EquityZen's Blog On Startups and Their Economics

Running for the Exits: The Great Unicorn Stampede of 2018

Nat Disston | June 14, 2018

We're not yet halfway through 2018 and the year is already being hailed as the return of the IPO. To that end, there were already twice as many IPOs through April 2018 as there were all of 2017 . Some have even gone as far as to say the IPO is "back" (where it went is a topic for another day). Among those firms that experienced exit events were household unicorns such as Spotify, Dropbox, and DocuSign. Those familiar with EquityZen's mission know we are proud to say that over the course of the past five years we have conducted 4000+ transactions in over 100+ companies. Now, with some of those transacted firms exiting, we wanted to discuss what these events mean for EquityZen, our investors, and our overall thesis of allocating investment funds for the private markets.

Before we dive into these exits in a bit more detail, please keep in mind that not all private securities investments will result in an IPO or an acquisition and not all IPOs or acquisitions will lead to positive investment returns. Private securities investments are speculative, illiquid, and carry a high degree of risk, including loss of principal.

With that said, 2018 has been a robust year for IPOs ; excluding SNAP, the average IPO has been over 85% larger in 2018 vs. the same period last year. While this looks like a seemingly boon time for tech companies, we have also seen less-than-glamorous exits via fire-sales or flops post-IPO (who could forget Blue Apron's IPO tailspin? ). In the last 12 months, EquityZen has had 11 portfolio companies exit. Let's take a look at how those investments have performed for us and our investors.

Diversification is the spice of life

First and foremost, the basics. When looking at individual investment returns it is important to remember one of the tenets of Modern Portfolio Theory: diversification . Any individual investment can have an outsized return or loss, but looking across the entire asset class provides a good lens into the strength of the asset class and its value in your portfolio mix. Diversification is one of the reasons EquityZen was founded: to provide private company shareholders and investors a way to diversify their holdings and investments. No longer does an employee at a private tech company need to keep 90% of their net worth tied to an illiquid stock. On the other hand, investors can access a new alternative asset class typically unattainable to individual investors and further diversify their portfolio.

Our asset class is late-stage private technology companies, otherwise known as "pre-IPO." This means that the majority of investment opportunities on our platform are companies that have received institutional financing from late-stage or growth funds and that they typically have an investment horizon of 2-5 years. EquityZen was founded almost exactly 5 years ago. Couple that with a wide IPO window these days and we're lucky to have seen a flurry of exits in the past 12 months. Spoiler alert : not all of these exits have been blockbuster hits. On the bright side, on average our investors have seen very positive returns over the past 12 months, continuing to prove that this is a viable asset class worthy of allocation in your portfolio.

Let's get down to brass tacks, shall we?

In the past year, EquityZen has seen 11 portfolio companies exit: 8 IPOs and 3 acquisitions. As shown in the below graphic, three of these companies have underperformed for us and our investors. The other eight have generally performed well post-IPO or through their acquisition.

*Past performance is no guarantee of future results*

I am keeping the math simple here, as many of our funds invested at various times and price points across these companies, and investors may have sold at varying prices once the publicly traded shares were distributed to them. The weighted average return across these 11 companies would be 107.5% including any fees that EquityZen received. Furthermore, only three of the companies lost money for our investors and these three companies represented just 7% of the transaction volume that exited in the past year. Nearly a 30% failure rate may seem pretty high, but it pales in comparison to the 70% of startups that raise a seed round and go on to either shutter or never experience an exit event.

In the following graph, the trailing twelve-month exit returns are shown for each individual deal conducted in each exited company. Said differently, we had 43 deals across the 11 companies that experienced an exit. The range of returns is in line with what one might expect for aggressive, high-growth tech investing: some investors lost their full commitment (-100%) while others more than tripled their money (200%+). Though certainly not without its share of disappointments, we are incredibly proud to have delivered an overwhelmingly positive return to our investors broadly and to continue to develop this market for all participants.

So what does it all mean?

