as interchangeable? And now, as people worry more about unicorns, has the gap widened?
Index funds and communism.
Vanguard Group celebrated the 40th birthday of indexing by attracting $200 billion of new money so far this year, "putting the investment group on track to smash last year’s record inflows and underscoring the big shift towards passive asset management." And about a third of that is into active funds, making Vanguard "one of the few asset managers to have actively managed funds that are also enjoying substantial inflows." I mused yesterday about indexing as a sort of loss leader for the financial industry, luring people to trust their money to Wall Street. It certainly seems to work for Vanguard.
Elsewhere in indexing, here is Cliff Asness at Bloomberg View on that Sanford Bernstein "Worse Than Marxism" note that we talked about last week. Like me, Asness isn't too worried about index funds, though for different reasons. His key point is that indexing's "free riding" problem isn't a problem: "Rather, the use of price signals by those who played no role in setting them may be capitalism's most important feature."
Speaking of the existential struggle between capitalist and communist systems, here is a strange post on the Bank of England's staff blog about asset managers and mutually assured destruction. ("What do the Cold War powers of the United States and the USSR have in common with modern day asset managers? The capacity for mutually assured destruction.") The post is kind of ... about bond market liquidity? But between this, and index-funds-as-Marxism, and a research note about "Mars, communism, fascism or war," it feels like the last couple of weeks have been big for communism references in finance. It is August, though, and I expect that Labor Day will put an ironic stop to it.
Here is a story about how Citadel has done a great job of breaking into index credit-default swap trading. Since the Volcker Rule was just a glimmer in Paul Volcker's eye, I have wondered when hedge funds and smaller independent investment banks would take over some of the market making businesses that regulation has made difficult for banks. The answer seems to be now. Or maybe "too late":
In some respects, Citadel’s recent success has been a little like crashing a house party after the police have already busted it up.
Global banking rules intended to make the financial system safer have caused a retreat from the market in recent years. The total size of the credit-default swap market has shrunk to $12 trillion from $34 trillion in October 2008, according to DTCC data.
Broadly speaking, two things make it hard for newcomers to break into a financial market dominated by big banks. One is market structure: If people trade by calling their salespeople at the same three banks, it's hard to get on their speed dial; if people trade by going to an exchange, it's much easier to get a spot on the exchange. Much of the Citadel story is about its bitterly contested fight for more transparency, central clearing, electronic execution, etc. in the CDS market.
The other thing is balance sheet. Big banks have so much money. This has not stopped Citadel and other high-frequency trading firms from taking a lot of business from them in the stock market, because it turns out you don't need that much money to trade a whole lot of stocks. (You just have to sell them quickly.) Traditionally, you need a lot of money to make markets in bonds or CDS, because you tend to hold on to them for a while. Central clearing of CDS helps with that problem, but even more helpful has just been a regulatory environment that negates the banks' cash advantage. For all their money, banks can't afford to hold on to trades any more than Citadel can.
Elsewhere, U.S. implementation of new uncleared swap margin rules is a bit of a mess. The Commodity Futures Trading Commission yesterday delayed the implementation deadline by a month, "due to certain practical and technical limitations." And here is a statement from CFTC Commissioner J. Christopher Giancarlo saying that the U.S.'s failure to delay the rules longer -- as most of the rest of the world has done -- "leave U.S. regulators going it mostly alone to the detriment of American financial firms, their employees and the American businesses they serve." On the other hand: "U.S. Unseats U.K. as Global Center for Rates Derivatives Trading."
Here is "A Plea for Plain English in Financial Documents." As a connoisseur of bad financial writing, I am not sure I am on board. You see these things every so often and I never know what to make of them. This plea is short and brisk, but it devotes one of its 33 sentences to a question about the serial comma debate. "We need to stop writing solely for lawyers and professional investors," say the authors, but financial documents are not difficult for amateurs to understand because of the commas. If I tell you that a startup's latest funding round doesn't really value it at $3.8 billion because a Black-Scholes-based option pricing model that takes into account the liquidation preference of the Series C preferred will calculate a lower value for the common stock and Series A that make up much of the capital structure, you will either know what I'm talking about or you won't, and if you don't, I could fill the rest of this screen with commas and it won't make a bit of difference. And if I instead just said "it could be worth more than $3.8 billion, or less, or the same, but it's really complicated," then something is lost in the translation.
