"Unicorns" is small, but should be even less

For startups, growing up to "unicorn" is very important. Companies whose valuation exceeds $ 1 billion in the eyes of competitors look more formidable, and customers and employees seem much more attractive and reliable than they actually are. In the past three years, the founders of startups have often asked investors to evaluate a billion dollars, regardless of whether a startup is actually worth as much as any traditional method of evaluation.

The National Bureau of Economic Research (USA) in its work concludes that “unicorns” are on average overestimated by about 50 percent. Researchers from the University of British Columbia and Stanford University studied 135 startups with an estimated $ 1 billion or more and found that with a more fair estimate, almost half of these startups (65) did not cross the threshold of $ 1 billion.
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Where does such a big difference come from? To obtain the status of "unicorn", most companies received financing on special terms, which gave new investors an advantage at the expense of previous investors and employees - owners of shares. Among such conditions are the following: the division of shares into different classes so that some shareholders get more rights than others; veto power, which allows certain investors to cancel an initial public offering (IPO) if its valuation is lower than the current valuation by a private firm; and also guarantees regarding IPOs, which give certain investors more shares in case of insufficiently high IPO prices.

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Who gets the money first

The most important conditions relate to the priority of payments during liquidation (liquidation privileges), which provides that in the event of a sale or IPO, the company's recent investors receive a certain payment first - before the rest of the shareholders can get at least something, and in some cases this amount can be four times the value of the investor’s investment. This can lead to the fact that if the company is not sold at a price several times higher than the last estimate, then the shares owned by the employees and previous investors will be useless.

Founders of startups often accept such conditions, knowing that they can get a good sum when they sell a company, even if the conditions of the acquisition itself are not the best. An example is Startup Practice Fusion, which worked on medical cards and was recently sold to AllScripts for $ 100 million (which is significantly less than the last published estimate): the CEO of a startup receives millions as a result of the transaction, and middle-level employees left with nothing ( source - CNBC ). At one time, the company had 450 employees, but at the time of the sale, the staff was halved.

"[Startups] sell one BMW in top of the range and transfer this price to all other cars - because this is the last sale on time."
- describes the situation by William Gornall

Similarly, at a price two times lower than the last private estimate , Navient bought a startup Earnest , which was engaged in student loans. Employees, some of whom paid thousands of dollars in tax on the use of stock options, received nothing on the sale. But CEO Louis Beryl and founder Ben Hutchinson, according to people familiar with the situation, agreed on amounts of up to $ 10 million each, including additional “by results” payments. Three people in leadership positions at Earnest received major termination benefits. Also, at least a dozen employees owning preferred shares received small payments. Middle-level employees, most of whom had ordinary shares, were left with nothing. At the time of the sale, the company had 150 employees. A spokesman for Earnest declined to comment on the terms of the deal.
This inconsistency raises important questions about how startups evaluate themselves. Usually, a start-up estimate is calculated based on the value of the most recently issued shares. But if payments to some shareholders, including employees, are less likely than other shareholders, should this not reduce the cost of such shares? And if it turns out that most of the shares of a startup are worth less, shouldn't this be reflected in the company's valuation?

“[Startups] sell one BMW in top of the range and carry this price on all other cars - because this is the last sale,” says one of the study’s co-authors William Gornall (William Gornall, University of British Columbia). “Employees get KIA as standard, and the company assumes that these cars cost as much as BMW.”

Gornall draws attention to an important point: employees - in fact, KIA owners - may think that their shares are more expensive than they are based on the structure of the company's shares. “If professional investors misunderstand such conditions - this is one thing. But ordinary people build their lives on this, ”he says.

Analysis of registration documents

Gornall and co-author Ilya Strebulaev of Stanford University tried to assess how the stock structure affects the company's valuation. With the help of three lawyers and three law students, they studied documents on company registration certificates in Delaware. These documents rarely attract attention, but they set out specific legal conditions, and usually they are difficult to understand: they are written in confusing language, companies often omit some information in them, moreover, only the permission to sell shares is reflected in such documents, but not the number of issued shares. In some cases, it was not possible to obtain documents on recent cases of raising funds by companies.

