The Power of Preference

Uber is getting a lot of attention for the eye-popping price of their lastest financing round ($17B, in case you missed it).  It’s amazing to me how many people criticize that it can’t possibly be worth that, while others insist the price is surely too low.  Benedict Evans said it well:  “It’s hard enough to value a fast-growing company in an entirely new market when you have all the numbers. When you have nothing it’s idiotic.”

Thanks Kevin for CC image via Flickr

In this case, the number is so large that you might learn something from a rough, top-down approach, and I enjoyed this post by Aswath Damodaran on FiveThirtyEight trying to size the opportunity from the top down, and I thought he took a pretty good stab at it.  The HackerNews commenters don’t necessarily agree, primarily with his failure to give Uber full credit for the adjacent markets might disrupt in the future, such as courier and delivery.  But the argument that you should just take it as a HUGE market on faith is really something we rationally do at the Series A investment stage, but would probably be foolhardy when the check size gets over, say… a billion.  [Aside: holy christ, as a former startup CEO:  how do you even contemplate spending a billion dollars?  On top of the quarter billion you sucked up 9 months ago?]

Regardless, I thought the analysis made a good point: this valuation is starting to reach the levels where you would have to believe some pretty aggressive things about (a) market growth, (b) margin stability, and (c) market share/defensibility in order for the new investors to get a return on their money.

Or does it?

I’d argue that is a question we can’t answer, because knowing only the valuation and amount of investment is only part of the story.

Damodaran’s article implies that, in order to get a 2x return on their investment, the new investors would have to see a $34B exit.  This would be a good assumption if Uber were a public company, but in a private financing event, this is almost certainly not true.

Large, late stage valuations are often as much a product of the terms associated with the stock, as they are with the price of the stock itself.

We put companies in a unicorn club and rank them by their reported valuation, but without the terms, we don’t know the whole story.

Preferred Stock is the key term I am focused on.

Most private financings are structured so that the new investor gets some form of preferred stock.  Most common would be “straight preferred.”  Stated simply, if you put $1.2B in cash into a company and value it at $17B, the entity is now worth $18.2B — just yesterday it was worth $17B and now it has another $1.2B cash in the bank.  The people who bought that stock, if they bought preferred, are saying: “the stock I bought with cold hard cash is more valuable than the stock you are bringing to the table, so if we sell the company for less than this price, I get my cash back first (plus interest, usually).”

When a company goes public, all shareholders agree to convert to common, losing any preference rights.

Less common but still present are more onerous forms of preferred stock, such as participating preferred:  when the company sells, I get my cash back off the top, and then I also convert to common and take a share of what’s left.  In this case, if the company sold for the post-money valuation reported ($18.2B), you’d get your $1.2B back plus 6.6% of what’s left — another $1.1B.  Still more onerous forms exist as well: 2x participating preferred, etc.

Why do companies give up these preferences to new investors?  In order to get a higher headline price on the business. You give the investor some “downside protection”, and in exchange, the existing business owners get diluted less due to a higher price, and in the upside case, they retain more of the gains.

The most likely scenario for Uber, in my experience, would be straight preferred.  If that’s the case, you can’t look at it like buying a share of Facebook.  With a public stock, asking: “Is Facebook worth $168B?” makes sense:  if it’s only worth $150B, and you buy it, you will lose 10% of your money when the market figures this out.

However, with a preferred instrument, the buyer are likely looking at a return that looks more like a combination of debt + an equity option:

On the principal of my investment ($1.2B), I get my money back in all scenarios where the company is worth more than capital in — let’s say $2B as a floor.  Plus interest.  Can we agree that it’s highly likely that Google or Facebook would buy Uber for $2B cash, now or in the future?  If so, this is like loaning the $1.2B to Uber:  I get interest at some rate.  Incidentally, something else we don’t know!  Is that number 6% or 12%?

In addition, I get an option on Uber:  if Uber really is the next Facebook, and in a few years is worth $168B, my 6.6% stake would be worth $11B.  (simplifying here!)

So, the 538 author concludes, per his headline:  Uber Isn’t Worth $17 Billion.  I think he makes some great points about market size and the difficulty in building enough cash flow to justify a $17B public company.

But as to his implication that these investors made a mistake –“I wouldn’t be that quick to conclude that smart investors always make smart investment judgments” — I’m not so sure.  If it’s a $1.2B loan earning 10% interest, low default risk, and comes with options on 6% of the company at valuations over a $18.2B?  I’m not sure exactly what that’s worth, but I wouldn’t be quick to call it a bad deal.

 

Also worth reading:

@om points out that this same 538 author thought Google was worth less than a tenth of what it’s now valued at.  LINK

@benparr has a nice writeup on the market potential of Uber and more thoughts on preferred stock  LINK

 

 

 

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Written by Josh Hannah
Josh Hannah joined Matrix Partners after a career as a serial entrepreneur (Betfair, eHow, wikiHow.) Read more about Josh.

One Response to “The Power of Preference”

  1. anshublog says:

    Crystal clear. I am going to have to bookmark this and send it out once every 3 months to the street smart economists with never a penny’s worth skin in the game.

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