How to Value Pre-IPO Companies

This article is brought to you by Equifund Technologies, LLC.

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Last month, we hosted our “2022 Pre-IPO Gameplan” webinar with special guest, and Grandfather of equity crowdfunding, Sherwood Neiss. In it we discuss the massive changes happening right now in the global financial markets and how retail investors (and crowdfunding) are reshaping investing as we know it.

Shortly after, I asked our Equifund readers to send in their questions about Pre-IPO investing (go here to submit your questions).

At the top of my list? “How should investors think about valuations when investing in Pre-IPO companies?”

It’s a great question every investor should be concerned with (and one we talk about in our recent “2022 Pre-IPO Gameplan” webinar we hosted…

Especially as we’ve watched share prices crater among several of the notable IPOs from 2021.

  • What’s the driving force behind this sudden sell off?
  • Why has this been spilling over into Pre-IPO valuations?
  • And what does it mean for Pre-IPO investors in 2022 and beyond?

To answer these questions, we first have to take a step back and look at one of the most important topics in finance…

How the Federal Reserve Impacts Financial Markets

Here’s a conspiracy-theory-free history of how the Federal Reserve – which is the central bank for the United States – came into existence.

I know this might seem like a total tangent to the topic of valuing Pre-IPO companies, but it’s important to see the impact history has on our everyday lives (and the spooky similarities that seem to repeat themselves).

In the Gilded Age – which started in 1870’s (post Civil War) and ended in ~1900 – America saw rapid economic growth.

With stock prices climbing ever higher, investors started to become more willing to take on excessive risk and speculate.

By 1900, industries began consolidating into a few large corporations – called “trusts” – that dominated in steel, oil, sugar, meat, and farm machinery.

A trust is a company that operates much like a bank, but is not required to meet the same reserve requirements – which is the percentage of deposits a bank is required to hold as cash.

At the time, banks were required to maintain a 25% reserve. If a bank held $10 million in customer deposits, that means they would need to have $2.5 million in cash (25% of $10M).

However, because trusts weren’t a central part of the payments system, they had a relatively low volume of check clearing compared to banks.

For this reason, they were only required to have a 5% reserve requirement.

But because trust-company deposit accounts were redeemable in cash, this made them especially susceptible to a bank run – an event where many customers demand cash withdrawals at the same time, but not everyone can get their money out.

If a bank run turns into widespread panic, it can lead to a stock market crash followed by a recession.

That’s exactly what happened in 1907 when two individual investors – Augustus Heinze and Charles Morse – attempted to corner the market on United Copper, a copper mining stock.

Morse had a simple formula for his business dealings: He would buy a controlling interest in a bank, borrow money from it, and then buy stock in another company.


Charles Morse (center), with two unidentified associates around 1915.

The bank would hold the stock as collateral for the loan, and he was left in control of the company.

As long as stock prices went up, Morse’s arrangements worked perfectly.

In 1907, Morse teamed up with one of investing partners – Heinze, who made a small fortune in copper mining – to buy up shares in United Copper (a company Heinze helped build).

Between the two of them, they had partial control of six national banks, 10 state banks, five trust companies and four insurance companies.

Strangely enough, their entire strategy was based on something that sounds eerily similar to the Gamestop saga we’ve been watching unfold: The Mother of All Short Squeezes (MOASS).

Here’s how a short squeeze works…

When investors short a stock, they have to borrow shares from another investor in order to sell at the present price… with the expectation they can buy more shares at a later date for cheaper than what they sold at to replace the shares they borrowed.

If the stock goes down, the short seller profits.

But if the stock goes up, they will need to cover their short by purchasing shares at a higher price, resulting in a loss.

Morse and Heinze had reason to believe there was a significant amount of short interest in the United Copper stock.

They believed they could acquire so much of the stock that – if there was a short squeeze – they would be able to unload their shares for whatever price they demanded.

The scheme appeared to work at first…

As rumors of the squeeze made rounds on Wall Street, speculators piled in and drove prices higher.

