Bubbles and acquisition valuation

By all accounts, the Indian “startup scene” seems to be highly overvalued, and in a bubble. VCs, flush with cash, and chasing similar opportunities, are said to be overpaying significantly in terms of valuations. Check out this piece by iSpirt’s Sharad Sharma (HT: Saurabh Chandra), for example, where he hopes for a “soft landing” from the bubble:

In the soft-landing scenario, e-commerce companies are able to raise money but at near flat valuations. This allows the fundamentals to catch-up with the inflated valuation. Here the pain is localized. It’s only the early stage investors who are unable to participate in the new rounds that see rapid dilution. The rest of the ecosystem remains relatively unaffected.

An obvious  things for companies to do when they are overvalued is to use their balance sheets – use the overvalued stock price to make acquisitions. This can help explain some of the LBOs done by Indian companies in 2007 (Tata Steel buying Corus; Tata Motors buying Jaguar LandRover come to mind). And some of the startups seem to have internalised this principle, and are making use of their overvalued valuations to buy up other startups. It also helps that the acquiring startups are rich in cash, following fund raises, which helps them to even do part-stock part-cash deals.

The point is that if you are a company that has a takeover offer from a funded startup, you need to keep in mind that you are going to be mostly paid in “bubbled stock” and put an appropriate haircut on that account. I can’t advise on what this haircut percentage has to be, but if you are in the startup world, I guess you can take a guess!

Extending this argument further, if you are an employee who has just been offered a job in a startup, and are going to be part-compensated in equity, remember that the equity that you are being offered is “bubbled equity” and possibly overvalued, and once again you need to impose an appropriate haircut. I might go to the extent of asking to examine the books of a private company part-compensating in stock, but that’s likely to lead to breakdown of talks!

Writing on the Facebook-WhatsApp deal in 2014, valuation guru Aswath Damodaran wrote:

First, it is possible (and perhaps even probable) that the market is over estimating the value of users at social media companies across the board. However, Facebook has buffered the blowback from this problem by paying for the bulk of the deal with its own shares. Thus, if it turns out that a year or two from now that reality brings social media companies back down to earth, Facebook would have overpaid for Whatsapp but the shares it used on the overpayment were also over priced.

Keep the bubble in mind while accepting payment of any kind in stock!

Cross-posted on LinkedIn

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