The data from our first batch of exits appears to give credence to our thesis: there are returns to be had in the private markets that investors may miss out on if focusing entirely on the public markets. And while the returns may not be the home runs that venture capital firms like Lightspeed Ventures and Sequoia hit, we're happy to provide a platform of singles, doubles, and triples for those seeking a more calculated high-risk investment.

This is why EquityZen was started in the first place. We feel strongly that this asset class is an important member of the alternative investment bucket, can help diversify and balance a portfolio, and can provide returns uncorrelated to other markets. The same holds true for our sellers, who have the ability to achieve early liquidity, lock in gains, and further diversify their net worth. With less than half of the year under our belt, we're excited with what's in store for both the public and private markets for the rest of 2018 and beyond.

Special thanks to Ketan Bhalla, Asa Lieberman, and Catherine Klinchuch for research and edits provided for this post.

Why Pre-IPO Liquidity is Important for Employees

Asa Lieberman | May 17, 2018

When Snap Inc. (SNAP) went public in March 2017, the company was valued at over $23B , or $17 per share. While early shareholders watched the stock price quickly rise to a high of $29, they were unable to realize these gains until the IPO Lockup Period expired. For most, those gains slipped away due to poor earnings and increased competition , which caused SNAP to slide below $14 over the course of the 180-day lockup.

An exit event, such as an IPO or acquisition, means access to liquidity for early investors—owners of ~23% of Snap at the time of IPO—who have been waiting upwards of 5-10 years to reap the rewards of their commitment. However, another important constituency—the company’s employees—is faced with a financial false-start, having to wait yet another stretch of time to have finally get the liquidity for their stock-based compensation . In this post, we'll look at why pre-IPO secondaries provide a smart solution for both early employees and the companies that the shares relate to.

The majority-minority: employee ownership

Startups rely heavily on equity compensation to align incentives between employees and the company. Typically, Equity Incentive Plans will be structured to provide some mix of Restricted Stock Units (RSUs), which vest over time, and Incentive Stock Options (ISOs), which allow employees to purchase shares for a predetermined price.

Continuing our Snap example: over 200 million shares and options were set aside through Snap’s Equity Incentive Plans for roughly 1,900 Snap Employees. Some quick arithmetic reveals that employees own somewhere between 16% – 20% of the company, depending on the number of shares vested and options exercised. This proportion of employee ownership is in line with industry standards, as venture capitalists typically push for 10 – 20% of equity to be set aside in an employee option pool when funding private companies.

Equity Incentive Plans (aka how Silicon Valley retains talent)

Though seemingly an eternity ago, Snap once boasted the highest value per employee among tech companies, as highlighted by Forbes . Remarkably, Snap was able to boast a $16B market cap with just slightly greater than 300 employees. For reference, Snap now has nearly 10x the employees… and a lower market cap (13.5B as of 5.16.18 according to Yahoo! Finance).

(Source: LinkedIn, Company Filings, Yahoo! Finance)

Snap also famously developed a reputation for offering generous equity incentives to attract top talent. During 2016, the company granted 104 million Class A shares to employees at an average fair value of $15.87. However, it is likely only a handful of early employees were able to realize million dollar gains when their shares became liquid in the 2017 IPO, due to the structure of the company’s Equity Incentive plans.

The majority of equity compensation offered to Snap’s employees was in the form of RSUs, which follow a 10-20-30-40 vesting schedule, meaning that the 1,859 employees hired in 2016 will likely only have vested 10% of their equity. Those employees, while potentially discouraged by the decline in stock price since IPO, will be incentivized to stick around until the remainder of their equity vests and the share price rises again.

In the Snap example and in general, earlier employees who have vested a greater portion of their RSUs are granted their first opportunity to sell with an IPO, and as such, are a greater concern for the company’s performance going forward. While sophisticated investors may be able to take long time horizons for an investment to pay off, employees are more likely to delay significant life events until their equity becomes liquid. As a result, early employees are the shareholders who are most likely to want to take money off the table, even if they may be reluctant at a depressed share price.

How secondaries save the day

If equity compensation is intended to incentivize top talent, Snap may be guilty of indulging in too much of a good thing . According to an article published in Harvard Business Review, there is such a thing and over-exposure to one company’s equity can hamper performance.

