Further cuts in late-stage valuations loom as startups miss revenue targets

When instacart lowered its internal rating From $39 billion to $24 billion in March, many in the VC ecosystem wondered if other startups would follow in the grocery delivery specialist’s footsteps.

A few months later, stripes, one of the largest and most closely watched VC-backed companies, took a similar step. The fintech specialist slashed the value of its common stock by 28%. Meanwhile, Instacart has cut its valuation twice more, reportedly lowering it to $13 billion in October.

Although Instacart and Stripe are among the largest companies known to have done this, others have recently begun reducing their internal ratings, known as 409A ratings. So says Glen Kernick, a managing director of krollwho leads the company’s technology assessment consulting business.

Kernick said his practice, which acts as an outside 409A surveyor for dozens of late-stage and pre-IPO companies, has advised about 40% to 50% of the companies analyzed to cut their valuations in recent months — not least, because many miss their own performance targets.

A fair market valuation of a company is generally based on a mix of the startup’s performance — whether it’s meeting its revenue projections and other key metrics — and ratings of comparable publicly traded companies.

In this environment, with most stocks trading lower, Kroll, formerly known as Duff & Phelps, appears to be placing more emphasis on startups’ ability to meet their own revenue goals. The majority of companies whose 409A ratings were lowered by Kroll are falling short of their financial guidance, Kernick said.

If Kroll’s sample is any indication, it would suggest that startups are in much worse shape than previously thought.

During this year’s market downturn, many investors have primarily attributed the downward pressure on private equity valuations to a reassessment of valuations in the public markets, rather than to the financial results of portfolio companies. The PitchBook index of listed former VC-backed companies has lost 58% of its value year-to-date.

But now the proverbial second shoe begins to fall. Many startups are feeling the effects of deteriorating economic conditions and are unable to attract new customers at expected rates.

As for the types of companies that are lagging behind their financial projections, Kernick says it’s mostly sector specific.

Consumer-centric companies are more vulnerable to broader economic downturns. At the same time, startups that sell software infrastructure and cybersecurity to other companies have generally performed according to their financial plan, Kernick said.

Learn more about 409A reviews

A 409A rating is a fair market valuation of a private company’s common stock. Companies engage independent surveyors like Kroll to determine or update the price of restricted stock units, known as RSUs, or the exercise price of stock options granted to employees.

409A ratings are separate from preferred stock ratings set by VCs in the funding round. Average pre-money late-stage valuation fell 29% from Q1-Q3 2022, latest data PitchBook US VC Valuation Report.

Investors can also periodically increase or decrease ratings between rounds during the period Mark to Market Process.

While the so-called inside and outside valuations should be close, they often differ materially.

Why did Intstacart decide to make its review cut public?

Instacart’s stated reason for the price reduction was to make stock options granted to employees and potential hires more attractive. A lower internal rating could be beneficial as it can result in an employee receiving a higher payout if the company eventually has a liquidity event such as an IPO or acquisition.

If a lower 409A score is good for employees, are startups interested in lowering it?

Not really.

While a low 409A rating has advantages, startups don’t take a price cut lightly. Because reviewers’ ratings are only a recommendation, some of the companies that receive a modest rating cut choose to hold their prices steady, Kernick said.

“[These companies] believe the employee base may be overreacting, even if it’s just 5% or 10% [price reduction,]’ he said, adding that companies are choosing not to lower ratings to keep morale strong.

Kernick said that failing to follow reviewers’ valuation recommendations is a new trend that he hadn’t seen much of until this year.

What about companies that accept lower 409A scores? Do they issue RSUs and option awards at a lower rate?

Yes, most companies whose ratings have been reset by Kroll issue new stock options at lower ratings. But the majority don’t adjust the strike price of existing options.

“Companies say, ‘We’re not going back [and reprice] because we’re optimistic that those options could be back in the money in a year or two,” Kernick said.

Are companies doing nothing for existing employees whose options may now have perished?

A handful of companies that have had their 409A ratings cut by 40% to 50% have taken steps to inject existing stock options, Kernick said.

Businesses have a number of ways to address pricing discrepancies in options.

For example, they could give employees more grants this year to compensate for “worthless” options, diluting the value of other shareholders’ equity. Companies may also revalue or cancel existing options and issue new ones at a lower strike price, which would result in additional accounting costs and tax consequences.

Featured image by kan_chana/Shutterstock

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