To evaluate companies, the authors considered a wide range of potential outcomes: from IPO and acquisitions to bankruptcy. They took into account the variability of returns on venture capital investments, prices at the time of start-ups with venture financing for IPOs, the likelihood of IPOs and prevailing interest rates. The data for the price at the time of the IPO and the IPO probabilities were taken for 10,000 companies from the VentureSource database over a period of decades.

It turned out that the largest “unicorns”, which include, among others, Uber, Airbnb, WeWork, Palantir, Pinterest, Lyft and Dropbox, had the least special conditions associated with equities, so their cost was usually less overpriced. According to the study, these companies were revalued by no more than 21%. (The exception is SpaceX: the company's estimate of $ 10.5 billion for 2015 is 59% percent higher than the estimate according to the researchers' formula, due to conditions conducive to recent investors.)

The company Magic Leap , engaged in augmented reality, after a round of financing in 2016 was estimated at 4.5 billion dollars. USA. However, the money came on special conditions: some shares were given a higher priority when selling, and certain investors were guaranteed payment at IPO. With this in mind, the study states that a fair estimate of Magic Leap is a third less than $ 3 billion. The representative of Magic Leap declined to comment.

The SoFi start-up student loan, whose legal financing conditions included cumulative dividends (this means that some investors should get a certain dividend before paying the dividends to others), liquidation privileges and the payout threshold for an IPO, turned out to be overestimated by 27% (estimated at 3 , $ 6 billion for 2015), Fanatics e-commerce site with an estimate of $ 2.7 billion for 2015 due to the priority of shares and the payout threshold for an IPO was overestimated by 64%. The SoFi spokesman declined to comment, Fanatics did not respond to the request for comment.

The study looked at companies that were bought or entered the stock market. According to the study, the Blue Apron product delivery service, whose private estimate was $ 2.1 billion, should have been valued at $ 1.6 billion. The company entered the stock market in mid-2017 with an estimate of $ 1.89 billion, just between the two figures above. To date, Blue Apron’s CEO and Co-Founder has already left the company, and management’s inability to retain customers has reduced market capitalization to $ 577 million.

“If a startup gets a higher estimate of value in exchange for special conditions, this is an occasion to think about the problems in the company.”
- Roy Bahat

Holders of preferred shares, as the name suggests, receive some privileges compared to other shareholders. However, Gornall and Strebulaev found out that sometimes financing conditions also harm preferred shareholders. In 66 of the 135 companies studied, new investors had a priority (payout priority) over some preferred shareholders. In 43 companies, new investors gained an advantage over all other shareholders, including privileged ones.

In addition, when selling shares in the secondary market, the conditions of purchase are often unclear. The study notes that with the secondary sale of ordinary shares of the e-commerce site Wish, whose evaluation in the framework of the financing round in 2015 amounted to about $ 3.7 billion, potential investors were not warned that the preferred shareholders of the company were seriously protected : The investor Digital Sky Technologies reserves the right to return its money in all cases, with the exception of an IPO, as well as the right to liquidation privileges in the event of an IPO, if the IPO does not give the firm 150% profit. This means that if Wish were sold for $ 750 million — and such a deal would be one of the largest e-commerce sales in the US — then preferred investors, such as DST, would return their money, and ordinary shareholders would not will get nothing. The representatives of the Wish did not respond to the request for comments.

However, not all startups agree to such burdensome conditions. Roy Bahat, head of investment firm Bloomberg Beta, says they have at least one company in their portfolio that declined a billion dollars in value and chose to give investors standard terms at a lower price. “If a startup gets a higher estimate of value in exchange for special conditions, this is an occasion to think about problems in the company,” Roy says.

