Last week a leading financial daily reported that several unicorns had suffered write downs in their valuation. You can read it here. https://economictimes.indiatimes.com/tech/technology/blackrock-cuts-byjus-valuation-by-over-60-to-8-2-billion/articleshow/100627551.cms
For those who have been observing the startup space even from the periphery, like me, this was not completely surprising. News about write downs had been trickling in for a while from 2022. What the news story did was to pull into one place the names of prominent venture capital (VC) funded companies and the extent of write downs they had suffered lately. The story suggested a worrying trend in the startup world in India.
In a post I wrote on LinkedIn on this matter I argued that news of these write downs must be viewed in the right perspective. They are not harbingers of financial Armageddon as such stories might suggest. Let me expand on my argument by starting from “the very beginning” by looking at what valuation is and how or why it should matter.
Pictures for representation only
The market for assets
Valuation is at the centre of the market for assets of any kind. Assets are bought for a variety of reasons. Most of the time they are bought for their utility, as in the case of a home, an automobile, plant and machinery or patents in a business. Sometimes they are purchased for earning extra income or for deploying surplus capital to grow one’s wealth. We generally refer to that activity as investment.
In either case, whether bought for personal use or for investment, the motive for purchasing assets is largely financial or commercial. When bought for personal use the buyer expects to save on rent or other similar expenses that can be saved by owning a home or a car. Occasionally, assets are also bought for sentimental or emotional reasons. My discussion does not include such non-financial purchase of assets.
An elementary idea of valuation.
Simply put, valuation is the process by which a buyer of an asset estimates the price she is willing to pay for it. The price she pays would be the investment she would make on that asset. The cash flows that she hopes to get from the asset should give her a rate of return on that investment.
This idea can be described as an astonishingly simple mathematical proposition: The rate of return on an asset is the cash flow received on the investment divided by the price paid or investment. Alternately, the intrinsic worth or value of an asset is the cash flow divided by the required rate of return.2 If an investor pays a higher price, it will reduce the rate of return to her. And vice versa.
That rate of return should be at least equal to what the investor might realise on other comparable assets. The trouble is in defining comparable. But we do not have to go there yet. The cash flows to the investor may be periodic and recurring, like rents, dividends, interest receipts, royalties and so on. Or, it could be a one time cash flow that the buyer might hope to get when she sells the asset.
No matter whether we compare the valuation of different assets or the valuation of the same given asset over different points in time, valuation is viewed in relative terms. In his introduction to corporate finance in his text book, Professor Ivo Welch writes: “(V)alue in finance is defined in relative terms (emphasis added). The reason is that it is easier to determine whether an object is worth more or less than equivalent alternatives than it is to put an absolute value on it.”
Over time, several measures and techniques have been developed for valuation of different kinds of assets. They vary a lot in terms of the mathematical sophistication of the technique and the extent of data required. But no matter how rudimentary or advanced, when distilled down to its core aspects, all valuation is relative. This is an essential feature that of valuation that must not be overlooked. It is a feature that will influence the way we interpret valuation.
What valuation means or signifies
The valuation of an asset may be interpreted in terms of several factors. I look at a few of them that are relevant to our discussion on unicorns.
Traditionally, the movement in valuation of assets has been seen as an indication of the changing cost of funds. This relates to a point made earlier: The value of any asset is that investment in the asset which will provide a commensurate rate of return. Thus the cost of funds and the valuation of assets are intimately connected. Changes in the valuation of assets across the board are indicative of a change in the cost of funds in an economy.
It would be great if that was all there to valuation. Unfortunately – or, fortunately for those who enjoy complexity – things are not that simple. I noted earlier that the rate of return is realized from the cash returns that one expects to earn from the asset. The greater the chance that the cash return might differ, the higher the rate of return one might demand to be compensated for the fact that one cannot be sure of the cash return from the asset. This squares with our daily experience as savers. Banks and companies that are eager to have us deposit our savings with them have to pay us a higher rate of interest, if we are not sure that they would pay us back on time. That would we mean the investor would pay less for the same asset, the greater the uncertainty surrounding the cash returns.
That leads to a second important use of valuation: Changes in valuation tell us something about our change in expectations regarding cash returns. Financial economists like to refer to it formally as change in riskiness of the asset. This change in expectations can be triggered by a change in our outlook for the overall economy of a country. For example, in recent times, that fateful morning Mr Putin’s men – and quite possibly women too, although the media did not show any pictures of women in combat fatigues – decided to go for an unfortunate excursion across the borders into Ukraine – asset prices went into a tizzy in nearly every country in the world. Sometimes these changes in expectation can be limited to specific industries, individual commodities or the financial performance of an individual company.
Net net, one might infer that the valuation of an asset depends(i) on the expectations of the cash returns from a company and (ii) the likelihood that it may not be as we expect it to be.3
Therein also lies the trouble. Valuation can vary a lot on who is doing the valuation, no matter how extensive the data and how robust the mathematical method one might use. Or, at least that is where the state of the art seems to be. Art it is, as many authors including Professor Welch might agree, as it is science. And hence the cliched saw: Valuation, like beauty, lies in the eye of the beholder.
Other factors that drive valuation
Valuation also depends on the competition to own the asset. The price of an asset that is in great demand can get pushed up to unreasonable levels, leading to an interesting problem known as the winner’s curse, particularly applicable to assets that are sold in auctions such as art or antiques or even shares in an Initial Public Offering in certain markets. An asset owner suffers from a winner’s curse when she pays more for the asset than it is worth. This again buttresses the view that valuation is largely dependent on the subjective view of the individual who is assigning that value, based on her view of the returns from asset in future.
