Ilya Strebulaev
A $1 billion valuation was until recently a significant badge of honor for a technology company, marking it as an unusually successful outlier. Now, though, as membership of the club has swollen to as many as 200 globally (with an aggregate valuation in excess of $600 billion), the “unicorn” epithet given to these billion-dollar companies on account of their rarity has become less apt and attracted considerable skepticism as to whether they can justify their sky-high price tags.
I specialize in economics, corporate finance and credit risk, with a particular focus on venture capitalism. From my vantage point at Stanford, I’ve naturally become especially concerned with the goings-on of Silicon Valley. Along with my co-author Will Gornall, when preparing Squaring Venture Capital Valuations with Reality, I set out to see whether concerns about the potential overvaluation of unicorn companies was justified. What I discovered may shock you.
Overvaluation is endemic
One in 10 unicorns is overvalued by at least 100 percent, and on average a unicorn reports a valuation 50 percent above the fair value we calculated.
The problem is that companies apply an inappropriate valuation model. The standard method of calculating the market value of a publicly listed company is to multiply the number of shares outstanding by the current trading price of a single share. So pre-IPO companies typically use the amount of money raised in their latest funding round and the amount of equity they gave away in the round to arrive at their valuation. The resulting figure might be a useful shorthand for many purposes (not least juicy media headlines), but — as our research found — it can be wildly inaccurate.
Post-money valuations assume that — as would typically be the case post-IPO — all shares are created equal. They aren’t.
In order to attract funding, companies offer investors inducements and securities. They may guarantee a certain return on their investment at the time of IPO — if the company doesn’t reach a certain valuation at that point, it will issue the investor more shares until the difference between the achieved and promised valuation is made up. This can happen several times, with shares issued at each funding round having potentially very different rights. Effectively, common shareholders pay the price, in terms of both their influence and their returns.
This situation is not taken into account by standard post-money valuations. When it is — we scoured the relevant documentation for more than 130 unicorns to crunch the numbers — it emerges that common shares are overvalued by 58 percent on average, and for almost half of unicorns “fair valuation” dips below the billion-dollar threshold.
Let’s take a look at some examples.
Payments technology company Square went public in 2015 at a $2.9 billion valuation, less than half the $6 billion headlines following its 2014 Series E round. But Series E investors didn’t lose out. Having been guaranteed $18.56 per share, they were issued additional equity at IPO to make up the difference from the $9 float price. A last private valuation reflecting those special conditions would have been $2.2 billion, making much more sense of the subsequent IPO price.
Elon Musk’s SpaceX, meanwhile, actually saw its fair valuation fall in 2008, while its reported valuation climbed. Investors in that round had been promised twice their money back should the company list, with seniority over all other shareholders.
Is overvaluation a deliberate tactic?
Former SEC chairman Mary Jo White highlighted this issue in March 2016, expressing concern about “whether the prestige associated with reaching a sky-high valuation fast drives companies to try to appear more valuable than they actually are.”
It’s impossible to say for sure whether companies are striking these deals with investors in a deliberate attempt to drive their valuations higher. But it’s not difficult to see how they benefit from those higher valuations. Aside from massaging egos and signaling success and attractiveness to future investors, they create a buzz that helps with marketing and, especially, hiring in a fiercely competitive talent market.
When we circulated an early version of our paper, plenty of companies’ general counsels got in touch, and we invited them to correct any factual errors or other mistakes in our working. We’ve not heard back from them.
Implications of overvaluation
The biggest effect of overvaluation is to drive up the value of shares issued in later funding rounds, as they come with greater control over the direction of the company and the return on the investment. Specifically, we found that 31 percent of unicorns give their most recent investors seniority over all previous backers, 20 percent empower them to block IPOs that don’t return a certain percentage of their investment and 14 percent provide guarantees of returns at IPO — all benefits for which investors will pay a premium.
The people most affected are employees with stock options. Many don’t understand that these options are disconnected from headline-grabbing post-money valuations and that their value falls as investors come on board with preferential deals. This further complicates employees’ decisions about how long to stick around to realize their options — especially considering that the longer they stay, the longer they take a hit on the salary they could earn elsewhere, where part of their compensation wouldn’t be tied up in stock.
The market is undoubtedly overheated, despite nine out of 10 VCs believing unicorn companies are overvalued (as I found in previous research). This is partly a result of non-traditional investors in Silicon Valley, such as Saudi Arabia and China, taking more of an interest in the area as low interest rates globally increase appetites for risk.
At some point, the market will demand either profitability or exits (both of which are becoming less common among unicorns), or valuations will start to fall. It’s hard to predict exactly when, though, as this depends on external macroeconomic trends.
Whether or not we will see a crash on anything like the scale of the bursting of the Dot Com bubble is similarly difficult to say with certainty, depending as it does on which dominoes fall first and how hard investor confidence is hit. But suffice it to say, there will be some major casualties.
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