In myth and legend, unicorns were horse-like creatures whose single horns were supposed to have magical powers. Many children believe in them, but few adults do.
Venture capitalists, however, are an exception, although the kinds of unicorns they believe in produce money in legendary proportions: In Silicon Valley, a unicorn is any venture-backed private company worth more than $1 billion.
But a paper by Poets&Quants’ Professor of the Week, Ilya A. Strebulaev of the Stanford Graduate School of Business, finds that market values of many of these unicorns are, well, mythical. They are based on simplistic valuation methods and valuing them in a more complex, realistic way would show many of these companies aren’t unicorns at all.
PROFESSOR OF THE WEEK: THE AVERAGE UNICORN IS OVERVALUED BY 48%
The paper, “Squaring Venture Capital Valuations with Reality,” co-authored with Will Gornall of the Sauder School of Business at the University of British Columbia, was published in January in the peer-reviewed Journal of Financial Economics.
After applying their more sophisticated model, Strebulaev and Gornall found that almost half of the 135 unicorns they studied lost their billion-dollar valuations. “The average…unicorn is overvalued by 48%,” they write. “Common shares are even more overvalued, with an average…overvaluation of 56%.”
The researchers trace the problem to the way venture capitalists, investors, and the media use a simple, back-of-the-envelope “post-money” valuation, calculated by multiplying the number of outstanding shares by the price per share at the latest financing round.
‘PROTECTIONS’ GRANTED EARLY INVESTORS OFTEN MAKE COMMON SHARES LESS VALUABLE
That, Strebulaev and Gornall point out, ignores the complexity of venture capital, which typically comprises several rounds of financing at different prices.
“Unlike public companies, which generally have a single class of common equity, VC-backed companies typically create a new class of equity every 12–24 months when they raise money,” the researchers write. “The average unicorn in our sample has eight share classes, where different classes can be owned by the founders, employees, VC funds, mutual funds, sovereign wealth funds, strategic investors, and others.”
That structure often gives certain shareholders—mostly recent investors—”major protections such as initial public offering (IPO) return guarantees…, vetoes over down-IPOs…, or seniority to all other investors.” These protections can make the larger universe of common shares much less valuable, the researchers found.
SOME UNICORNS STUDIED WERE OVERVALUED BY 145%
To prove their hypothesis, Strebulaev and Gornall dug deep into the legal documents issued by these 135 companies, which on average were “founded in 2007 in California, raised seven rounds of funding, and most recently raised a round of about $250 million in 2014 at a post-money valuation of around $3 billion,” they wrote. “Of the 135 companies in our sample, 84 are still private as of February 1, 2018, 12 were acquired, 35 went public, and four failed.”
They then carefully sorted out the different rights granted to investors during each financing round. This “contingent-claim” methodology took account of the values inherent in options on preferred shares. Once those were properly valued, the remaining common shares were often worth considerably less. “Post-money valuations are substantially above fair values for many unicorns because of the preferential contractual terms they gave their most recent investors,” the researchers note.
On average, unicorn IPOs are overvalued by 48%, although “a large variation exists in the degree of overvaluation,” Strebulaev and Gornall write. “While the ten least overvalued companies are overvalued on average only by 13%, the ten most overvalued companies are on average overvalued by 145%.” Interestingly, because late investors in ride-sharing company Uber got few extra rights over common shareholders, its overvaluation was relatively small, at 12% before it did its initial public offering.
OVERVALUATION IS A MAJOR PREDICTOR OF AN UNSUCCESSFUL EXIT
Strebulaev and Gornall’s findings have broad implications for VC and IPO investors. “Overvaluation is a significant predictor of an unsuccessful exit,” they write. Their research suggests investors should be aware of these companies’ true values before jumping on the unicorn bandwagon. (The two researchers have set up an online calculator at www.valuation.vc that will allow investors and employees to value their holdings more accurately.)
Strebulaev, 44, is the David S. Lobel Professor of Private Equity and Professor of Finance at Stanford GSB. His research interests include venture and angel capital, recently focusing on decision making by startup investors, returns to VC investors, and the impact of venture capital investments. He teaches MBA, Ph.D. and executive education students, and has been teaching a class on Angel and Venture Capital Investing and Decision Making for the last several years.
Having earned his bachelor’s degree at Lomonosov Moscow State University, he got his master’s from the New Economic School, also in Moscow, and a master’s and Ph.D. in finance from the London Business School. He has taught at Stanford since 2004.