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The valuations of privately-held tech companies has become increasingly complex and opaque in recent years. A variety of factors, including liquidation preferences, anti-dilution rights and myriad other protections offered to investors obfuscate the direct link between performance, potential and valuation.
Often growing losses in tech businesses are seen by private investors as smoke signals that signify faster future growth and hence deserving of higher valuations. The public market investors, however, take a very different view on private market valuations of loss-making tech businesses.
Growing private valuations are often propped up by late entrants, who are willing to sign cheques for higher valuations based on future-bound assurances of bottom protection and priority in liquidation.
The public markets offer no such comforts . The future arrives every quarter — rating the company on financial performance and corporate governance, determining corporate valuation based on the uncontrived simplicity of P/E ratios and other objective metrics.
Given that most businesses will consider an IPO as part of their future plans, it is important for entrepreneurs to recognise that public markets do crystallise a reality check. And for this transition to be evolutionary and not cataclysmic, it is important to ensure that the company’s capital structure are not designed for failure.
For existing businesses, the first thing that needs to be done is a reset of liquidation preferences and antidilution rights, so that the interests of all shareholders are aligned in terms of business strategy, timelines and desired outcomes.
Investing with the knowledge that valuations will be based on performance and not on the strength of shareholder agreement clauses, will automatically force the investors to factor in business risks.
In the absence of astronomical valuations, companies will raise less money, because the cost of capital will be high. This will allow entrepreneurs to build their businesses at a sensible pace with a focus on economics and customer experience.
Yes, it would probably mean that fewer start-ups will race to become unicorns in their first 12-18 months, but it would also mean that the path to such milestones would be paved with hard work, discipline and grit and not with hidden staircases and free rides.
Large cash burns also postpone the profitability pangs for companies, putting them in a cheap-capital induced haze that hides the path to profitability, delaying the journey towards sound unit economics More companies in our ecosystem would start going public sooner if the path to profitability won’t be as nebulous as it otherwise seems given rising cash burn. Therefore, less capital to burn is a faster and clear-headed way to go public, with less distractions and excuses on the way.
Entrepreneurs need to demonstrate a long term view on their business, and be willing to take one on the chin on the valuation, but know that they also haven’t guaranteed downside protection to investors.
(The author is CEO of Snapdeal)
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