In the United States, there are more and more startups that become extremely valuable, especially in the Tech sector. When these startups are worth more than a billion, they get Unicorn status, because this is so rare and almost impossible. In 2013, Tech Crunch, a major American online Tech magazine, wrote that there were 39 super startups that belonged to the club of Unicorns. In the previous ten years, an average of four startups were added every year. Since then, the speed at which these companies are created has increased extremely. Last year, there was even a record number of 151 new Unicorns. The Tech Crunch meter currently stands at 452 Unicorns. In this blog, I explain how this is caused by what Venture Capital investors call the Spray and Pray method, so you know the risks involved in investing in startups.
How does Venture Capital work?
Venture Capital investors invest large amounts of money in young and new companies. These investments carry high risks. Yet this form of investment is very valuable to society. After all, the investors invest in companies that are not yet able to go to a bank and often need too much money to borrow from friends and family.
However, the underlying reason for these investments is different than what most people think. Venture Capital money is meant to help a company get started and grow quickly. As soon as the company is big enough to continue on its own and raise money through, for example, an Initial Public Offering (IPO), these investors sell their stake so they have money for the next round. The funny thing about this model is that these parties are not focused on a positive business result or profit, but on the valuation of the shares. After all, this is how they recoup the money in an IPO. They do not stay long enough in a company to earn back the investment with a profit. Especially when you calculate that many startups don't make it, losing the investment entirely. Profit is absolutely the best but not necessary.
Maximizing share values is the most important thing. For Venture Capital companies, it does not matter whether these valuations are justified. The primary goal is for the startups to become more valuable.
How to artificially increase a valuation
Like I said, it's all about the valuation. It sounds strange, but this can be artificially increased. This is because investors re-determine the valuation of a company with each new investment round. So it could be that a loss-making company like Uber is still worth between 80 and 120 billion dollars. Or that Hubspot, whose losses rose faster than its revenue, was still able to make a $2 billion IPO. The investors say they are willing to invest for that value, and so that is a fact. Who pays, decides.
Of course, this does come with risks. What if, six months before an IPO, you invest 100 million dollars at a valuation of 2 billion dollars, only to see the value of the company at the IPO drop to 1.6 billion dollars? Suddenly your investment is worth 20% less. That's not why you do it, of course. Meanwhile, solutions have been found for these practices. Often, investors receive additional securities in later rounds in exchange for the higher valuation.
For example, it can be agreed that an investor who makes a substantial investment at a late stage can demand compensation in the form of additional shares if the company's valuation falls during an IPO. Sometimes investors even demand compensation of at least 20% above the original investment. A guaranteed return of 20% on such a mega-investment, not bad.
Why would a founder want this?
Of course it is nice for founders to have a higher valuation for their company. After all, this means they have to be less diluted when raising money. Dilution means that your percentage of the total number of shares is reduced by issuing new or extra shares. If you have 200 shares out of a total of 1000, that is 20%. If you then want to raise 1 million euro and you sell 100 new shares for it, you keep 200 shares. However, these are 200 of the 1,100 shares. Your stake is thus reduced to 18.18%. At a higher valuation, you would, for example, only have to sell 50 shares for the same investment of 1 million euros, leaving you with an interest of 19.05%, namely 200 of the total 1050 shares. If a company is going to make tens or even hundreds of millions in profit, a percentage point like that can make a considerable difference.
However, for the same reason, it is not nice if you are diluted further afterwards, because the valuation at the IPO is lower after all. There is a solution for this too. Unicorns need a lot of money to grow. For that reason they often have multiple funding rounds. For these Unicorns that are not yet making a profit, founders often cash out in one of the last financing rounds before the IPO. They use this round to secure a portion of the money. Take Groupon, which invested 1.1 billion dollars in the last round before the IPO. Of this, $946 million went to the existing shareholders including the founders. They then sold (part of) their shares to these investors. This meant that they too were safe, along with the investors.
But what does it matter?
The question is, of course, what difference it makes. However, there are also people who suffer from this. In America, and increasingly in Europe, it is normal to pay part of the salary of employees of start-ups in share options. This means that they not only receive a salary, but also the opportunity to buy shares at a later stage at a pre-agreed price. When they sell them, they are left with the difference as a kind of addition to their salary or bonus, depending on the level of the latest value. However, their cash salary is kept extremely low by this arrangement.
These options are given to the employees at the last valuation of the company at the moment they started working there. So if an employee joins when the company is worth the equivalent of 10 euros per share and receives 2,000 options, he can buy these shares for 20,000 euros. If he does that when the same share is worth 40 euros after an IPO, then the investment of 20,000 euros is suddenly worth 80,000 euros. That is of course a nice profit.
However, what often happens with the above schemes is that the shares don't come out that high at all. Perhaps they do not even reach the minimum threshold for the investor, who then gets extra shares and the employee's interest is further diluted. Or even worse, the value of a share drops below 10 euros. Then such an option is underwater. Cashing in the option is no longer useful. In fact, the employee has worked so cheaply for nothing.
Are there any other people potentially affected?
However, even more people could suffer from this. Those who buy up the shares after such an IPO are often people who have little or no experience with investing. and have not read the information memorandum (the information memorandum is a document containing information about the company that is making an IPO. This information is needed to determine whether the investment makes sense). These people see a fast growing company with huge sales and think that the company is profitable because the sales are large. Unfortunately, this is often not the case, or the profit only comes years later. In that case, the new investor (the one with little or no experience) invests in the hope that someone else comes along who is willing to pay more for the same share. So it is a gamble. However, it does not feel that way because experienced investors have invested large sums of money in the company. These new investors think they are making a safe investment.
Are there no rules for determining the value of a company?
Of course, there are many ways to value a company. These methods often have wonderful names and abbreviations, such as the Discounted Cash Flow(DCF) method, which looks at the future free cash flow. A simple method can also be used, such as a multiplier on the EBITDA or turnover. But when a company makes losses of hundreds of millions or even billions, sometimes even with losses higher than the turnover itself. Or even companies with no turnover, you can let the market determine the value. In short, what the market will pay for it. Thereby it can happen what was described in the previous paragraph: that a next investor comes along who is willing to pay more.
Venture Capital companies combine this with making as many investments as possible. In doing so, they hope to invest in the one company that makes it. Venture Capital houses call this "Spray and Pray": spread as much money as possible at as many companies as possible and pray that one of them will make it all back for you. Governments assume that the parties and investors who buy shares on the stock market know what they are doing. Therefore it is perfectly legal. Whether it is morally right, however, matters less to these parties and investors.
Should you be doing something with this?
Stay critical when you invest. Don't blindly follow the hypemachine that these companies call the marketing department. Of course, there are plenty of stories of people who have become millionaires by investing in young companies. However, these are often people who got in at one of the stages before the IPO and then got "lucky" that the companies they chose actually became successful. Unfortunately, most of the profits from companies making an IPO are often already forgiven to Venture Capital firms that got there in time.
Make no mistake: making money investing is absolutely still possible. I therefore hope that through this blog you've learned more about what's involved in investing. This way you can research your next investment with the right knowledge or when you get offered an option package at a job in exchange for a lower salary you know what this means.
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