A recent WSJ article titled Andreessen Horowitz’s Returns Trail Venture-Capital Elite triggered a swift response from Scott Kupor, the managing partner at Andreessen Horowitz, and Damodaran also chimed in on the issue with a follow-on article. The articles carry some good nuggets of information, namely on how VCs “mark-to-market”.
VC Marks Are Not a Measure of Performance
Scott emphasized that marking-to-market for VCs is purely a theoretical accounting exercise and should not be used as a measure of VC performance, as
- VCs should be judged by the actual cash and stock (that can be converted to cash) that they return to investors
- VCs’ marks are not based on marketable public securities
- Different VCs can mark the same investment very differently
Methods VCs Use to Mark-to-Market
Scott highlighted 3 main valuation methods used by VCs to mark their investments:
- Last round valuation/waterfall
- Pro-rate the last round valuation (of the same company) to their ownership stake.
- Comparable companies
- Find public comparables
- Pick a metric (e.g. revenue multiple)
- Apply public multiples to your subject company
- Apply a 20-30% discount for lack of marketability (DLOM)
- Pro-rate the valuation to their ownership stake
- Option pricing model (OPM)
- Mathematical model that prices each series based on the price per share of a financing round and on a set of probabilistic exit outcomes.
On the application of public comparable companies, Damodaran noted that it should only apply when the private business has enough operating substance. Damodaran also mentioned two additional methods
- Comparable private companies
- Essentially the same as the public comparable companies method above, except applied to private companies and without the application of DLOM.
- Forward pricing (commonly known as “VC method”)
- Forecast metrics (e.g. earnings, revenues) 2, 3, or 5 years out
- Apply a pricing multiple
- Discount to today using a target rate of return (which incorporates survival risk, cash flow risk for a conventional going-concern, dilution risk, and negotiation)
Marks Can Differ Wildly on the Same Investment at the Same Time
All of the methods above are consistent with GAAP, however the methods can produce wildly different marks. Scott gave an example of a $10m investment in Slack, which can be marked to $380m using the last round valuation method, $200m using the comparable companies method, and $160m using OPM.
While Scott highlighted that accounting firms would likely accept all the different methods, it is interesting to note that Andreessen Horowitz chose to use OPM to mark their securities (through the use of a third-party software), which shows what they think is “more right” compared to the other methods.