Secondaries, particularly in pre-IPO companies, create liquidity in private markets, which in turn allows early employees to convert some of their holdings to cash, alleviating financial pressures and enabling them to focus on the company’s goals. Depending on demand, Snap shares vested in 2016 would likely sell nearer to the $15.36 price paid by investors in May 2016, a ~15% premium above the post-lock-up stock price before taking into consideration the time value of money (not to mention an even more significant premium against the ~$10 share price now in May 2018).

Though largely dependent on a company’s vesting schedule, it is generally safe to assume that the largest portion of equity available for sale will be held by early employees, many (if not all) of whom are the most senior staff. An IPO represents the first opportunity for many of those employees to liquidate their holdings, and the volume that reaches the market is an important signal for investors evaluating the longevity of a given company. Pre-IPO secondaries solve the issue two-fold: early employees can lock in the value of their equity grants before a massive, highly-volatile banner event, and companies can be relieved of the pressure that early employee sell-offs might cause.

As always, check out other posts on our EZ Meditations Blog to learn more about the private markets, employee equity, and more. Special thanks to Charlie Joyce for much of the research used in this piece.


EquityZen's 2018 IPO Outlook — Q2 Update

Catherine Klinchuch | May 10, 2018

At the beginning of this year, 2018, our Research team put together a 2018 IPO Outlook report that outlined the private companies most likely to go public throughout the course of the year. With a third of the year in the books, 2018 has already been crowned the champion of the IPO, singlehandedly bringing the IPO market "back." Here, our Research team provides an update.

Our Q2 2018 IPO Update includes fresh observations and predictions to supplement our previously-published 2018 IPO Outlook . Here, we take a look at the IPO environment YTD as well as which of our prior predictions worked and which did not. We also highlight some changes to our outlook for the balance of the year.


Stock Splits — Explained

Catherine Klinchuch | April 19, 2018

We have received many questions from investors over the past several years on stock splits and how these events impact their investments. In particular, companies often do share splits in conjunction with an IPO and the discrepancy with the post-split IPO price and the pre-split investment price can create confusion. Today, we will shed a little light on this topic and explain what stock splits are, why they are used and—the most critical part from an investment standpoint—why they don’t impact returns.


Tax Reform: What it Means for Your Startup Equity (Part II)

Chris Giampapa | April 05, 2018

It's tax season, friends! That's right, time to break out the W2's, 1099s, K-1s, and the rest of the alphabet soup that only your local accountant can decipher. Though EquityZen is proud to help shareholders get liquidity and investors into private companies, these events may have unique implications on your taxes. This is part two of a two-part series on the subject.

Welcome back to another dive into the most exhilarating of topics: taxes . While it might not be the most titillating of all subjects, it certainly helps to be informed. If you haven't read the first part of this series—where we break down the differences between the old and new tax laws— catch up here .

Last time, we posed the question: what exactly is an 83(i) election? Today, we're going to look at who can make an 83(i) election , as well as who can offer 83(i) elections, and how this affects startup employees, founders, and investors.

Who can offer section 83(i) elections?

The new Jobs Act option is available to private companies with broad-based employee compensation. Only an “eligible corporation” can offer 83(i) elections; an “eligible corporation” is one for which, in a calendar year:
  • none of its stock is readily tradable on an established securities market; and
  • the company has a written plan under which, in that calendar year either:
    • 80% or more of its US employees receive stock option grants or
    • 80% or more of its US employees receive RSUs; and
  • the option grants or RSUs all have the same rights to receive qualified stock.

Who can make an 83(i) election?

