Meditations
EquityZen's Blog On Startups and Their Economics

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.


Stay tuned to our Blog and browse the Knowledge Center for more insight on all things finance, investing, and private markets!

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Year in Review — A Letter from the CEO

Atish Davda | February 01, 2018

The year that was 2017 will go down in the history books of EquityZen. Within the course of twelve months, we raised our Series B from Draper, grew headcount, surpassed our performance goals, and continued innovating around our platform to best serve our users. In honor of a tremendous year, our CEO, Atish Davda, offers the following thoughts on what we’ve accomplished and where we’re headed next.

2018 is off to a strong start for us and our clients, joining together in helping EquityZen bring private markets to the public. As 2017 turns into a memory, I want to take this moment to share moments of excitement and learning for the EquityZen team.

Last year was a wonderfully wild ride at EquityZen. While Q1 kicked off what looked poised to be a normal year for IPO volume (save for the 11th-hour AppDynamics acquisition ), the rest of 2017 was a letdown for the US IPO market. Yet, bankers and deal lawyers remained busy, as did capital market technologists like the EquityZen team. We processed IPOs for platform companies that managed to reach escape velocity and delivered shares for earlier exits whose lockups expired. In spite of this, in 2017 we managed to nearly quadruple our transaction volume year-over-year - that's nearly four times amount of pre-IPO investment access and liquidity delivered.


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SoftBank: A Blessing or a Curse for Investors?

Chuk Okpalugo | January 25, 2018

Japanese telecoms giant SoftBank has undoubtedly made a huge impact on the global technology landscape with multiple $1B+ investments in industry leading private tech firms over the last few years. SoftBank continues to make bold, and public, bets on the future of technology, but whether this large influx of capital is positive for private companies and their investors in the long-run remains to be seen. In this note we discuss some of the possible effects SoftBank is having on technology markets from an investor perspective.


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The Trend Is Your Friend: 8 Lucky Consumer Investing Trends in 2018

Kartik Ram | January 04, 2018

The new year is in full effect, and with it comes the inevitable barrage of 2018 predictions, hot takes, and lists. In a world that is creeping closer to the embodiment of a Black Mirror episode, we wanted to present an alternative to the usual lists you are going to see over the next few weeks.

To do this, we have again called upon friend of EquityZen, and FashionFund Managing Director, Kartik Ram, to give us Consumer Investing trends to look out for without using the words "crypto," "AI," and "VR."


Counting on ancient wisdom in lucky numbers, we curate eight consumer trends private investors might find refreshing and profitable. In researching this list, sectors we thought would boom were cooling off and those we weren’t watching closely, surprised, and delighted us. Here’s what I'm keeping my eye out for in 2018:

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From College to FinTech — Why I Chose to Forgo a Large Finance Firm to Enter Tech

Asa Lieberman | December 28, 2017

We take a break today from investor research and tax bills to reach out to the real MVPs of December: the college students who pushed and persevered through finals only to come out on the other side and fall headfirst into resume dumps and interviews. We've been there. This is for you.

The month of December means something special to everyone. For some, hot cocoa and Mariah Carey on the radio. For others, sales emails. So many sales. But for college students, December brings with it the unique one-two combo of finals and recruiting. While the cramming of a semester’s worth of material in a matter of days is a rite of nervous passage for all students, the latter is what can really keep you up at night (aside from Netflix). It’s exciting. It’s terrifying . It’s what a lot of your educational career has been building up towards.

Roughly one year ago, I was that college student. And though many of my friends went the grad school route or into a large bank—both fine options for sure—I chose to leap into FinTech. I couldn’t be happier with my decision, and I think all majors from various backgrounds should consider this route. Here’s why.


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Retail 2.0: Digital Native Brands Take on Tradition

Kartik Ram | December 21, 2017

As we approach the end of December, the holiday season is in full effect. While retailers prepare for their busiest time of the year, we take a look at what the wave of innovation and tech in the retail space means for both the firms competing in it and the consumers the space serves.

We’ve tapped friend of EquityZen, and FashionFund Managing Director, Kartik Ram, to dive a bit deeper into Digital Native Brands (DNBs) and the rapidly growing reach of e-commerce.

