When Instacart lowered its internal valuation from $39 billion to $24 billion in March, many in the VC ecosystem wondered whether other startups would follow in the grocery delivery specialist’s footsteps.
Several months later, Stripe, one of the largest and most closely watched VC-backed companies, made a similar move. The fintech specialist cut the value of its common shares by 28%. Meanwhile, Instacart has reduced its valuation twice more, reportedly bringing it down to $13 billion in October.
Although Instacart and Stripe are among the largest companies known to have done this, others have recently begun to reduce their internal valuations, known as 409A valuations. That’s according to Glen Kernick, a managing director at Kroll, who runs the firm’s technology valuation advisory business.
Kernick said his practice, which acts as a third-party 409A appraiser to dozens of late-stage and pre-IPO companies, has over the last few months advised about 40% to 50% of the companies it analyzed to cut their valuations—at least in part because many are falling short of their own performance targets.
A fair market valuation of a company is generally based on a blend of the startup’s performance—whether it is hitting its revenue forecasts and other key metrics—and valuations of comparable public market companies.
In this environment, where most of the stocks are trading lower, Kroll, formerly known as Duff & Phelps, seems to be placing more weight on startups’ ability to hit their own revenue targets. The majority of the companies that had their 409A valuations lowered by Kroll are falling short of their financial projections, Kernick said.
If Kroll’s sample is any guide, it would indicate that startups are in much worse shape than was believed until recently.
During this year’s market downturn, many investors have explained the downward pressure on private stock valuations as primarily a function of a valuation reset in the public markets rather than portfolio companies’ financial results. The PitchBook Index of publicly-traded former VC-backed companies has lost 58% of its value year-to-date.
But now the proverbial second shoe has begun to drop. A large swath of startups are feeling the impact of deteriorating economic conditions and are unable to attract new customers at the rates they anticipated.
As for the types of companies underperforming against their financial projections, Kernick said it is mainly sector-specific.
Consumer-facing companies are more susceptible to broader economic declines. At the same time, startups selling software infrastructure and cybersecurity to other enterprises have generally been performing according to their financial plan, Kernick said.
More on 409A valuations
A 409A valuation is a fair market appraisal of a private company’s common stock. Companies hire independent appraisers such as Kroll to help them determine, or update, the price of restricted stock units, known as RSUs, or the strike price of stock options granted to employees.
409A valuations are separate from valuations of preferred equity set by VCs in the financing round. The median pre-money late-stage valuation fell 29% from Q1 to Q3 2022, according to the latest PitchBook US VC Valuations Report.
Investors may also periodically increase or decrease valuations in between rounds during the mark-to-market process.
While the so-called inside and outside valuations should be close, they are often materially different.
Why did Intstacart decide to make its valuation cut public?
Instacart’s stated reason for slashing its price was to make stock options granted to employees and prospective hires more attractive. A lower internal valuation could be beneficial because it may result in an employee receiving a bigger payout when the company eventually has a liquidity event like going public or being acquired.
If a lower 409A valuation is good for employees, are startups eager to have them lowered?
Not really.
While a low 409A valuation has advantages, a price reduction isn’t something startups take lightly. Since appraisers’ valuations are only a recommendation, some of the companies that receive a modest valuation cut are choosing to hold their prices constant, Kernick said.
"[These companies] believe the employee base may overreact, even if it’s only a 5% or 10% [price reduction,]” he said, adding that companies opt against lowering valuations in a move to keep morale strong.
Kernick said that not following appraisers’ valuation recommendations is a new trend that he hasn’t seen often until this year.
What about companies that are accepting lower 409A valuations? Are they issuing RSUs and options grants at a lower price?
Yes, most companies that have had their valuations reset by Kroll are issuing new stock options at lower valuations. But the majority aren’t adjusting the strike price of existing options.
“Companies are saying ‘we’re not going to go back [and reprice] because we’re optimistic that in another year or two, those options may again be in the money,’” Kernick said.
Are companies not doing anything for existing employees whose options may be underwater now?
A handful of companies that had their 409A valuations slashed by 40% to 50% have taken steps to help bring existing stock options into the money, Kernick said.
Companies have various avenues for addressing options price discrepancies.
For example, they could give employees more grants this year to compensate for “worthless” options, which dilutes the value of equity owned by other shareholders. Companies can also reprice existing options or cancel them and issue new ones at a lower strike price, which would, as a result, incur additional accounting expense charges and tax consequences.
Featured image by kan_chana/Shutterstock
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