Certain senior officers and highly compensated executives are excluded from using the new Jobs Act provision. To make an 83(i) election, you must be a “qualified employee.” A “qualified employee” is anyone who is not an “excluded employee” under the statute, and who agrees to meet applicable tax withholding requirements. An excluded employee is an employee who:
  1. is the current or former CEO or CFO of the company
  2. owns (or has owned) one percent or more of the company’s stock at any time during the current calendar year or preceding 10 calendar years
  3. is the child, grandchild, spouse or parent of any employee described above; or
  4. is one of the four highest paid officers of the company for the tax year or for any of the preceding 10 tax years.
Note: if you make an 83(i) election and become an “excluded employee” (get promoted to CEO or CFO, become a 1% owner – high-quality problems...) your income tax on your qualified stock will be due in the year in which you become an “excluded employee.”
In addition, the “qualified employee” must receive “qualified stock” – it must be granted in connection with the exercise of stock options or the settlement of RSUs and the options or RSUs must have been granted in connection with your service as an employee and during a calendar year when the company was an “eligible corporation.” Stock where you have the right to receive cash in lieu of stock at the time your stock vests is not “qualified stock.”

How does an 83(i) election compare with an 83(b) election?

Unlike Section 83(i), which permits qualified employees to defer federal income taxes for up to five years, Section 83(b) allows eligible employees to recognize income upon the purchase of unvested stock using their stock options upon purchase (otherwise the income would be recognized when the shares vest—see Part I here ). So, an 83(b) election allows you to speed up when you pay income taxes on a stock purchase, while section 83(i) allows you to defer when you pay federal income taxes (for up to five years).

When would you ever want to voluntarily pay taxes early? Particularly for founders and early startup employees, an 83(b) election can make sense, because the value (and thus, the amount of federal income tax due) at the time you purchase unvested shares may be very low. This can result in a low (or even zero) federal income tax bill if the exercise price of your options is at or close to fair market value. It can also help lower your federal income tax bill down the road if your shares continue to grow in value.

In sum, the new 83(i) elections let eligible employees defer federal income taxes for up to five years. 83(b) elections are still available to allow startup employees to accelerate their federal income taxes where that makes sense for their individual circumstances.

What about the AMT (Alternative Minimum Tax)?

Many startup employees will no longer be subject to the AMT following the recent changes to the tax code. The Jobs Act increased the AMT exemption and phase-out amounts from $54,300, phasing out at $120,700 in 2017 to $70,300, phasing out at $500,000 for 2018 for single filers and heads of households. For married taxpayers filing jointly, the Jobs Act increased the AMT exemption and phase-out from $84,500, phasing out at $160,900 in 2017, to $109,400, phasing out at $1,000,000 in 2018. For more information about understanding the AMT as it relates to stock options, you can read up here .
For those of you who are clamoring for more discussion on all things tax laws, here are a few links to help scratch that itch:
*     *     *
This is for informational purposes only and does not constitute tax advice.  Please consult a tax advisor for advice specific to your circumstances.  Any information contained in this communication (including any attachments or linked content) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Tax Reform: What it Means for Your Startup Equity (Part I)

Chris Giampapa | March 29, 2018

It's tax season, friends! That's right, time to break out the W2's, 1099s, K-1s, and the rest of the alphabet soup that only your local accountant can decipher. Though EquityZen is proud to help shareholders get liquidity and investors into private companies, these events may have unique implications on your taxes. This is part one of a two-part series on the subject.

Startup employees who receive equity compensation sometimes find it challenging to exercise their stock options because of taxes. Are you are a startup employee who receives stock options, whether ISOs or NSOs or RSUs ? If so, you may have a new option to defer any federal taxes under the new tax law. Specifically, the Tax Cuts and Jobs Acts created a new potential option—a Section 83(i) election—that can potentially result in tax savings.

Of course, the question then becomes: what in the world is an 83(i) election ? We'll dive into that; but first, here’s some quick background on how equity compensation was taxed before the new tax bill.


Spotify: Blurring the Private and Public Market Lines

Nat Disston | March 22, 2018

With 160 IPOs in 2017 , it is rare for a company's initial public offering to get as much coverage as Spotify's already has this past year. In many ways, however, Spotify deserves the attention. For starters, Spotify is a widely used consumer product that continues to exhibit impressive growth against deep-pocketed and experienced competitors (*cough* Apple *cough*). Many Spotify fans and cynics alike will be eyeing their listing and continued results as a public company. Secondly, Spotify's decision not to raise any capital and forgo a traditional Initial Public Offering in lieu of an Initial Public Listing has already made them stand out in the tech world. While Spotify's trailblazing attitude allows them to eschew Wall Street banks and save unnecessary dilution from a traditional IPO, it comes with its own bevy of risks, such as price discovery and liquidity once the shares are publicly traded.

