The Securities and Exchange Commission (SEC) is working to change the way that startup companies are valued. Currently, many startups are being overvalued because investors are extremely eager to get involved in the next big thing.
Traditional metrics that are used to measure the success of a company, such as the company’s cash flow and operating costs, are being overlooked because of the “high potential” of these companies. But in reality, most of these companies will never reach such lofty expectations.
Many startup companies simply focus on gaining a popular following rather than generating revenue and profits. These companies ride the wave of hype to high valuations without actually doing what companies are supposed to do: make money.
Investors get overly excited when the hot startup company becomes available, and they get suckered into buying overpriced shares. Later, when the market realizes that the company can’t actually make any money, the shares plummet, and the investor is left looking like a fool.
Making matters worse is that it’s not just everyday investors who are being duped. Professional retirement fund managers are all getting involved as well. Big money managers such as Fidelity Investments, T. Rowe Price and BlackRock have all spent billions of dollars to acquire shares of hot startups that are pooled into the mutual funds of America. This causes long term investors to get screwed over.
As a result, questions are quickly being raised as to why companies with no operating profits, and sometimes even no revenue, are being valued so highly. Now, the SEC is taking its own look into the matter.
In recent months, the SEC has been asking large fund companies regarding their methods of evaluating startup companies. The SEC wants to know if their processes represent accurate methods of estimating the worth of a company. The way things look right now, it’s very possible that the current methods are a total sham.
Chairman of the law firm Morrison & Foerster’s Jay Baris said, “Startup shares are not traded on an exchange, so a market quote is not readily available. The question is, how do you put a fair value on it when you’re looking at squishy data?”
Perhaps they would get a better idea about a young company’s performance by looking at things like revenue or profit instead of “squishy data”.
In recent years, hedge fund managers have been stocking their portfolios with stakes in several private startup companies such as Uber, Dropbox and Airbnb. This year through September, five of the biggest fund firms in the company participated in a funding spree that has been determined to be worth a combined $8.3 billion. This is an increase of more than $1 billion from 2011. Many of these investments have landed in important mutual funds that are critical to everyday people trying to save money.
Another major problem concerns liquidity. The privately held stakes can be very difficult to sell, meaning that it can be impossible to back out if something goes wrong. If the startup bubble does indeed burst, there will be a dangerous market of declining values and little liquidity. And that is a very real and scary possibility.
Since private startup companies are not traded on an exchange, their values are not updated very often. The estimated valuations of such companies can easily plummet overnight. Recently, investment firm Fidelity decreased its estimated valuation of Snapchat by 25%. Yes, overnight, Snapchat suddenly lost a quarter of its value.
Meanwhile, Dropbox received a rude wake-up call when it was warned by investment bankers that its IPO value would be nowhere near as high as the company had anticipated. The same thing happened to payment processing startup Square, which was valued at $4 billion, when it expected to be valued at $6 billion.
Unless changes in the process of evaluating startup companies are made, it appears that the problem could continue to grow worse. For now, it’s very fair to be wary of startup companies. While they might seem like the next big thing and a source of quick money, those dreams could quickly come crashing down.