"Human beings have the remarkable ability to turn nothing into something. They can turn weeds into gardens and pennies into fortunes." - Jim Rohn
Many people think that you must have everything figured out before you can move forward. But increasingly, businesses and companies are turning nothing into a lot of something.
In the case of Rivian, the electronic vehicle company with major backing from Amazon and Ford Motors, $80 billion worth of something. That was their valuation before their initial public offering (IPO) in November of 2021.
A friend of mine working at Rivian then told me that at the time, they had not delivered a single car yet. "Not one," he said. "But we are asking for a valuation that is more than GM, a company that sells 7 million cars a year."
How can a car manufacturing company that hasn't made a single car be worth more than the one selling millions each year?
Like banks, public companies create money using valuations.
Before going public, meaning that the company's stock can be purchased on the public stock market, companies are private and limited to investments from friends, family, and certain venture capitalists, or VCs.
Going public is an opportunity for companies to raise more capital by convincing investors they are highly valuable. That's a primary goal for venture capitalists. Most are not looking to keep their investments in the same companies forever. Their business model is to invest widely and keep an eye out for companies that raise capital or bring in high revenue. These they can sell for a big payout. To make this model work, VCs want their portfolio companies to raise capital in higher and higher valuations.
So, private company investors are incentivized to push valuations higher at each funding round. And since regulators have no say in how private companies invest, investors have free rein on those valuations.
Let's consider WeWork. One of their VC investors asked me to appraise the company and insisted that its value was 60% higher than my appraisal. I pointed out that WeWork's business model is very similar to that of Regus Space so their values would also be similar. My client did not like that comment. As a VC investor trying to create a lucrative IPO, he needed increasingly impressive valuations of the company.
Of course, six months later he had to face the music. The investors took a 70% haircut when the valuation of WeWork dropped from $47 billion to $12 billion. Today, WeWork is worth about $9 billion - 80% lower than the original $47 billion, though still higher than Regus' $2.8 billion.
With such a staggering drop in valuation, you might wonder how a company can be valued so highly pre-IPO. The disconnect happens when the company goes public and the traditional methods of valuation - income, market, and cost - come into play.
Private investors use non-traditional valuation methods that highlight the potential growth of the company. You don't need to generate revenue or even make a product. If you can convince investors and markets that your company will show exponential growth, your valuation may touch ten digits. A company with a promising growth story can almost legally print its own money.
Like my friend at Rivian said, "If the markets want to give us $80 billion, we aren't going to say no. I already have my boat picked out."
A pre-IPO valuation is like a Hollywood film set. It's built by creative and ambitious people. It's temporary and designed for a specific purpose. It's a two-dimensional object in a three-dimensional world. From an outside perspective, you can admire it and imagine how amazing it would be to go there, but if you were to walk inside, you would see it's only a persuasive illusion.
So, the next time you're tempted to invest in an IPO, ask yourself two questions:
- How much of their valuation is based on future growth?
- How does a competitor's valuation stack against them?
In the past, you became a billionaire through inheritance, marriage, or maybe winning the lottery. Now, starting a company, raising venture capital, and a promising valuation could be your path to billions. For more on pre-IPO valuations, see Veristrat.