I was on Twitter last night and saw Nick Chirls and Mark Suster go back and forth a bit on the difference of share price and valuation. It made me realize we’re either mis-interpreting the meaning of “valuation” or we are understanding it incorrectly.
The term “valuation” was originally described to me as follows:
“The current market value of the entire company based on its most recent round of financing.”
And the Formula:
“If I buy 10% of a company for $100.00, that means it would cost $1,000 to buy 100% of the company.”
And in a world of one share class that is completely true.
But we do not live in a world of 1 share class. We live in a world of a number of classes of stock, and each class has a different value.
And so if I purchase 10% of the most senior class of stock in a business for $100.00, it does not mean it would have cost me $1,000 to purchase the entire company. It would almost certainly cost me less!
Just like if I purchased 10% of a company’s common stock, it would likely cost me more than $1,000 to purchase the entire company inclusive of the more senior shares.
Uber is not worth $50B even though it’s latest round of financing “valued” the company at $50B.
Uber’s most recent round of financing did not imply it would have cost $50B to purchase the entire business.
Rather, it meant that it cost $2B to buy the most senior 5% of the business.
The company is not worth $50B according to that round. Each subordinate share price would have been purchased for less money than the most senior share price (let’s imagine the previous round’s shares are 90% as valuable, and the previous rounds’ shares are 80% as valuable, and so on).
If you hold series seed shares in Uber (a fairly subordinate class of stock) and mark them as if the entire company is worth $50B, and that your shares are worth the exact same as the more senior shares, you’re lying.
So the real value of the company is what it would cost to purchase all of the shares of the business. It means purchasing the top 5% costs $2B, and purchasing the next 5% probably would cost ~$1.8B, and the next 10% would cost ~$3.5B until you finally got to common stock, which would be valued less highly than all the other classes.
And so a “company’s valuation” can absolutely be absurdly high and unrepresentative compared to what a company is actually worth. But it doesn’t mean the last round over-valued a company or purchased shares for too high a price.
Which makes my head hurt. And probably means we need to start using the term differently. There’s a difference in pricing a particular security and a particular company and we just don’t account for that.
Final Note in Response to “But Won’t All Shares Convert to Common at the IPO?”
Yeah! Assuming there is an IPO, but the downside protection preferred shares get in case there isn’t an IPO, or in case the IPO gets priced lower than the current valuation is the whole reason they are more valuable than the current common shares. And that $50B value of Uber isn’t actually real until the IPO (which is the next round of financing) and the conversion has been made, and the shares are actually priced the way a “valuation” implies they should be.