That brings us to the third reason we're looking forward to this listing (one that has not been discussed much on the interwebs): Spotify, once again the black sheep of the tech world, appears to be welcoming trades of their private shares with open arms. EquityZen's mission is to bring private markets to the public, and Spotify's recent maneuvers—although intended to help them with public market price discovery—are further evidence of the blurring of the lines between the private and public markets.

First, they disrupted music; Now, they're coming for Wall Street

It seems it was not enough for Spotify to disrupt the recorded music industry , get users to begin paying for music again, and allow artists and labels to make money from streaming after it beat physical and digital music sales for the first time last year. Spotify also has to disrupt Wall Street with their much-hyped "non-IPO. " As has been written about numerous times already, Spotify's direct listing will skip most of the bankers, a road show, an initial offering, and the large infusion of institutional capital that comes with a traditional IPO. The plus side is that they will save a quite a few bucks forgoing the fees paid to the banks who handle IPOs. Additionally, they will avoid giving away more equity in the company to new investors, and they can avoid underpricing their IPO because there will be no initial offer price. Essentially, the shares will just begin trading one day. The cynics and Wall Street bankers have their concerns, however. With no roadshow and initial investors, what will be the initial price and who will be selling on the first day?

Spotify does it the Spotify way

I have to hand it to Spotify, they ignore conventional wisdom, push through adversity , and do what they feel is right for their business. Whether it is insisting that paying fractions of pennies per stream of a song will work at scale or this non-IPO, they do it their way. Additionally, Spotify's answer to Wall Street's concern over what price they will trade and how to limit volatility when they do is no exception. Spotify is simply allowing buyers and sellers to trade freely while the company is still private. Bloomberg notes Spotify's response well , quoting that "private trading is expected to be a key part of the company’s effort to guide the market to a price... The company recently informed existing investors that it waived its right to buy shares before they are offered to others."

In private company stock sales, purchasers are typically subject to a 30-day Right of First Refusal. This adds a delay in the transaction process but also gives the Company some protection over their cap table. Spotify has recently thrown this out the window, with Bloomberg reporting that it will allow trades--while still a private company--between existing shareholders and new investors to happen faster, and at a more efficient clip. The goal here for Spotify and their advisors (they are still paying a few banks $30 Million! ) is to get a real-time view into the buy and sell orders right up until the listing. With an active private market, how different can the public market be?

Private markets are the new public

We're excited to see how Spotify's listing plays out (pun intended). However, while we all speculate on their listing decision and potential outcome, Spotify has no doubt benefited from the wide publicity it has generated (like this , this , this and this ) for their type of listing. We're excited about the discussion it has ignited around IPOs, private and public markets, and what this means for upcoming tech companies. EquityZen was started because secondary markets were broken, because shareholder's liquidity needs weren't the same as their employer's, and because access to this asset class required a seven-figure check. We want to bring private markets to the public and provide liquidity for all. Spotify's warm welcome to secondary sales is music to our ears (excuse the puns) that others feel the same way. This experiment serves as an example of how the private secondary markets can be an asset for contemplating an offering, and the ever-growing blurred lines between private and public markets.

We recently included Spotify in our 2018 IPO Outlook ! While Spotify was far from a surprise, be sure to check that piece out to see what other companies have caught our eye for the year ahead.

Investments in private technology companies, such as Spotify, involve substantial risk, including total loss of investment. Not all private technology investments, including those available through EquityZen, will perform like the subject of this post.


SEC Charges Theranos With Fraud: Initial Thoughts

Shriram Bhashyam | March 14, 2018

The SEC announced today that it has charged Theranos, Elizabeth Holmes (founder and CEO), and Sunny Balwani (former President) with what it is calling a "massive" fraud. This story is still developing, but since it is an important one we are going to dive in to some preliminary reactions.