Consumers have more choices in affordable luxury than the standard fare that malls and boutiques serve up. Today, the world’s leading retailers are all online. The long-tail playbook has won. But the fastest-growing digital brands aren’t following it. Most such companies focus on selling only a handful of different products, and many started out with just one. Casper began by selling the single, killer product, namely, the “perfect bed.” Bonobos started with a single pair of men’s pants. Allbirds made its mark with a distinct wool pair of minimalist shoes. This new generation of disruptive brands is not only a consumer phenomenon but also threatening to shake up retail.

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EquityZen's 2018 IPO Outlook

Catherine Klinchuch | December 07, 2017

2018 – More of the Same?

The past year capped yet another relatively subdued year for tech IPOs, with activity still well below 2013/2014 levels despite favorable market conditions. In our view, the underlying reasons for the ongoing public offering torpor remain consistent with prior years: an abundance of capital (and high valuations) in private markets, the high costs of becoming—and remaining—a public company, analyst scrutiny, and an increase in liquidity alternatives. We believe these factors may continue to weigh on IPO volume in the year ahead.

Number of Venture Backed IPOs Since 2013
Source: Company data, EquityZen estimates


Nevertheless, we believe 2018 could shape up to at least match 2017’s IPO pace (market conditions permitting), with a little over 20 startups ready to join the public ranks. Our projection is based on a bottom-up analysis, starting with a list of over 200 of the largest VC-backed companies. We then use a combination of quantitative and qualitative factors that have historically presaged an S-1 filing to determine IPO readiness.

The Profile of a Successful Tech IPO

History can serve as a valuable guide for determining which companies are primed for public debuts. We crunched the numbers on over 100 venture-backed companies that have completed an IPO since 2013 to gauge what the “average” tech IPO looks like. Our data set excludes biotech, life sciences, companies with a market capitalization below $50 million (many of which are shell companies for which sufficient data is not available) as well as Alibaba’s monstrous $21.8 billion IPO, which skews results meaningfully. Based on our results, we believe the following characteristics are useful guideposts for evaluating IPO prospects:

Age. At the time of IPO, the average venture-backed company from our data set has been private for approximately 11 years. With few exceptions, we consider 7-8 years as the minimum acceptable operating tenure for IPO candidates.



Most Recent Round of Funding. At our average company's IPO, their most recent round of private fundraising was $106 million. Returns to investors are increasingly coming from the private market, as investors who gain access to these companies even in the final round of fundraising stand to see very solid gains. We note that the total return for investors in the last private round to the IPO price was – on average – an outsized 180%.



Valuation and Revenue. The average size of the public offering was approximately $207 million, translating to an equity market cap of $1.45 billion at the opening bell (formerly private shareholders were diluted by about a fifth, on average). Annual revenues average $267 million in our dataset; we believe revenues should exceed $100 million at the very least to make a public offering viable.



Less Quantitative Factors. While not explicitly measured by our data set, we believe the following factors can also be important for IPO readiness:

  • C-Suite Experience: Companies that successfully complete IPOs tend to have c-suite executives experienced in the offering process, particularly in the CFO seat.
  • Industry sentiment: IPO windows are heavily dependent on investor sentiment on a particular sector. Companies may delay an IPO if negative industry sentiment would weigh on valuation (and thus offering proceeds).
  • Corporate culture: Public market investors are unlikely to feel confident investing in companies dealing with loss of management confidence, key employee exodus or regulatory investigations.

And The Nominees Are…

With the above criteria in mind, we list startups we view as S-1 ready below. While we have listed three companies here, please check out our report on the full listing of all 22 companies on our radar. Note that all valuations below are as of the company’s last funding round.

DocuSign

- Year Founded: 2003
- Industry / Description: Software / cloud-based electronic signature platform
- Most Recent Equity Funding: $310M Series F (2015)
- Total Implied Valuation: $3.5B
- Revenue Estimate: $100M+
- Other Notes: Docusign’s CEO recently signaled his expectation to go public by early 2018. The company indicated it reached cash flow breakeven in 2017.

Lyft


- Year Founded: 2007
- Industry / Description: Logistics / Ride-hailing service
- Most Recent Equity Funding: $1.5B (2017)
- Total Implied Valuation: $11.5B
- Revenue Estimate: $700M in 2016
- Other Notes:  The company reportedly engaged underwriters in October for a potential offering.



