Unicorn Valuations Inflated by Late-Stage Investor Protections

(Bloomberg Businessweek) -- WeWork’s fall from grace seems to have been a temporary setback in the unicorn world. Case in point: Just days into the new year, a source familiar with China’s social-media/e-commerce startup Little Red Book told Bloomberg News it would start a fundraising round aiming for a $6 billion valuation, double what it was worth after its last round, in 2018.

But do this and similar eye-popping valuations reflect the real value of these startups? According to a recent study published in the Journal of Financial Economics, the average unicorn is priced 48% above its fair value. Looking at 135 unicorns in the U.S., the authors found valuation inflation in every case, with the degree of overstatement ranging from 5% to 188%.

Does that mean private investors are irrationally overpaying? Not necessarily. Unicorns these days can go through as many as seven funding rounds before emerging on public markets, and late-stage investors often insist on layers of protective clauses to blunt their potential losses.

One popular option, for instance, entitles them to extra shares if a startup’s valuation at its initial public offering is lower than where they bought in. Take the case of parent company We Co. It agreed to give some private investors more than $500 million in additional shares if its IPO valuation fell below $10.5 billion; most of that would have gone to SoftBank Group Corp. Or consider Square Inc.’s disappointing 2015 IPO. Its Series E investors were promised at least $18.56 per share; when Square’s price came in at less than half that mark, it had to give them an extra 10.3 million shares.

There are other clauses that work in late-stage investors’ favor. Those who bought in most recently can often get their money back before everyone else if the company folds or gets bought. Others get the right to pull out of an IPO if Wall Street values the unicorn lower than what Silicon Valley does.

Take the idea to its logical conclusion, and you wind up with an unsettling thought: If a unicorn wanted a $47 billion valuation, investors might be happy to comply so long as they’re given enough protection against the possibly inevitable downfall.

Considered in that light, the unicorn world has one thorny moral hazard problem. All this fine print gets set down out of the public eye. What retail investors see is an impressive number they don’t realize is propped up by a bunch of investors with safety clauses. But there’s also a big caveat for private investors: All these preferred shares convert into common stock as soon as the unicorn goes public, which means the investors lose their valuable options.

If we could see the contractual terms unicorns agree upon with their patrons, no reasonable investor would say these startups are worth as much as they claim. But, alas, these are private contracts, leaving the unicorn world as murky and fluffy as ever.
 
Ren is a finance columnist for Bloomberg Opinion.

To contact the editor responsible for this story: Jillian Goodman at jgoodman74@bloomberg.net

©2020 Bloomberg L.P.