Barron’s Goes Unicorn Hunting

In Barron’s November 20 cover story, “The Trouble with Unicorns,” Alex Eule discusses some of the finer points of venture-stage valuation that are often overlooked in the press.

The article is prompted by the dual observations that (1) a large number (170 and counting) of venture-backed companies are achieving unicorn status, and (2) despite a long bull market for public equities, IPO activity remains tepid. This pairing ought to make sense – after all, one reason venture-backed companies reach unicorn status is that they remain private well beyond the point at which successful companies formerly went public. Successful entrepreneurs have developed a preference for relying on private, rather than public, sources of capital. The more interesting question is whether that preference will have any long-term effects on such businesses.

That’s where the valuation arcana come in.

As noted in the Barron’s article, “headline” values are rarely what they appear to be. To entice investors to provide capital at high nominal valuations, venture companies are offering increasingly favorable terms, including guaranteed minimum exit prices in the event of an IPO. The story cites a recent academic study by Ilya Strebulaev and Will Gornall that calculates the fair value of the unicorns taking into account the special preferences of the various ownership classes in what often become dizzyingly complex capital structures. One well-known, and egregious, offender is SpaceX: compared to a “headline” value of $10.5 billion, the researchers calculated the fair value of the company to be just $6.6 billion.

If it were just a matter of journalists not understanding the fair value of the venture companies, that would be one thing, but as Uele notes, there are real-life implications for this disconnect.

1. The more complicated a start-up’s cap table gets, the bigger the wedge between the value of common shares (the class typically granted to employees) and the preferred shares owned by late-stage investors. Since venture companies often rely heavily on equity-based compensation, wide disparities between preferred and common share classes can create problems attracting and retaining valuable employees. My colleague Sujan Rajbhandary wrote a great post on this issue in 2015.
2. Inflated “headline” valuations increase the likelihood of so-called “downround” IPOs, or public offerings that are completed at per share prices below the most recent private capital raise. Aside from being somewhat embarrassing, this phenomenon has the potential to cause companies to delay going public further. Even if richly-funded unicorns do not need to access public capital to fund operations, an IPO remains the most transparent way to provide needed liquidity to employees (who eventually tire of being paper millionaires) and early-stage venture investors (who need to return capital to LPs).
3. “Private” capital is not so private anymore. As Eule notes, the regulatory regime has not really caught up with the reality that much late-stage financing is being provided by publicly-traded mutual funds. The ability of such funds to provide timely and reliable marks on esoteric, highly-engineered securities remains uncertain.

Against the backdrop of these issues, it will be interesting to observe how the unicorn phenomenon plays out in the next several years. The Barron’s article does a great job of exposing these issues to a wider audience.

Related Links

• Consequences of Calcified Cap Charts: A Few Thoughts on Startup Equity-Based Compensation
• Accountability, Rights, and Discipline in Early-Stage Companies
• Trends Influencing the Fair Value of Private Equity and Venture Capital Portfolio Investments
• Consequences of Complex Capital Structures – A Coda or a Bridge?
• Unicorn Valuations: What’s Obvious Isn’t Real, and What’s Real Isn’t Obvious