Airbnb


- Year Founded: 2008
- Industry / Description: Hospitality / marketplace for travel accommodations
- Most Recent Equity Funding: $1B Series F (2017)
- Total Implied Valuation: $31B
- Revenue Estimate: $4B
- Other Notes: The company hired Laurence Tosi as CFO in 2015. Tosi has strong public markets experience, previously having served as CFO of the Blackstone Group.
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Thank You From EquityZen

Ketan Bhalla | November 23, 2017

As we celebrate the Thanksgiving holiday in the United States, we wanted to continue our annual EquityZen tradition and reflect on a few things that we are thankful for this year.  Thanksgiving snuck up on a lot of us this year and it's hard to believe that 2017 is quickly coming to a close.

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Silicon Valley Unites to Preserve Equity Compensation

Shriram Bhashyam | November 16, 2017

It was fast and furious, but in the end the US Senate ultimately came around. The Senate's version of the tax bill to implement sweeping changes and cuts to the tax code, the Tax Cuts and Jobs Act, included a provision that would have taxed stock options and restricted stock units (or RSUs) upon vesting. This would have been disastrous for the startup community, which relies heavily on equity awards to compensate employees. The startup community quickly rallied to inundate local Senators with opposition to this provision, and late Tuesday night, November 14, 2017, the Senate relented and struck that provision. We break down why this matters and how it was resolved.


Original Proposal and Why It Was Dangerous

As has been widely reported, the Trump Administration and Congress have been working on tax reform. The Senate's version of the tax bill sought to tax stock options and RSUs upon vesting. Currently, options are taxed upon exercise and RSUs are taxed when the underlying shares are released (for background on equity compensation, see this post ). Typically, options vest over four years, with a one year cliff followed by a monthly vest over the remaining three years. By bringing forward the taxable event to vesting, employees would owe taxes on shares they don't even own yet! For options, startup employees would be hit with big tax bills every year, even before the options were exercised and whether or not the employee actually sold the shares to get cash. There would be a similar result for RSUs, where taxes would be due before employees actually got the shares, let alone sell them to get cash.

This perverse outcome would create terrible economic consequences for employees, undermining the lucrative potential of startup equity. In fact, this could have been a fatal blow to equity compensation at startups.

Silicon Valley Unites

Led by Engine and the NVCA, as well as a groundswell of activity by various stakeholders in the startup ecosystem, Silicon Valley rallied to defeat this provision. EquityZen proudly supported the effort by signing on to Engine's letter, which was joined by more than 600 companies. You can read the full letter to Senator Hatch here .
Not only did the Senate strike the offending provision, it put in a new provision that actually helps startup employees deal with tax issues. The current Senate markup includes a provision that would allow startup employees to defer, for up to five years, income associated with the exercise of options if the shares are not readily tradable on an established securities market, as recognized by the Treasury Department (hey, we know someone working on a liquid market for shares like these!).
This was a nice swing! In fact, EquityZen has been supporting efforts in Congress to move the needle even further. We'd like to see the taxable event not at the time of exercise but at the time of sale, when a selling shareholder gets real income (the kind you can spend) on the sale of shares and would have the money to pay the taxes owed.

* * * * *
When the startup community unites, we can have a real and meaningful impact on the laws that govern how we live and work. We are excited to stay vigilant and fight for what's important for our little corner of the world.

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Artificial Intelligence Startups: The Key to Real Returns in the Modern Economy?

Catherine Klinchuch | November 09, 2017

It appears that Artificial Intelligence may finally be ready for takeoff! In our view, AI will be pervasive in the modern economy and we believe investors will benefit from gaining exposure to this theme. Historically, technological revolutions have been triggered by a vital economic input becoming cheaper. Ultimately, AI does just that. AI reduces the cost of prediction, a key input for business decisions across many economic sectors. Given AI’s broad applicability, the potential impact of the technology is staggering, with two prominent consultancy firms pegging the eventual economic contribution at ~$14-16T . For a detailed analysis of the industry and the major players in this sector, please download the report here: EquityZen Artificial Intelligence Sector Report

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