But then, a large block of stock came onto the market, likely from the Rockefellers who hated Heinze from a previous copper scheme.

Rumors started to circulate that the Heinze/Morse scheme had failed, causing shares of United Copper to plummet.

The banks that lent money to the scheme – which Heinze/Morse owned – suffered massive bank runs.

A week later, this led to the downfall of the Knickerbocker Trust Company – New York City’s third largest trust.

This, in turn, spread fear throughout the city’s trusts as regional banks withdrew reserves from NYC Banks.

Then, the rest of the nation panicked…

This eventually led to a catastrophic collapse of the US Stock market – the NYSE fell almost 50% from the previous year’s high and several state and local banks and businesses went bankrupt.

How did this crisis – the Panic of 1907 – happen?

  1. Depositors lost confidence in the institutions holding their money.
  2. A lack of market liquidity – which is a term used to describe the ability to quickly buy/sell an asset without causing drastic changes in price.
  3. Too much speculation with borrowed funds (known as “leverage” or “margin”).

This convinced many Americans that establishing a central banking system – which the country hadn’t had since the Bank War of the 1830s – might be a good idea.

Eventually, this led to The Federal Reserve Act – passed on Dec 23, 1913 by President Woodrow Wilson – and the creation of the Federal Reserve System.

The U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act:

  1. Maximizing employment,
  2. Stabilizing prices, and…
  3. Moderating long-term interest rates.

This system consists of twelve regional Federal Reserve Banks – which, in turn, is managed by the Federal Reserve Board of Governors, who are appointed by the President of the United States – that are jointly responsible for managing the country’s money supply, making loans and providing oversight to banks, and serving as the lender of last resort.

The Act also required that all nationally chartered banks become members of the Federal Reserve System, purchase non-transferable stock in their regional Federal Reserve bank, and meet certain reserve requirements.

In exchange, member banks would receive access to discounted loans at what’s known as the “discount window.”

It also led to the creation of a single United States currency, the Federal Reserve Note.

At the time, those notes were backed by gold…

Today, the notes are backed by financial assets that the Federal Reserve Banks pledge as collateral, which are mainly Treasury securities and mortgage-backed securities that they purchase on the open market…

All of which is handled by the Federal Open Market Committee (FOMC), which – by law – must meet at least four times a year in Washington D.C.

They are also responsible for setting monetary policy – which includes the whole interest rate thing everyone is talking about right now.

Not to make this whole FOMC thing anymore convoluted or complicated than it already is…

This actually refers to something called the Federal Funds Rate – which determines the interest rates banks charge one another for overnight loans.

Banks use these loans, called the fed funds, to help them meet their cash reserve requirements… which they need to continue lending money to borrowers.

What does any of this have to do with pre-ipo valuations? A lot more than most people realize…

Eventually, all companies are worth the sum total of all profits, over the entire lifespan of the company, discounted to today (known as Discounted Cash Flow).

Yes, things like assets, intellectual property, revenue, and profit can and do impact valuation.

But these classical methods for determining valuation don’t work too well for early stage companies with a limited track record (and minimal “real” assets on their balance sheets).

For this reason, companies have a tendency to be valued relative to other market comparables and influenced by narratives of their future worth.

And this is where things start to get complicated when trying to answer “what is the true value of this company?”

However, the true “value” of anything is what someone else is willing to pay for it. Simply put, supply and demand.

In many ways, this means valuation is based on the founder’s ability to effectively raise capital… and then deploy that capital in a way that creates shareholder value.

And again, thanks to the laws of supply and demand, the company’s ability to raise capital is influenced by monetary policy (i.e. interest rates) and macroeconomic conditions (i.e. inflation).

Here’s why…

Interest rates determine what’s known as the risk-free return – what an investor would expect from a risk-free investment over a specified period of time.

Short-dated US Treasury bills are considered a risk free investment because there is virtually zero risk that the US government will default on its debt obligation.

Take a look at the chart below…

For this reason, the Federal Funds Rate (blue) and the 1-Year US Treasury (red) move in almost perfect lockstep… whereas the 10 Year Treasury (green) tends to follow it directionally.

