From darlings to dogs? Venture equity valuations in the current market
Opinion 5 minute read

From darlings to dogs? Venture equity valuations in the current market

23 January 2023

In the first of a two part series, TMF Group’s Director of Valuation Services examines the challenges of valuing equity markets after a difficult year.

Valuation of privately held investments can be a difficult proposition, though in recent years market forces  simplified matters. That’s because up until the end of 2021 public equity markets generally went in one direction…up. Valuations in the private market followed suit. Marking shares to the most recent round of financing was a simple and often supportable valuation approach.

However, the significant declines in public equity markets suggest that this time things are different. Funds that previously did valuations inhouse may find that their processes and approaches are ill-equipped to deal with the current market environment. Funds about to engage in the valuation process for the first time may be surprised by the complexities involved. Those that are unprepared are likely to experience pushback from their auditors and, potentially, even delays in financial statement issuance as they work to revise their valuations to comport with generally accepted valuation standards.

The fundamental premise of marking to the recent round is that investors are assigning little value to the liquidation preferences, because they perceive a high probability that all shares will convert. Accordingly, if investors view all preferred shares as effectively common stock, they should be valued accordingly.

When a company raises an up round, particularly one where there is a substantial valuation step-up, the increase in price alone suggests an expectation of conversion and fully-diluted exits. This conclusion and approach were supported by the 2019 AICPA Accounting and Valuation Guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the PE/VC Valuation Guide):

Funds marking their shares to a recent round price, particularly upon an up-round, were unlikely to receive much pushback from auditors.

The bear market last year was particularly acute for venture-backed technology companies, many of which saw values cut by 75% or more. Up to Q4 2022,  PitchBook’s VC Backed IPO Index was down approximately 60%, an indication of how broad-based the pullback has been for previously high-flying recent entrants to the public markets. Unfortunately for venture investors, the bear market has not been exclusive to the public markets.

New data published by PitchBook indicates that the market for later-stage privately-held VC-backed companies were under pressure in 2022. Not only has deal count declined markedly for late-stage financings, but valuations have come down as well. While these declines have not mirrored the public market routs, the average pre-money valuation declined 15% in 2022, and the top decile pre-money valuation declined by 27%.2 Not surprisingly, the pressure is being felt most acutely by the most richly valued companies.

There are many other factors that suggest valuations for high flying later-stage private companies are declining. The number of public exits in 2022 through to the end of Q3 was 70% below the total number of exits in 2021, a gap that was certainly not closed in the fourth quarter. Such a drop in exits suggests that companies are waiting until they can exit at favourable valuations.  Instacart, which raised capital at a $39 billion valuation in early 2021, publicly cut that to $24 billion just one year later, followed by additional reductions to $13 billion and then $10 billion by the end of 2022. It’s also worth noting that the data published by PitchBook does not track the same companies every year. Companies that raised large rounds in 2021 are unlikely to have had to come back to the private markets in 2022, obscuring the extent of the declines in value.

In spite of everything transpiring in the public markets and the market for later-stage VC-backed companies, the picture is slightly better for earlier-stage companies. While deal count continues to be down, the median pre-money valuation for seed-stage companies increased 16% in 2022, from $9.0 to $10.5 million. Similarly, the median pre-money valuation for early-stage companies increased 22%, from $45 million to $55 million. Even top decile seed and early stage pre-money valuations increased in 2022.

The obvious question that arises from this data is why has the market for seed and early-stage companies not followed that of their later-stage peers? Unfortunately, it is only possible to speculate.

One hypothesis would be that early-stage companies have delayed time between financings, allowing them more time to create value. However, the median time between rounds of financing decreased across the board in 2022, quashing that theory as a potential explanation. Another hypothesis is that earlier stage companies are still growing at such a rate that declining valuation multiples are more than offset by increases in revenue, though there is insufficient data to explore this further.

Finally, because of the erosion of the IPO market, investors may prefer to invest in companies with a longer time horizon, such that they are positioned to exit concurrent with an upswing in the market. Were this to be the case, it would shift demand from later-stage to earlier-stage companies and help bolster early-stage valuations. Unfortunately, this is another theory that cannot be tested.
With all of these considerations in mind, venture investors will undoubtedly turn to the implications for valuation at year end, as these will be the first audited financials since the onset of the bear market.

There is little doubt that for 2022, more than many recent years, valuations will be carefully scrutinised by auditors and investors alike, as it is the most subjective and impactful component of VC fund financials.

Funds continuing to mark solely to the most recent round of financing, especially if that financing was done prior to 2022, will be hard pushed to support that conclusion given the public equity markets. LPs may also push back on GPs suggesting that their funds have not diminished in value. Therefore, it will be important to be particularly thoughtful about valuations, to present investors with an accurate estimate of the value of their investments and to avoid delaying issuance of financial statements because of pushback from auditors.

Find out more

TMF Group is your global partner for fund administration services. We offer a full suite of fund administration, investor reporting and special purpose vehicle (SPV) administration services tailored for private equity, real estate, infrastructure, private debt and venture capital managers.

Make an enquiry to find out how TMF Group can help support efficient back office operations for private funds.

Accounting and Valuation Guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. Available from: VitalSource Bookshelf, Association of International Certified Professional Accountants (AICPA), 2019.

Q3 2022 US VC Valuations Report, PitchBook, 2022.

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