Academics: Without Terms, Almost Half of Unicorns Would Lose Horns

— Tim Wilson, Partner, Artiman Ventures, comments to WSJ Pro on unicorn valuations —

Patience Haggin – WSJ Pro – April 26, 2017 7:30 a.m. ET – It’s been conventional wisdom for the past few years: venture investment terms such as ratchets and liquidation preferences have sent unicorn valuations sky-high. Now two academics are trying to determine just how high.

In a forthcoming paper, two business academics argue that traditional valuations overstate the value of “unicorn” startups. The authors propose a novel method of calculating valuation that accounts for the highly structured terms of venture financings. The authors say deal structure drives the value of the average U.S. unicorn up by 51%. Under their method, they say almost half of the unicorns they surveyed would lose their unicorn status.

Venture capitalists pay a different price for each share class, and receive different rights and terms to protect against the downside of investments. But those distinctions are forgotten when venture capitalists and the press refer to a company’s valuation.

Post-money valuation values all shares at the price of the last round. The paper proposes “fair valuation,” which treats each class of shares differently, based on the terms.

The paper’s authors, Will Gornall of the University of British Columbia’s Sauder School of Business and Ilya Strebulaev of Stanford University’s Graduate School of Business, recalculate unicorn valuations based purely on the share price and terms of each round. Notably, they don’t use any revenue or other financial data.

The authors’ “fair value” method values the latest class of shares at the price of the last round. But it assigns a lower value to each earlier class of shares, based on its seniority and terms. They use a financial model to predict how the rights of more senior classes might affect the lower classes’ payout in a down exit. The more recent preferred classes are worth more, and common shares are worth least of all.

The authors applied their model to 116 U.S. unicorns, and found that 53 would lose their unicorn horn. Others would keep unicorn status, but see their eye-popping valuations slashed. For example, investors valued Space Exploration Technologies Inc. at $12 billion in its last round. Those investors got the right to redeem their shares for twice as much within six years. The paper’s authors argue the company’s “fair valuation” is $6.4 billion.

Now-public mobile payments company Square Inc. was valued at $6 billion in its last private round, which came with a punishing IPO ratchet. These authors argue that round’s “fair valuation” was only $2.2 billion, accounting for the terms. Their model would value The Honest Company at $1.2 billion, rather than its $1.7 billion post-money valuation. It values real estate industry software maker Compass at only $300 million, rather than its $1 billion reported post-money valuation.

Venture capitalists called the paper interesting, but said its arguments weren’t news to them. They are well-aware that not all shares are the same, and that post-money valuations get a little ahead of their skis. Menlo Ventures Managing Director Venky Ganesan and Artiman Ventures partner Tim Wilson both agreed with the idea that post-money valuations tend to overstate a company’s value.

The paper’s authors assert that venture firms typically mark the value of their shares up to the last round price when reporting holdings to limited partners. Prof. Strebulaev said limited partners would benefit from his paper so they could look more skeptically on their holdings.

But many venture capital firms have already taken this advice to heart. Mr. Ganesan said his firm and most firms he knew well already use an option-pricing model similar to that described in the paper when reporting their holdings to limited partners.

Prof. Strebulaev said he thought investors buying private company stock on the secondary market would benefit from his advice, as would employees who want to gauge the value of their common stock. He suggested that regulators like the Securities and Exchange Commission–which has warned Silicon Valley about playing fast and loose with unicorn valuations–may take an interest as well.

“People buying secondary stock sometimes don’t quite understand what they’re buying, and I think that’s who should read the paper,” said Mr. Wilson.

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