From College to FinTech — Landing Your Dream FinTech Job

Asa Lieberman | March 08, 2018

Interested in a career in FinTech? Looking to be on the front line of emerging technologies right in the heart of New York City? Think you know other folks who may fit this description as well? Check out our open positions on our EquityZen Careers page now!

Recruiting is tough. Did I say tough? I meant excruciating . At a certain point in the process, the networking dinners become repetitive, the interview questions grow seemingly stale, and you're not even quite sure if the person on your resume is really you.

In a previous post , we discussed the reasons why joining a FinTech firm out of college presents an exciting adventure ripe with insightful experience, real-world responsibility, and leadership opportunities that a standard finance position might not offer. That was step one: the ideation phase. Once your heart is set on this journey, the next step is a simple one: get the job !

Did I say simple? I meant attainable —with a purposeful plan and meaningful interactions. In the following, we will discuss a few things you should be doing if you're hoping to make the leap into FinTech full-time. Before we start, step 0.5 is to apply for a position at EquityZen if you think you're a good fit! Alright, on with the show...

Hunt Down Your Desired Field

FinTech is a fun catchall term. Trust me, I've already used it four times in this post. Yet, this concoction of finance and tech actually encompasses a vast array of topics in and of itself. A small sampling of these fields includes:

  • Peer-to-Peer Lending
  • Private Markets
  • Wealth Management
  • Personal Finance & Mobile Banking
  • Blockchain Tech

Plan accordingly. Research each of these fields and pick those that appeal most to you and your skill set. From there, look up the firms in the given field that are getting press. Some places to check are the Forbes FinTech 50 , BuiltInNYC , and similar lists. Many of these rankings are of course subjective, so for those who seek validation in dollar amounts, I recommend checking Crunchbase and AngelList for info on certain companies, including recent funding rounds and/or press releases that may indicate upward movement. When I was making my initial search I happened to notice a few companies popping up in multiple articles, each with a growing buzz (one of these was EquityZen). As you dive into this world, it should become easier and easier to deduce the companies that are thriving and that fit your desired path.

Extend Feelers and Use Your Network

I'll address the second half of this first (to keep you on your toes). The ability to effectively utilize your network—be it relatives, former high school acquaintances, or college alumni you're somewhat connected to—will always be a skill paramount to the hunt. The difference between using your network for standard recruiting and for FinTech recruiting is simply that the FinTech world is by its very nature smaller. All circles grow smaller with time and experience. Think of the startup world as an accelerated example of this. Someone who has spent three years with a firm could likely be one of its longest-tenured members and therefore hold plenty of clout in the organization. All this is to say: if you have anyone remotely related to FinTech that you can reach out to, seize that opportunity. Even if what that person does isn't right for you, it's highly plausible they have friends in the scene to whom they can make the first introduction.

By now, you've likely mastered the art of the recruiting email (if not, there are many solid blogs on the internet dedicated to this task). It is true that you will undoubtedly send quite a few to the people you have identified in your network or to the firms at which you wish to work. However, it is important to consider the multitude of avenues available for correspondence. A simple LinkedIn message might do the trick. Getting face time is even better: go to a MeetUp function, attend FinTech conferences, meet with professors to explore their networks, etc. As I mentioned, it's a small world. Make yourself known, make it clear you know why you belong in this field, and an opportunity will open up.