There is an interesting extension to this. The eagerness of a buyer to own an asset seems to depend, among other considerations, on how eager the buyer is to spend money buying that particular asset. When there is a lot of such money wanting to buy the same asset, investors seem to put on rose tinted glasses while viewing the prospects for earning a rate of return from the given asset. So that is another one of many variables that seem to spook the valuation process.
This problem is especially acute in the market for venture capital or private equity. Industry practitioners refer to it as “money chasing deals”. The problem of demand for assets like edtech startups, health-tech startups and startups in other industries that are the flavour of the season is further exacerbated by the fact that good quality investment opportunities are in limited supply. Not all ed tech start-ups or machine learning start-ups, to cite two examples, are made equal. The ones that have been started by a great team of entrepreneurs or that have a unique or difficult to replicate technological advantage will be in greater demand than the ones that do not have such an advantage, other things remaining equal. The limited supply of such start-up opportunities and the competition among prospective buyers to own those assets pushes up their valuation.
Enter incentives…
Now add to all those factors the human element of incentives. VC fund managers raise capital from investors and deploy them in start-ups. Fund managers are paid for the quantum of funds they manage as well as the returns they deliver to their investors. There is thus a built in bias in the currently prevalent fund management architecture towards managing larger and larger sums of money. At the same time, the more money fund managers raise the greater the pressure to find good quality start-ups. And the greater the proclivity to push up asset prices.
The story does not end there. The valuation of different assets does not remain constant at the prices at which they are bought or sold. Asset prices or valuations respond to changes in expectations as we saw earlier. But they respond with different speeds to inputs that affect valuation. The prices of shares that are traded on a stock exchange change every time a buy or sell transaction takes place. The valuation of private equity holdings however changes only when the fund manager chooses to reflect that change. Usually fund managers wait for compelling evidence to make those changes. When it comes to a write-down the evidence has to be even more so. You can imagine why. An interesting blog on the CFA institute website, which you can read here, talks about some of the issues in valuation in private equity and venture capital. https://blogs.cfainstitute.org/investor/2020/10/28/myths-of-private-equity-performance-part-i/
Valuation and the story of unicorns
How does all that relate to the story of unicorn valuations? Our understanding of the process of valuation tells us that this number that media like to talk about so much is one that is arrived at through a fraught process, which is influenced by so many factors. The lower valuations that we read about today could be as much of an over-reaction on the pessimistic side as the excessive prices that fund managers may have possibly paid when they competed to fund those fancy unicorns.
Does it mean that valuation numbers are meaningless? Clearly not. It just means that we that we need to see these numbers in the right spirit. I propose below my view, which I am sure many from the academia and the world of practice might disagree with.
First, as a basis for buying or selling valuation provides a starting point for the negotiation. I would be surprised if a deal got closed at what the valuations pundits recommended as a price for buying or selling. That is when the deal makers step in.
Second, when a change in valuation for a lone asset like a private equity investment is reported one should be curious to know what triggered the change. However, it does not necessarily or always mean that the company is headed for major trouble. It need not even that the company is facing long term challenges. It may simply be an instance where investors overpaid for the company in the past. Or may be they are over-reacting now because some other investor did. Neither does it mean the onset of an avalanche of bad news that will bury a whole lot of other companies, investors, founders and other stakeholders under financial difficulties. A lone swallow does not make a spring to use an idiom from my ancient childhood.
Third, when a slew of write-downs is reported it could mean either that the industry or the economy as whole is likely to pass through turbulence. That is definitely worth taking note of. But each of those write downs is likely to have a story that is distinct. It is worth knowing what those stories is. Often would see stories of imprudent fiscal management, in some instances even shenanigans, that explain why those valuations collapsed like a house of cards, to use a cliché.
Fourth, sentiment seems to play an important part in financial markets. A slew of bad news does seem to affect most startups in the ecosystem. At the same time it is worth remembering that companies that are built on a fundamentally sound footing, seem to stand firm even in the face of a gale of bad news. Before the onset of the “financial winter” India boasted 108 Unicorns. In spite of all the reduction in valuation we still have sixty eight standing.4
Finally, if, like me, you hoped that valuations would one day settle down to reasonable levels and stay there forever, I must tell you that I am not as sanguine. As Michael Mauboussin and Dan Callahan noted in a paper they authored in 2020, the increased flow of capital to private equity is here to stay. As long as that condition persists the drop in valuations for might be just a passing blip from which it may bounce back sooner than you think and I might like.
So if you are lucky not to be a stakeholder in the yin and yang of valuation, just stand by on the shores and watch the drama.
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1The author G.Sabarinathan, PhD teaches at IIM Bangalore. He writes when he wants to inflict his confusion on others. Views expressed are his own.
2This is a rudimentary or simplified representation of the underlying mathematics; but one that suffices for our current discussion. This article is not intended to be a rigorous or comprehensive discussion on valuation.
3Students of mine who happen to read this might wonder that this is idiosyncratic risk that could possibly be diversified away to an extent. My response is that this article is written in the context of VC investing where fund managers accept diversifiable (idiosyncratic) risk. So I am ignoring it for this discussion. On the contrary, on a humorous note, they might not read it when they see my name in the byline.
4These are the numbers I recall. I could be off by a few.
