Beware Inflated Unicorns: Protections for Late Investors May Be Exaggerating Startup Valuations

Everything in tech these days seems larger than life: the scope of innovation, the brilliance of the coders, the entrepreneurial zeal of the founders...and the valuations.

The problem that the last category presents is that it may be exaggerating the actual value of the enterprises under consideration, especially those in the $1 billion-plus range, the so-called unicorns. And the reason is not market potential or innovative genius - it's the terms demanded by later-stage investors. JL


Randall Smith reports in the New York Times:

Late-stage financing terms include extra protections, like a minimum return on investment. Valuations of many unicorns have been inflated by the terms of the private investments that set those valuations before any initial public offerings.

Warning: Some unicorns may be smaller than they appear.

The recent proliferation of so-called unicorns — start-up technology companies valued at more than $1 billion — has been greeted variously as a sign of healthy innovation or an indication that valuations have become dangerously overheated.

Led by the likes of the car-hailing service Uber at $41 billion and the home-rental website Airbnb at $10 billion, the global ranks of unicorns have more than doubled, to 102, over the last 15 months, according to PitchBook Data, which tracks private financial markets.

Less noticed is that the reported valuations of many unicorns have been inflated by the terms of the private investments that set those valuations before any initial public offerings of stock — often with little or no disclosure of those terms.

Increasingly, venture investors say, late-stage financing terms include extra protections, like a discount to the price of any eventual initial offering, a minimum return on investment or extra shares if the company later raises money at a lower valuation.

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The Rise of the ‘Unicorns’

Venture capitalists invest in companies in search of breakout hits. These rarities, called unicorns, have grown in size and number as investors chasing returns have bid up their value.

OPEN Graphic

For example, the cloud software provider Box Inc. raised $150 million in July 2014 from two investors, Coatue Management and TPG Capital, at $20 a share — a reported valuation of $2.4 billion. Under terms of their investment, Coatue and TPG were entitled to receive additional shares if Box later went public at a lower price, and a 10 percent discount to the I.P.O. price to boot. When Box priced its initial offering at $14 a share in January, the lower price dropped the Coatue-TPG purchase price to $12.60 a share and increased the number of shares they received by 58 percent. Box’s current stock market value is about $2.1 billion.

Such protections, which Box disclosed because it had already filed plans to go public, are controversial among start-up investors. Early-stage investors warn they can jeopardize a company’s financial stability, diluting the value of their original stakes and worsening a company’s prospects in a downturn.

But the protections appeal to company founders because they provide new cash at the highest nominal valuation, reducing dilution if all goes well. And later-stage investors argue that they provide valuable insurance.

The protections, known among investors as structuring or ratcheting, can inflate a unicorn’s indicated valuation 10 percent to 25 percent, according to Rick Kline, a lawyer at Goodwin Procter whose firm does legal work on start-up and initial offering financings. He said the phenomenon has been part of a general “frothiness” in late-stage valuations.

The cost of the extra insurance against a downturn — borne by the company and its other investors — effectively counts against the sale price and thus should reduce the valuation. But companies generally do not count such implied costs in reporting the valuations, venture investors say.

The Silicon Valley law firm Fenwick & West recently analyzed 37 United States unicorns that raised money in the year ended March 31. It found that five of them promised to pay additional shares to late-stage investors if the companies’ initial offerings were priced below their pre-I.P.O. investment valuations, and six others allowed the investors to block an offering below the price of their investment. Fenwick did not identify the companies.

As a result, the firm said, about 30 percent of unicorn investors “had significant protection against a down round I.P.O.” The same report noted that one-third of the companies had valuations at or just above $1 billion, “indicating that the companies may have negotiated specifically to attain the unicorn level.”

In an interview, the report’s co-author, Barry Kramer, noted that unicorns could also increase their reported valuation by increasing the number of shares in the option pool set aside for employees, even if those options have not been issued, much less exercised.

Samuel Schwerin, managing partner of Millennium Technology Value Partners, which invests in mid- to late-stage technology start-ups, noted that some late-stage investors had sought such protections partly because many start-ups have gone public or subsequently traded at prices below those paid by late-stage investors.

Since the start of 2014, Mr. Schwerin noted, 11 technology companies have priced their initial offerings below the investment price of the last financing rounds before the offerings. In addition to Box, they include the software providers Apigee and Globant and the big-data manager Hortonworks. Mr. Schwerin also estimated that more than two-fifths of venture-backed technology companies had fallen below their initial offering price in the same period.

Like Box, Globant also gave late-stage investors price protection, although it expired before Globant’s initial offering, and its stock price has since doubled from its offering price.

The developments in late-stage financing have taken on greater importance as more companies stay private longer, allowing their valuations to blossom before public investors have a chance to get in on the action.

During the dot-com bubble of the late 1990s, companies often went public within a few years of being founded, and their stock prices doubled or tripled soon after their initial public offerings. Now, a greater share of such gains is being reaped by investors before the offering.

As a result, the amount of money flowing into late-stage investing has swollen, and the value of such investments has sometimes ballooned as unicorn valuations have shot up. Wellington Management, for one, is raising a fund devoted to late-stage investments.

But recent losses have made some investors more cautious. One investing partner at a big venture capital firm, who spoke on the condition of anonymity because of the sensitivity of discussions on the matter, said there was a “sea change” in requests for protection by late-stage investors after some suffered temporary paper losses at several companies like Hortonworks, which went public in December, and the home-goods shopping website Wayfair, which had an I.P.O. in October.

Mr. Schwerin, whose firm decided two years ago to proceed more cautiously in making new investments because of prevailing high valuations, said, “Only time will tell whether providing companies with such monster valuations in exchange for such sophisticated structures” is a good idea.

Companies are also considered more likely to grant such protection if their path to profitability or a successful initial offering is less assured. That was the case with Box, which was burning through cash at the time of its $150 million fund-raising in mid-2014.

Investors are reluctant to discuss their arrangements, and those that did spoke on the condition of anonymity because they did not want to jeopardize their relationships with the companies.

Among current pre-I.P.O. start-ups, Uber has offered to sell stock at a discount of 20 percent to 30 percent of an eventual offering price to investors that participated in a $1.6 billion debt financing led by Goldman Sachs in January, according

to Bloomberg News. And it gave minimum-return protection to at least one investor, TPG, in mid-2013, two investors said.

Lynda.com, an online learning company, also gave protection to investors led by TPG in raising $186 million in January at a valuation of nearly $1 billion, one investor said. LinkedIn agreed to acquire Lynda.com in April for $1.5 billion. A LinkedIn spokesman declined to comment.

And one fantasy sports site, FanDuel, is negotiating a late-stage round that may also include investor protections, two investors said. A FanDuel spokeswoman said she could not discuss any funding details.

“I think entrepreneurs get starry-eyed about the high valuations and don’t realize they come with all sorts of caveats if everything doesn’t work perfectly,” said Daniel Ciporin, a venture capital investor at Canaan Partners.

Neeraj Agrawal, a general partner at Battery Ventures, said such structures work for companies when, “like ‘The Lego Movie’ theme song, everything is awesome.” But, he added, “things won’t always be awesome, and when they aren’t, a company can blow up over this issue.”