New York-based financial advisory startup Betterment, which raised $ 275 million in venture financing, received investment proposals with a company valuation of more than $ 1 billion, which, however, was accompanied by unattractive conditions, including guarantees to investors about IPO , therefore, the company chose to accept a lower estimate - but without any conditions. “When attracting capital, the primary task is to provide conditions that will work in the most clear way in favor of our team,” notes the company's CEO, Jon Stein.

Nihal Mehta, general partner of Eniac Ventures, says that if investors receive privileges for themselves in the later stages of financing, this hurts previous investors, including his company, as they usually invest in the first round of financing. Together with his partners, Nihal is trying to teach the founders of startups to “accept reasonable conditions with grades to which they are able to grow.” “We believe that the founders should not strive by any means to increase the rating,” he says.

Bradley Tusk, an investor who finances start-ups through his own venture capital fund Tusk Ventures, says his company has refused to re-invest in some companies because of burdensome conditions and high ratings that worsen the situation of previous investors. This situation is increasingly forcing investors who have invested in the early stages to sell shares in the secondary market before the company is sold or enters the stock market. "It is increasingly reasonable to get rid of stocks early," says Bradley.

How much are unicorns overvalued?

The study showed that many private companies valued at more than $ 1 billion should be priced lower because the conditions applied to a portion of the shares make the remaining shares less valuable. Here are examples of inconsistencies identified in the study:

Airbnb
EVALUATION DATE: SEPTEMBER 2016
PUBLIC EVALUATION: $ 30 BLN
ASSESSMENT IN RESEARCH: $ 26.1 BLN
DIFFERENCE: 15%

Buzzfeed
EVALUATION DATE: NOVEMBER 2016
PUBLIC EVALUATION: 1.7 BLN DOLLARS
ASSESSMENT IN RESEARCH: 1.08 BLN DOLLARS
DIFFERENCE: 57%

Cloudflare
EVALUATION DATE: SEPTEMBER 2015
PUBLIC EVALUATION: $ 3.2 BLN
ASSESSMENT IN THE RESEARCH: 1.59 BN USD
DIFFERENCE: 101%
COMMENTARY OF THE COMPANY: AT THE TIME OF THE LAST ATTRACT OF FINANCING, CLOUDFLARE ANNUAL INCOME INCREASED BY 500%

Dropbox
EVALUATION DATE: JANUARY 2014
PUBLIC EVALUATION: $ 10.4 BLN
ASSESSMENT IN RESEARCH: 8.6 BLN DOLLARS
DIFFERENCE: 21%

Fanatics
EVALUATION DATE: AUGUST 2015
PUBLIC EVALUATION: $ 2.7 BLN
ASSESSMENT IN RESEARCH: 1.65 BLN DOLLARS
DIFFERENCE: 64%

Flipboard
EVALUATION DATE: JULY 2015
PUBLIC EVALUATION: $ 1.3 BLN
ASSESSMENT IN THE RESEARCH: 700 MILLION DOLLARS
DIFFERENCE: 86%
COMPANY COMMENT: FLIPBOARD GROWING FROM YEAR TO YEAR, AND THIS EVALUATION IS INCORRECT REPRESENTATION OF THE CURRENT COMPANY SITUATION

Magic leaf
EVALUATION DATE: FEBRUARY 2016
PUBLIC EVALUATION: $ 4.5 BLN
ASSESSMENT IN THE RESEARCH: 3.0 BLN DOLLARS
DIFFERENCE: 50%

Uptake
EVALUATION DATE: OCTOBER 2015
PUBLIC EVALUATION: 1.1 BLN DOLLARS
ASSESSMENT IN THE RESEARCH: 382.6 MILLION DOLLARS
DIFFERENCE: 187%

Wework
EVALUATION DATE: MARCH 2017
PUBLIC EVALUATION: $ 18 BLN
ASSESSMENT IN RESEARCH: 15.27 BLN DOLLARS
DIFFERENCE: 18%

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