Startup Markups and Markdowns: What the heck is going on!?
The reassessment of the valuation of startup holdings at a number of mutual funds, notably by Fidelity, has caused a fair amount of comment of late. Notably of the "Unicorn sky is falling" variety when it comes to mark-downs. And the sky isn't falling ... when it comes to mark-ups. Fred Wilson of Union Square Ventures recently addressed the broader topic of the blurring of public and private capital markets of which this issue a component part.
In my experience there are two common sources of confusion many early stage investors and founders have about these mutual fund valuation changes. They are reflected in these two questions:
1. Why are they doing this in the first place?
And related to this:
2. Why do they move the values up and down "so often"?
As a former sell side research analyst here is my attempt to add a little clarity:
1. The Why Do It At All
This one is easy. Mutual funds change the valuations they report for their illiquid startup holdings because ... they have to. And the requirement to reset valuations applies just as much to marking up an appreciated asset as marking down a depreciating one.
The key point is that investors can buy and sell shares in a mutual fund on a daily basis - and they do so at NAV (Net Asset Value), the price reported by the fund. Hence, as "open ended" investment vehicles, mutual funds need to mark their valuations to market on a daily basis to reset that NAV.
With public securities, assessing the contribution to NAV is "easy" in most cases. For illiquid securities (like holdings in a startup) the valuation reflected in overall NAV needs to be "fair value as determined in good faith by the Board of Directors". (The Board of Directors of the mutual fund in question that is.) Hence, by taking in mutual fund money, a private company goes (a little bit) public by proxy ... because the valuation of its equity is open to potentially daily reassessment by a mutual fund. However, unlike the public markets, any revaluation (again up as well as down) is only visible when a fund choses (or more likely is required) to make it public.
Fidelity funds report monthly holdings although the SEC requirementis for mutual funds to report holdings to them (and hence the public) only on a quarterly basis. Even then, funds have up to 60 days after the end of a quarter to do it. And just to make it clear that this reporting needs to be honest and fair ... the SEC requires a fund's principal executive and finance officer to "certify" the holdings report is accurate.
Less obvious (once you know the SEC requirements anyway) is the answer to the second question:
2. The Why So Volatile
In most cases early stage investors, angels and VCs, and the founders they are backing only see startup valuations change infrequently. This "mark to market" happens when a new round is priced (up or down). At that point there is an explicit one time step function change in valuation that prevails until the next financing provides the next step function change. Obviously valuation also changes when a company is acquired and there is a definitive last and final price assessment.
With very very few angel backed investments making it to the public markets via IPO, and a small proportion of venture backed companies for that matter, the experience of frequent (month to month never mind second by second) valuation changes is in turn uncommon. But that doesn't mean they aren't happening! The point being valuation is a function of many variables and they all (inconveniently!) are themselves changing in real time which is why, of course, public stocks fluctuate real time. So external factors like interest rates, risk premia, the macro economic outlook, market place/competitor developments, media coverage etc as well as internal factors like new product launches, personnel changes, major new investments and earnings reports. Whether visible or not all this stuff happens to start ups too.
"We" just don't revalue them second by second because: a) it would fry our brains and b) circling back to point 1 above ... we don't have to. But, as I laid out above, once you add a mutual fund to the cap table the game changes and in comes that quarterly (or monthly) requirement to revalue. Blame the SEC for that if you will ... and the real world for the volatility!