Know Why You're A Fit

You've researched the firm. You've gotten ahold of someone at the firm (hopefully in a position without the word "ninja"). You're meeting them for coffee. You've done the legwork and now is the time to razzle dazzle 'em in the interview like you usually do, right? Well, kinda . It is true that many of the pointers from your standard interviews will carry over (we have a handy guide to pitching yourself right here ). Competency with financial markets, interview etiquette, and knowing your resume front and back are all prerequisites for a FinTech interview. However, while a large bulge bracket bank has many slots and a regimented interview process, a FinTech firm is often pickier about their candidates because there are fewer spots available and less capital. Each new employee is a serious investment for a FinTech startup. While a new analyst at an investment bank may feel disposable, a startup is expecting a new hire to come in and hit the ground running, taking on responsibilities that may affect revenue, all the while matching the culture fueling that company's growth.
With that in mind, it is absolutely imperative that you understand how you fit into the puzzle. Know exactly how your concentration in corporate finance is a direct value-add to a startup from a business development perspective. Know precisely why your degree in comparative literature and previous internships at a consulting firm will give you a unique vantage point with which to sculpt an aggressive new marketing/branding campaign. Understand that you are being brought on not simply to be a cog in a wheel but as a vocal, valued contributor from the minute you walk through their doors. All of the case studies in the world will not prepare you for all that you will learn in your first month. Your goal is to prove in that interview that you're ready for whatever comes your way, and that you have a few ideas of how to move the needle forward, too.

Is That It?

Well in a nutshell... kinda. No two experiences through this process will be alike. You might think to yourself, "well, that's the same as anywhere." Having gone through the process at several big firms on Wall Street, I can attest to having a similar—if not identical—process (down to the exact questions!) as my peers. There's merit to that, of course, and those firms have the capacity to do so. FinTech firms are constantly seeking growth, and while bringing in new talent is vitally important, it is also taxing as it pulls people away from their day-to-day responsibilities with little to no cover. If you've successfully followed this outline, you should be in a great position to prove this interview is a worthwhile trade-off.
I bid you good fortune as you journey through the brave new world of FinTech. One more time for the folks in the back: if you've got EquityZen on your radar, submit an app here ! Be sure to peruse our blog for deeper dives into FinTech concepts and topics. Happy hunting!

The Dangers of the P/S Multiple

Catherine Klinchuch | February 15, 2018

When we talk about startup valuations, we typically speak in term of P/S (price-to-sales) multiples. Why? For starters, many of them have not yet reached profitability, so valuing them off of earnings is impossible. Second, we often have very limited financial information for private companies, which makes more intricate valuation methodologies difficult. Finally, multiples turn a complex topic like corporate valuation into a seemingly simple equation. Consider Company A, an enterprise SaaS company with $100M in revenue. I observe a group of similar enterprise SaaS companies trading at an average of 6x sales. A multiples-based valuation would tell me Company A is worth $600M ($100M * 6).

Easy, right?

Well, not so fast. When you dig deeper, the ostensible simplicity of multiples actually belies their considerable complexity. Even so, while multiples are often unavoidable for valuation analyses, their pitfalls are not. In our view, a thoughtful multiples-based valuation approach is very achievable, keeping in mind the following:

  1. Multiples are really just shorthand versions of their longer and more tedious cousin, the discounted cash flow (DCF) analysis.
  2. A proper multiples-based analysis (also called comparables analysis) can take just as long—or perhaps longer—than a DCF.
  3. P/S multiple analysis is among the hardest to get right given the amount of information not captured in comparable company multiples.
  4. Even when not perfect (and they are usually not), multiples can still be useful; the key is to understand their limitations and proceed with caution.

What is a multiple and a multiples-based valuation?

Put simply, a multiple is a way of expressing the value of an asset relative to some financial (or sometimes operating) metric. In my example above, revenue ($100M) is the financial metric. The multiple (6x) is an expression of the company’s value relative to sales, which would be $600M in this example. If sales instead were $200M, valuation would be $1.2B. The key in a multiples-based analysis is deriving the multiple. Typically, we base the multiple on observed valuations of companies similar to the one I am interested in (“comparables” or “comps” in industry parlance), either through public trading activity, M&A or private market funding rounds. For this reason, a multiples-based analysis is often called a comparables (or comp) analysis.

Put more complexly, a multiple is a shorthand version of a discounted cash flow analysis. A DCF—which financial theory generally posits as the correct way to value a company—states that a company’s value is the sum of its projected future cash flows. A diagram of the approach is provided below.