Assuming the interest rates are higher than the rate of inflation, investors can simply park their money in government backed bonds and get a guaranteed return.

But what happens when interest rates fall below the rate of inflation?

That capital needs to find somewhere else to go to generate a reasonable rate of return.

That’s why there’s been a whole lot of money going into high-risk investments in the stock market, private markets (like Pre-IPO), and crypto…

And it’s also why we’ve seen valuations over the past few years become completely disconnected from fundamental analysis.

Why? Supply and demand.

Thanks to a combination of factors, there is a high demand for investments that can deliver huge upside.

However, there is a limited supply of companies that can unlock these juicy gains investors want.

The end result?

Billions – even trillions – of dollars all chasing after the same investment opportunities…

Which, in turn, creates a completely warped version of capital markets where companies can raise crazy amounts of money, almost immediately, at whatever valuation they want.

This inevitably creates a speculative frenzy that starts to push valuations into a self-fulfilling prophecy.

The price goes up because more investors want it. Then — because investors see prices increasing — more pile-in… which, in turn, drives prices even higher.

Even worse, people start borrowing money to speculate with because it seems like an easy way to “get rich quick.”

…until it doesn’t.

The Shift from “Risk On” to “Risk Off”

In terms of thinking about Pre-IPO valuations, we can take an important lesson from Morse.

Speculation works great as long as the stock price goes up… and there’s someone left to buy your shares at the price you want to sell!

In an era where the FOMC has kept interest rates at record low rates for nearly a decade – and have pumped trillions of dollars into the economy…

It’s no wonder why private companies are raising rounds at completely absurd valuations.

It’s no wonder we’ve seen record highs in the stock market.

And it’s no wonder why we saw 1,000 IPOs in 2021.

People were getting rich and it seemed like there was no end in sight!

But in an instant, all of that can change.

A possible trigger? The FOMC announcing they need to fight inflation and raise rates.

According to the Wall Street Journal…

One interpretation is that the leap in yields was the pin that pricked the bubble in growth stocks, shocking investors out of their lazy assumption that Big Tech just always went up.

A cluster of wildly expensive crypto, clean energy, meme stocks and SPACs have been deflating since early last year, when bond yields also soared.

Like magic, investors started to lose their appetite for money burning “story stocks” that are years away from generating any revenue…

And pre-IPO valuations have started to collapse as there seems to be fading interest in the public markets.

To bring us back to the question “How should investors think about valuations when investing in pre-IPO companies?”

It’s probably the hardest question for any investor to answer…

But here at Equifund, we want to see valuations that are grounded in some version of reality.

For any company who is looking to raise capital, it’s not just about the valuation of the current round…

It’s about all of the capital they will need to continue to raise in the future.

If they raise too much money, too soon, at too high of a valuation… This can lead to a “bet the company” moment.

If they can efficiently deploy that capital and hit the aggressive growth targets needed to support that valuation… they’ll likely be able to continue to raise capital at higher valuations.

But what happens if they miss? It could lead to a “down round” that winds up killing the company.

That’s why we want to see a stress tested business model that has reasonable assumptions about their growth potential…

We want to see a believable story around how the use of funds will create shareholder value…

And perhaps most importantly of all, a path to a potential exit that helps us answer “how do we make money in this deal?”

But sadly, the future is hard to predict… and it gets harder to predict the longer you go out.

When we’re looking at companies that can take years – even decades – to fully mature… so many things can change that impact the assumptions made when you invested.

And that’s what makes Pre-IPO investing high risk and speculative in nature.

Remember: there is no substitute for proper risk management and due diligence when investing.

Don’t let the “Fear Of Missing Out” be a reason for moving faster than you’re comfortable moving.

There’s always another opportunity somewhere.

Sincerely,

Jake Hoffberg

Jake Hoffberg – Publisher
Equifund

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This article is not an Equifund Crowd Funding Portal Inc communication. It is brought to you by Equifund Technologies, LLC.

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