How Volatile is Late-Stage VC?

How much does later-stage VC have in common with the public markets? As companies stay private longer, it has become increasingly common for public markets investors like Fidelity and T. Rowe Price to invest in startups 1-2 rounds before their IPO. Conventional wisdom suggests these late-stage investments are more or less the same as public markets investments.

But we’ve found late-stage investments do not follow the same price diffusion pattern as public market investments. Instead, they appear to have much more extreme outcomes.

The implications of our findings are consequential not just for late-stage investors, but also employees of unicorn companies who hold common stock. In this blog post, we’ll explain why late-stage venture does not act like public market investments. We do so by adapting a model for studying the returns of illiquid investments taken from recent research into commercial real estate (CRE) returns.

How Startups Are Like Office Buildings

On the surface, venture capital and CRE may seem like very different asset classes. But startup and CRE investing share two important qualities:

• They are illiquid. There is no active public market trading the assets. When an investor needs to become liquid quickly, they may have to sell at a large discount.
• There are distinct exit and entry times for each asset. Put another way, CRE and VC both involve waiting several years for a substantial distribution from an initial investment.

A recent paper by Professor Jacob Sagi found CRE assets do not follow a mathematical model known as a “random walk with drift” (RWD). RWD is a standard model for how public market equities behave. Per Nasdaq, “for a random walk with drift, the best forecast of tomorrow's price is today's price plus a drift term. One could think of the drift as measuring a trend in the price (perhaps reflecting long-term inflation).”

Instead of RWD, Sagi found CRE assets have a large, statistically significant illiquidity premium, or a fixed “extra” return for each investment that investors cannot access because of the illiquidity of the assets.

Professor Sagi’s paper sets up a simple test for whether assets follow a RWD:

• Assets that follow a RWD should have returns that average out to “X% per year held.”
• Assets that don’t follow a RWD should have returns that average out to “Y% per year held plus an illiquidity premium of Z%.”

We retrofitted Professor Sagi’s test for the 20k+ venture investments made on the AngelList platform over the past decade. When we ran the same analysis, we saw a statistically significant positive intercept—an indication that startup share prices do not follow a random walk with drift (and therefore do not behave like public markets investments).

The thick orange line is the linear regression fit while the horizontal gray line represents 0% gross investment return. The positive intercept at a holding time of zero years—the gap between the orange and gray lines—is clearly visible.

When we divided the investments by early-stage and late-stage, we found that late-stage investments were a better fit for the RWD model, but that both early and late-stage venture investments had a statistically significant illiquidity premium (a p value of less than 5% is generally cause to reject a hypothesis in social science research).

Startups Don’t Go on Random Walks

The conventional wisdom says that early-stage venture has wild volatility, late-stage behaves more like public markets than early-stage, and public markets follow a RWD model. Our research suggests that while late-stage is a closer fit to RWD than early-stage, late-stage investing is more volatile than people may think.

For instance, in a prior study we found the average money-losing late-stage venture investment loses nearly 60% of its value—an average loss that would be extreme in a public markets portfolio.

Interestingly, this volatility has the effect of decreasing the valuation gap between common stock and headline valuations. Common stock, traditionally held by founders and employees, is generally less valuable than its preferred stock counterparts (for more, read our guide on common vs. preferred shares). Headline valuations (also known as the post-money valuation) typical refer to the value of the company’s preferred stock, which has rights and privileges that common stock lack.

If the future exit of the company is either much higher or much lower than the current headline valuation, common and preferred holders are largely treated the same: they either both make a lot of money, or they both lose a lot of money.

This suggests unicorn employees entertaining offers for their shares on the secondary market may not want to accept significant discounts on their shares just because they hold common shares and investors hold preferred. Absent other information, our work suggests asking for something closer to the price-per-share of the latest headline valuation.

In relation to the recent downturn in late-stage venture, our research indicates that what’s taking place isn’t a market correction so much as natural volatility. For years, late-stage investors benefitted from that volatility when they were making large gains on pre-IPO startups. Now that the volatility has swung negative, investors who expected the private market to behave like the public market may be in for an unpleasant surprise.

Footnotes

1. A recent paper assumed that late-stage venture investments followed RWD and used that assumption to support a conclusion the typical unicorn company is actually worth about 50% of its headline valuation. Our research does not support this study's conclusions, since our research work rejects the idea that late-stage venture investments follow a RWD process.