The authors also dislike the phrase "Notwithstanding anything to the contrary contained herein." Everyone dislikes that phrase! It's terrible. But it's not a vocabulary problem. None of those words are actually hard to understand. The problem is conceptual: If you write "notwithstanding anything to the contrary contained herein, X," then that means that you suspect that somewhere in your document you have said or implied Not X, and you can't be bothered to find and correct it. It means that the structure of whatever you're doing got away from you. You can fix the vocabulary problem by saying "Never mind what we say anywhere else: X." But you have not solved the conceptual problem with your "plain English."
I do not want to overstate the complexity of finance, but at the same time there is some actual complexity. The advantage that professional investors have over the general public is not that they know more words, but that they know how companies work. The idea that financial documents will be clear to everyone as long as we use shorter sentences and smaller words seems to fundamentally misunderstand not just the nature of finance but the nature of complexity itself.
The New York Times and the Financial Times have articles about a recent study finding that unwritten dress codes tend to keep candidates from less-privileged backgrounds out of jobs in British banking.
One executive quoted in the survey said students from non-privileged backgrounds often had the wrong hair cut or were wearing an oversized suit. “They don’t know which tie to wear,” the executive said.
As a form of socioeconomic bias, this seems bad, but at the same time there seems to be a bit of a misunderstanding of what the banking industry is. Look:
“He looked at me and said: ‘See that tie you’re wearing? It’s too loud. Like you can’t wear that tie with the suit that you’re wearing,’ ” the unidentified candidate is quoted in the report as saying. “What kind of industry is this where I can be told that I’m a good candidate, I’m sharp, but I’m not polished enough?”
The sales kind of industry! That's the kind of industry that it is! Because the investment banking industry sucks up so many graduates of top universities, people develop the mistaken impression that it is a meritocracy of pure intellect, where banks compete to hire the smartest people and where intelligence is the key to success. And, look, it helps not to be dumb. But the basic role of an investment banker is to hang out with rich executives, play golf, reminisce about your days rowing on the Cam, and get them to hire you to advise them on a merger. It is a job of relationships and connections and social skills, as much as it is a job of quantitative analysis. You can see how people in an industry built on upper-class chumminess would tend to recruit their upper-class chums.
Obviously this is a failing of the industry, and many banks express -- and some actually have -- a preference for "poor but hungry" recruits, and it is much easier to get an analyst a new tie than it is to teach him good valuation instincts. But it is a problem with a broader context, and one piece of the context is that you really should wear a nice tie to a merger bake-off. Another piece of the context is that the report "made no mention of dress codes for women, saying: 'Where issues relating to dress were raised by interviewees, it was almost always in relation to male business attire, underlining the strong association between investment banking and masculinity.'"
Elsewhere in banking culture, here is an article about how an investment banker actually took a month and a half of paternity leave, some of it "at a rented villa in Bali."
Here is a Securities and Exchange Commission enforcement action accusing a lawyer of "defrauding professional athletes and other investors out of millions of dollars, much of which he spent on his girlfriend and to cover personal expenses like alimony, past due taxes and credit card bills." It is pretty standard stuff -- alleged misrepresentations about an investment opportunity that was about to take off, alleged misappropriation of the investments -- though it gains some glamor from the fact that he got million-dollar investments from both an NBA and an NFL player. But my favorite part is what the allegedly fraudulent business, Masada Resource Group, did:
Masada is a company that purportedly owns certain patents for technology that supposedly converts organic waste to fuel.
It's a company that converts garbage into energy. In a metaphorical sense, a lot of SEC securities-fraud cases are about people spinning garbage into power. This one is just more literal.
Buy your bonds on Craigslist.
Around here we talk occasionally, reluctantly, about Jacob Wohl, the teen trading phenomenon who has been harassed by thuggish regulators for putting out marketing materials that perhaps do not meet those regulators' standards in every particular. Anyway his current venture is called Montgomery Assets. Here is a Craigslist ad, purportedly from Montgomery Assets, for "a limited $25M offering of high yield notes to investors looking for a safe, secure and conservative investment without the wild up and down swings and dangerous volatility of the stock and bond market." I don't know if it's real, or what "real" would even mean in this context, but I have never before seen a securities offering on Craigslist, and that seems worth sharing.
People are worried about unicorns.
I mean, see the thing about startup valuations, supra. But also: "Good Technology Investors Sue J.P. Morgan, Claiming Conflicts." My view about unicorns is that they have essentially replicated many of the most desirable elements of going public, without actually going public. But Good, at least, has also replicated some of the less exciting elements of going public, like lawsuits over mergers that shareholders are unhappy with.
People are worried about bond market liquidity.
I mean, see the thing about Citadel, supra. But also here is the latest Treasury Notes blog post about bond market structure, this one about "Changes in Non-Residential Asset-Backed Securities Markets."
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