Turns out most valuations are actually way off the mark

Pitchbook came up with a formula for figuring out what a company is worth, and found 60% are wrong

With valuations going off the rails in the last couple of years, resulting in more unicorns than you can count, its actually pretty useful to know how exactly VCs come up with those numbers. Do they base them on anything tangible, or are they sort of pulled from thin air?

Apparently, it's all pretty subjective. As in, there's really no set formula for it, meaning how valuations are calculated varies depending on the company and on the firm. That's a pretty big problem, especially for companies in the early stages, where there isn't much, if any, data to go on yet. 

"It's not hard to understand why estimated valuations are difficult to predict. Early-stage company valuations are often driven by subjective factors and estimates, while later-stage companies have more quantifiable data to work with like operating statistics and performance indicators," PitchBook wrote in a post on Wednesday. "The weight given to these factors varies from investor to investor and company to company. These subjective factors and weights are difficult to measure and quantify, making it extremely difficult to estimate valuations."

So, in response to that bit of news, the company went and came up with a solution, creating a formula for more accurately determining what a company's valuation is. And, as a result, it found that the majority of current valuations are wildly off base.

To figure out what a company should be worth, PitchBook used data from the company's current round, data on previous rounds, industry data, data on participating investors and its location. The formula, it said, is "similar to calculating market cap for publicly traded companies and incorporate factors like issued number of shares and option pool estimates."

The eventual number they came up for a company with falls within a 5 percent margin of error of what its valuation should. Even more startling, they also found that, when running the test on companies, the vast majority, over 60 percent of them, are not within 15 percent of what their actual valuation should be. That's about as far away from the actual number as it should get. 

"For most professionals, a 15% accuracy threshold is likely the highest that could be used to conduct business with any degree of confidence," said PitchBook. "But with only about 40% of test cases falling within that range, there's another 60% that have an accuracy rate well outside of that 15% threshold."

So that means that, chances are, if you're an entrepreneur, or an investor, the valuations you're working with are way off the mark. And that doesn't do anybody any good. 

Unicorns everywhere

Finding out that valuations are too high doesn't really shock me. I mean, just look at what's happened since 2014.

There were 47 new unicorns in the U.S. alone in 2015, for a 38 percent increase over 2014. There were also 28 new unicorns outside of the U.S., a 100 percent increase over the 14 from last year, for a total of 78. That equals 1.5 new unicorns every single week for the year, which is 

By the of the year, investors had already started to panic over ballooning valuations, leading them to devalue come of the biggest companies in the world.

Fidelity, for example invested in Snapchat's $538 million round this past May, which valued the company at $15 billion, a round that made Snapchat the fourth most valuable private company in the United States, behind Uber, Airbnb and Palantir. Then, earlier this moth firm decided to write down the value of its stake by 25 percent, dropping it from $13.9 billion to $10.4 billion.

The firm also cut the value of its shares in Zenefits by 48 percent, and marked down the value of its share in Dataminr by 35 percent.

The same thing happened to Dropbox earlier this year, when of its investors, BlackRock, cut its estimate of the company’s per-share value by 24 percent.

Another sign of the deflating market is that were also far fewer new unicorns in the last quarter of the year, with the number of companies reaching billion dollar valuations dropping to nine, after hitting 23 in both Q2 and Q3. It was the lost number new unicorns since the second quarter of 2014.

That may indicate that the bubble has already popped.

"The fact that a lot of these later stage investors overpaid for some of these companies, and only the true breakouts are able to keep raising more capital at higher valuations, or go public. You’re seeing the corrections happen in the public markets, as well as subsequent private rounds for companies that still haven’t hit their breakout points. Which means some down rounds, flat rounds, and even some companies running out of capital and at risk of going out of business," Alex Gurevich. Partner at Javelin Venture Partners, told me in a recent interview. 

"So I think to that extent we were in a bubble, I think that bubble has actually burst already. I've already seen this in several companies that are out there that have had their valuations slashed and are having a hard time raising capital once you start getting beyond the $500 million or so valuation mark. It's definitely tougher out there right now. So I think the bubble has already burst."

(Image source: vincari.com)