When Instacart lowered its internal valuation from $39 billion to $24 billion in March, many in the VC ecosystem wondered if other startups would follow in the grocery delivery specialist’s footsteps.
Several months later, Stripe, one of the largest and most watched venture capital-backed companies, made a similar move. The fintech specialist reduced the value of its common shares by 28%. Meanwhile, Instacart further cut its valuation twice, bringing it down to $13 billion in October.
While Instacart and Stripe are among the biggest companies known to have done this, others have recently started to lower their internal ratings, known as 409A ratings. That’s according to Glen Kernick, managing director of Kroll, who leads the company’s technology assessment consulting business.
Kernick said his firm, which acts as a third-party 409A evaluator for dozens of late-stage and pre-IPO companies, has over the past few months advised about 40% to 50% of companies analyzed to reduce their valuations – at least in part because many are not meeting their own performance targets.
A fair stock market valuation of a company is usually based on a combination of the startup’s performance — whether it hits its revenue forecasts and other key metrics — and valuations of comparable companies in the public market.
In this environment, where most stocks are trading lower, Kroll, formerly known as Duff & Phelps, appears to place more importance on startups’ ability to meet their own revenue targets. The majority of companies whose 409A valuations have been lowered by Kroll are below their financial projections, Kernick said.
If Kroll’s sample is any guide, it would indicate that startups are in much worse shape than believed until recently.
During the market downturn this year, many investors explained the downward pressure on private equity valuations as being primarily a function of a reset in public market valuations rather than the financial results of portfolio companies. The PitchBook Index of former publicly traded venture capital-backed companies has lost 58% of its value since the beginning of the year.
But now the proverbial second shoe has started to fall off. Many startups are feeling the impact of deteriorating economic conditions and are unable to attract new customers at the rates they anticipated.
As for the types of companies that are underperforming against their financial projections, Kernick said that’s mostly sector-specific.
Consumer-facing businesses are more sensitive to broader economic declines. At the same time, startups selling software infrastructure and cybersecurity to other companies have generally operated according to their financial plan, Kernick said.
Learn more about 409A assessments
A 409A valuation is a fair valuation of the common stock of a private company. Companies hire independent evaluators like Kroll to help them determine or update the price of restricted stock units, called RSUs, or the exercise price of stock options granted to employees.
409A valuations are separate from the preferred stock valuations set by VCs in the financing round. According to the last PitchBook US Venture Capital Valuation Report.
Investors may also periodically increase or decrease valuations between rounds during the go-to-market process.
While so-called internal and external assessments should be close, they are often significantly different.
Why did Intstacart decide to go public with its valuation drop?
Instacart’s reason for reducing its price was to make stock options granted to employees and job applicants more attractive. A lower internal valuation could be beneficial because it can result in an employee receiving a larger payout when the company eventually has a liquidity event like an IPO or acquisition.
If a lower 409A valuation is good for employees, do startups want to drive them down?
While a low 409A valuation has its benefits, a price cut is not something startups take lightly. Because appraiser ratings are only a recommendation, some of the companies that receive a modest valuation discount choose to keep their prices constant, Kernick said.
“[These companies] thinks the employee base may overreact, even if it’s only 5% or 10% [price reduction,]“, he said, adding that companies are choosing not to lower valuations in an effort to keep morale high.
Kernick said not following reviewers’ rating recommendations is a new trend he hasn’t seen often until this year.
What about companies that accept lower 409A ratings? Do they issue RSUs and option grants at a lower price?
Yes, most companies whose valuations have been reset by Kroll issue new stock options at lower valuations. But the majority do not adjust the strike price of existing options.
“Companies say ‘we’re not going back [and reprice] because we’re optimistic that in a year or two these options could be profitable again,” Kernick said.
Are companies doing nothing for existing employees whose options may be underwater now?
A handful of companies whose 409A valuations have been slashed by 40% to 50% have taken steps to help bring existing stock options back into the money, Kernick said.
Firms have various avenues for settling option price discrepancies.
For example, they could give more grants to employees this year to compensate for “worthless” options, which dilutes the value of equity held by other shareholders. Companies can also change the price of existing options or cancel them and issue new ones at a lower strike price, which would, therefore, lead to additional accounting charges and tax consequences.
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