It could be a banner year for initial public offerings (IPOs) of “unicorns”—those venture capital-backed companies that are reported to be worth more than $1 billion before they hit the stock market.
Names like Airbnb, WeWork and Uber all come to mind, and there are scores of smaller companies that fit the unicorn definition.
The problem is that many of these companies aren’t worth anything close to $1 billion, according to some striking new academic research.
Mutual funds, pension managers and journalists are making the same elemental mistake in the way they value these private companies, the research suggests. Specifically, they are parroting simplistic valuations proffered by investment bankers and venture capitalists that have an interest in seeing the unicorns touted at valuations far above a fair market assessment.
The study, Squaring Venture Capital Valuations with Reality, shows that the typical valuation assigned to a unicorn is based solely on the most recent round of venture financing.
So when a pre-IPO investor pays $100 million for 10% of the shares in a venture capital–backed company, its value is trumpeted at $1 billion.
Wrong. The study’s coauthors, professor Ilya Strebulaev of Stanford University and assistant professor Will Gornall of University of British Columbia, point out that the terms for shares in the newest round of financing are almost always far more generous than the previous ones, making the investment proportionately far more valuable than the previous rounds.
“VC-backed companies issue a variety of shares with different terms, which means that these shares have different values,” the study says.
For example, the terms of the new financing often guarantee that in an IPO, the new investors will receive at least as much for his/her shares as he put into the company—an incredibly valuable benefit.
Such guarantees are essentially paid at the expense of earlier investors, since the company is typically required to issue more shares that would drastically dilute their holdings. In the example above, if the company went public at a $500 million valuation instead of $1 billion, the company would need to increase that 10% stake to 20% to make the earlier investor whole. That would mean issuing additional shares that would dilute previous holders investment to 80% of the company from 90%. Ouch!
There are also often preferences given to the latest investors in terms of liquidation rights on its shares should the unicorn go belly up. And there are options and other terms that are routinely ignored in the perfunctory valuations.
The discrepancies amount to serious money, with the referenced valuations of some unicorns overstated by 100% or more.
Example: Square, the Internet-payments company, went public in November 2015 at a price that valued the company at about $3 billion. The last round of venture capital financing before that pegged the company at $6 billion, using the simplistic method.
The overvaluations are not just a matter of concern for pensions, endowments and foundations that invest in VC-backed companies. Mutual funds have been plowing money into unicorns as well, though in amounts that are relatively small given the size of their portfolios.
Still, that suggests some of them aren’t putting the appropriate price tag on them, especially given that different rounds of financing carry the exact same price tag. “Almost all mutual funds hold all of their stock of VC-backed companies at the same price,” the study says.