When the business media reports on an increase or decrease in a private company’s valuation after a round of financing, it’s often clear the reporter doesn’t understand the difference in how valuations are calculated for publicly traded companies versus private companies.
For example, I read an article in which a reporter expressed confusion about the price a private company’s employees were offered to sell their shares, stating: “It’s unclear why the company’s valuation has risen more than its per share price.”
This type of statement makes me crazy. Here’s what you need to know to avoid the same confusion.
In the public markets, price per share (last sale price) and fully diluted shares outstanding (disclosed in SEC documents) are known, and the reported valuation is derived using the formula:
Valuation = Price Per Share x Fully Diluted Shares Outstanding
Price per share is what matters because it’s evidence of what any shareholder could have received for their share of stock.
In the private markets, however, there is no full-disclosure requirement and we must rely on incomplete information to determine valuation.
When a valuation is higher than price per share, it may be because the valuation was calculated based on preferred shares. These are typically priced higher than common shares owned by employees.
Quite simply, common shares are not the same as preferred shares.
Preferred shares have preferences which make them more valuable than common stock, including liquidation preference (i.e., preferred shares get paid back with a calculated return before the common shares receives any payout), preferential voting rights and various other determiners of value.
This means the valuation of common shares using the price per share they would be worth can be different from the implied valuation of a different price per share of the preferred stock.
Another consideration is how many shares are used in the calculation.
In the public markets, it’s easy to determine because every share is a common share (there are no preferred shares) and its disclosed. But it’s not so simple in the private markets where there’s a capital stack of preferred shares with different preferences. Therefore, the following valuation calculation is used in the private markets:
Valuation = Amount of Investment ÷ Percentage Ownership (on an as-converted basis)
This generally inflates the valuation because earlier investors – particularly those holding common shares – don’t share in the preferences of the most recent investor. Yet the calculation assumes that ALL shareholders share equally in the valuation.
Anyone reading about the sale of a company at a fraction of its Unicorn valuation, and in which common shareholders receive nothing, knows how this works.
The lesson? Applying a public market valuation methodology to a private company with multiple series of preferred stock results in inaccurate valuation calculations and comparisons. Those entrusted to report on the markets should have enough knowledge and experience to understand why a private company’s valuation might be higher than its per share price – and be willing to explain it.
