Why Private VC-Backed Cos. Need A New Valuation Method

The authors discuss the challenges of calculating valuation for privately held companies, especially when those companies are growing rapidly and involve new technologies and markets.

Venture capital (VC) financing has long been an important feature of capital markets for high-growth companies in the U.S., but its importance has grown substantially over the past fifteen years, and more companies delay their IPOs and reach very high valuations while private. Valuation of VC-backed private companies can be challenging because of the lack of financial information and because of the distinctive characteristics of those firms. Thus, market participants often rely on the price of new financing rounds to back out the total value of the company as given by the post-money valuation, which is calculated by multiplying the per-share price of the latest round of financing by the total number of (fully diluted) shares outstanding.

This metric, however, does not appropriately reflect the complexity and heterogeneity of the preferred convertible stock issued by VC-backed companies. In this article, authors Ilya A. Strebulaev of Stanford University and Manuel Vasconcelos of Cornerstone Research explain how using an appropriate methodology to value the company at the time of a financing round, such as the Gornall-Strebulaev methodology, can and often does result in valuations that are substantially below those implied by the post-money valuation. These differences can be central to many types of disputes involving VC-backed companies, their investors, employees, founders, and tax authorities, among others.

This article was originally published by Law360 in July 2022.

The views expressed herein are solely those of the authors, who are responsible for the content, and do not necessarily represent the views of Cornerstone Research.