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Welcome to the varied world of tech start-up fundraisings; Recent eye-catching start-up fundraisings tell only part of story

June 19, 2014 3:17 pm

Welcome to the varied world of tech start-up fundraisings

By Richard WatersAuthor alerts

When it comes to putting money into high-flying tech start-ups, not all investments are created equal.

The bald numbers that have hit the headlines after recent eye-catching fundraisings – such as Uber’s $18.2bn valuation two weeks ago – tell only part of the story. In reality, the varied terms of this and other deals have made direct comparisons misleading.

There is also a risk that, with the valuations of late-stage private tech companies booming once again, the fundraising tactics involved will store up trouble for initial public offerings to come.

Take the Uber deal, which valued the taxi app company at 30 per cent more than Twitter was worth at the time of its own IPO last year. For a start, the Uber figure includes the $1.2bn of new cash raised in its latest round: the pre-money figure, which gives a better measure of the value of the business, was $17bn.

Perhaps even more significant is the fact that investors were not buying ordinary shares but convertible preference stock – in effect, a type of debt that will require the company to make its investors whole if the share price falls below its current level at the time of a future exit.

Some prefs, as they are known, are more attractive than others. When Uber last raised money, less than a year ago, it guaranteed investors a 25 per cent return over the life of the investment, according to two people familiar with the terms. That so-called “ratchet” is particularly attractive in a low-interest rate environment, says one investor, because it brings a decent return while also providing a free call option on a high-growth business.

At the other end of the spectrum are rounds such as the recent fundraising that valued online storage and collaboration company Dropbox at $10bn – at the time a high-water mark for the current batch of tech start-ups, before Uber put it in the shade. The prefs in that case only protect investors if Dropbox is acquired for less than the value of the investment round, said one person familiar with the terms: there is no special treatment in the case of a future IPO.

But for some entrepreneurs caught up in the latest internet boom, conservative structures such as this partial preference are out; chasing headline numbers seems to have become an obsession. Valuations are leaked or, increasingly, boasted about. When Microsoft took a stake in Facebook in 2007, the fast-rising social networking company bragged in a press release that the deal had lifted its valuation to $15bn. Left unsaid were the terms of the instrument issued to Microsoft, which it called simply an “equity stake”.

But straining after a high valuation could come with a sting in the tail if it pushes private-market values to levels that cannot be matched in a later IPO. Companies could be forced to issue more stock to make up a shortfall, diluting other shareholders, says one start-up investor. That can lead to difficult negotiations with key investors at a critical time, says another observer.

The recent correction in high-growth public tech stocks is a reminder that this possibility is more than just theoretical, though prices have since stabilised.

The downside protection may be one reason why valuations for hot tech start-ups in the private markets are seemingly being driven up so fast. The catalogue of investors being sucked into the market now includes not only the traditional venture capital and growth equity investors, but hedge funds, private equity firms and even public-market investors such as mutual funds, all of them chasing the seemingly sure-fire profits from investing in the final round before an IPO.

Investors who see this as a one-way bet should think twice. Lock-up arrangements normally prevent them from selling in the first six months after an IPO. That can be a long and painful wait, as turned out to be the case with Groupon. By the time the lock-up for the online daily deals company had lifted, its stock had fallen 50 per cent below its IPO price.

But even in cases such as this, there may be ways to soften the blow. Zynga’s biggest backers, having already unloaded a relatively moderate $150m worth of shares at the time of the IPO, persuaded the company’s investment banks to relax their lock-up. They then dumped $515m worth of shares on the market before the company’s rank-and-file employees got a chance. It was well-timed: Zynga’s stock price plummeted by nearly half in the remaining two months that the original lock-up period had to run.

For the alert start-up investor, it seems, there is usually some way to guard against the downside.

 

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About bambooinnovator
KB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing. KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund. Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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