There are several steps involved in a DCF. First, we forecast a company’s cash flows out into the future. Then each future cash flow is adjusted by a rate that reflects both the time value of money (i.e. interest rates) and the riskiness of the investment. This is also called “discounting” the cash flows. Finally— adding yet more complexity—we also estimate a terminal value. What does that do? In theory, companies can last forever; yet, it's neither practical (nor possible) to explicitly forecast cash flows in perpetuity. The terminal value reflects the value of the company beyond the explicit cash flow forecast period.

At this point, it may be evident why people prefer multiple-based analyses. DCFs can be lengthy and complicated. Predicting cash flows one or two years out can often be difficult enough; how do you project out five or even ten years? What is the right discount rate to use? I won’t even go into the considerations necessary to ensure a proper terminal value.

This brings us to the second consideration from above

A proper multiples-based analysis can actually take the same amount of time (or longer…!) than a DCF. The key thing to realize is that multiples and DCFs are rooted in the same theory. A multiple simply takes all of the DCF components (future cash flow projections, discount rate, terminal value) and rolls it up into one number. There is mathematical proof for this; the other way to think about it is: both analyses are trying to get to the same place (the valuation), they just take different paths to get there. One path is obviously long and difficult. The other looks shorter, but you may get quickly and unexpectedly stuck in a bad situation...

Consider these examples: You are looking at two software companies with identical earnings next year (say $2.00/sh) but one is growing at 20% while the other is growing at 2%. You would probably pay more for the former; however, if you simply applied a comp (e.g. the average software-industry multiple… say 15x) to both companies, they may appear to have the same value. Or, consider two companies with identical earnings next year, but one has no debt outstanding while the other’s debt equates to 90% of its total capital. Debt is senior to equity and presents risk for equity holders. Again, you would probably pay more for the former company; however, the appropriate valuation differential may not be immediately apparent using a multiples-based approach.

It gets trickier for startup valuations…

P/S multiples, which are pervasive in valuing VC-backed companies, are arguably one of the most difficult to get right. Why? Compared to earnings or other income metrics, sales capture fewer elements that should drive differences in valuation—most notably margins. Take our two software companies again. Both have identical sales (say $100), but one has 90% margins while the other has 2% margins. The companies have wildly different earnings ($90 in one case, $2 in the other), but applying the average software P/S multiple to both would falsely yield the same valuation.

To get it right, a multiples-based analysis would adjust the valuation multiple for all of the intricacies that would drive higher or lower valuations for the company we were looking at. Some key factors include:

  • Margins (operating & profit margins). All else equal, higher margins = higher multiple.
  • Growth. All else equal, higher growth = higher multiple.
  • Financial leverage (debt). All else equal, higher levels of debt generally would lead to a lower valuation.
  • Non-operating assets (e.g. the company owns its headquarters, which does not contribute to sales, but still contributes to company value). All else equal, a company with more non-operating assets would command a higher multiple.
  • Management team. All else equal, a stronger management team = a higher multiple.
  • Transparency. Higher transparency with investors = a higher multiple.

It’s not all bad news for multiples

Multiples, even if imperfect, can still be useful to make investment decisions if you keep their limitations in mind. Some considerations that we find helpful:

  • Even if you don’t do a full DCF analysis, it’s useful to understand the formula and how its various components impact the value of one company relative to another. Is growth higher or lower? Does a more competitive landscape present a risk to future earnings and cash flows? What are margins like? Various internet resources may be helpful here. One of our favorites is Dr. Damodaran at NYU. See some of his notes on DCF valuations here .
  • Multiples are very well-suited towards relative valuation analyses. Say we observe software companies trade at 5x revenue, on average. You have the opportunity to buy shares in SmaSoCo, a small software company, for 4x revenue. You know that SmaSoCo consistently generates better margins and growth than its peers. Based on this information, SmaSoCo shares may be a good buy (better cash flow drivers, lower relative valuation).
  • Always factor in a margin of error. In theory, there is a correct valuation; in practice, people rarely find it. Know where your analysis can go wrong and use appropriate caution. In times of market dislocation (see our post on a topsy-turvy market ), a wider margin may be prudent.

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