"Unicorns" are few, but there should be even less

For startups, growing up to a “unicorn” is very important. Companies valued at more than $ 1 billion, in the eyes of competitors, look more formidable, while customers and employees seem much more attractive and reliable than they really are. In the past three years, startup founders have often asked investors to give a billion dollar valuation, regardless of whether the startup is actually worth as much by any traditional valuation method.

National Bureau of Economic Research (USA) in its workconcludes that “unicorns” are on average overestimated by about 50 percent. Researchers from the University of British Columbia and Stanford University studied 135 startups with a valuation of $ 1 billion or more and found that, with a fairer assessment, almost half of these startups (65) would not cross the threshold of $ 1 billion.

Why is there such a big difference? To obtain the unicorn status, most companies received financing on special conditions that gave new investors an advantage at the expense of previous investors and employees who owned shares. Among these conditions are the following: division of shares into different classes so that some shareholders receive more rights than others; a veto right that allows certain investors to cancel the initial public offering (IPO) if its assessment is lower than the current assessment by a private firm; as well as guarantees regarding IPOs, which give certain investors more shares in case of insufficiently high IPO prices.

Translated to Alconost

Who gets the money first

The most important conditions relate to the priority of payments upon liquidation (liquidation privileges), which stipulates that in the event of a sale or IPO, the last investors of a company receive a certain payment in the first place - before other shareholders can get at least something, and in some cases this amount can be four times the value of the investor's investment. This may 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 employees and previous investors will be useless.

Founders of startups often accept these conditions, knowing that when selling a company they can get a good jackpot, even if the conditions of the acquisition itself are not the best. An example is the startup medical practice startup Fusion, which was recently sold to AllScripts for $ 100 million (which is significantly less than the last published valuation): the startup’s CEO receives millions as a result of the transaction, and the middle-level employees owning shares are left with nothing ( source - CNBC ). Once the company had 450 employees, but by the time of the sale the staff had halved.

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

Similarly - at half the price of the last private assessment - Navient bought the startup Earnestwho was engaged in student loans. Employees, some of whom paid thousands of dollars in tax on the use of stock options, did not receive anything during the sale. But CEO Louis Beryl and founder Ben Hutchinson, according to people familiar with the situation, have agreed on amounts of up to $ 10 million each, including additional payments "based on results." Three people in senior positions at Earnest received large severance pay. Also, at least a dozen employees holding preferred shares received small payments. Mid-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 discrepancy raises important questions about how startups evaluate themselves. Typically, a startup’s valuation is calculated based on the value of the last issued shares. But if payments to some shareholders, including employees, are less likely than to other shareholders, should this not reduce the value of such shares? And if it turns out that most of the startup’s shares are worth less, should this not be reflected in the company's valuation?

“[Startups] sell one BMW in the maximum configuration and transfer this price to all other cars - because this is the last sale,” said William Gornall, University of British Columbia, one of the co-authors of the study. “Employees get the KIA as standard, and the company suggests that these cars cost as much as BMW.”

Gornall draws attention to an important point: employees - in fact, owners of KIA - may think that their shares are more expensive than what is obtained from 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.

Registration Analysis

Gornall and co-author Ilya Strebulaev from Stanford University tried to evaluate how the stock structure affects company valuation. With the help of three lawyers and three law students, they examined documents on certificates of incorporation in Delaware. These documents rarely attract attention, but they set out specific legal conditions, and it is usually difficult to understand them: they are written in a confused language, companies often omit some information in them, in addition, such documents reflect only the permission to sell shares, and not the number of issued stocks. In some cases, documents on recent cases of raising funds by companies could not be obtained.

To evaluate companies, the authors considered a wide range of potential outcomes: from IPO and acquisition to bankruptcy. They took into account the variability of the profitability of venture capital investments, the prices at the time startups with venture financing get IPOs, the likelihood of IPOs and prevailing interest rates. The data for the price at the time of the IPO and IPO probabilities were taken by 10,000 companies from the VentureSource database over a period of tens of years.

It turned out that the largest "unicorns", which, among others, include Uber, Airbnb, WeWork, Palantir, Pinterest, Lyft and Dropbox, had the least special conditions related to stocks, so their cost was usually less than inflated. According to the study, these companies were revalued by no more than 21%. (Exception - SpaceX: valuation of the company at $ 10.5 billion for 2015 by 59% per cent higher than the estimate by the formula the researchers - because of conditions favoring the final investors..)

Company Magic Leapafter a round of financing in 2016, it was valued at $ 4.5 billion. However, the money came under special conditions: some shares were given a higher priority during the sale, and certain investors were guaranteed a payment during the IPO. With this in mind, the study claims that a fair valuation of Magic Leap is a third less than $ 3 billion. The representative of Magic Leap declined to comment.

Student loan startup SoFi, the legal financing conditions of which included cumulative dividends (which means that some investors must receive a certain dividend before paying dividends to others), liquidation privileges and the payment threshold for IPOs, was revalued by 27% (when estimated at 3 , $ 6 billion for 2015), Fanatics' e-commerce site with an estimate of $ 2.7 billion for 2015 due to stock priority and IPO payout threshold was 64% overvalued. SoFi representative declined to comment, Fanatics did not respond to a request for comment.

The study examined companies that were bought or entered the stock market. According to the study, Blue Apron Product Suite Delivery Servicewith a private estimate of $ 2.1 billion, should be 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 numbers above. To date, the CEO and co-founder of Blue Apron has already left the company, and the management's inability to retain customers has reduced its market capitalization to $ 577 million.

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

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

In addition, when selling shares on the secondary market, the terms of the purchase are often unclear. The study notes that with the secondary sale of common shares of the Wish e-commerce site, which was estimated at around $ 3.7 billion in a round of financing in 2015, potential investors were not warned that the company’s preferred shareholders received significant protection : The investor of Digital Sky Technologies reserves the right to return his money in all cases, except for the IPO, as well as the right to liquidation privileges in the event of an IPO, if the IPO does not give the company 150% profit. This means that if Wish were sold for $ 750 million — and such a deal would become one of the largest e-commerce sales in the United States — then privileged investors like DST will return their money, and ordinary shareholders will not receive anything. Representatives of Wish did not respond to requests for comment.

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

Betterment, a financial advisory startup in New York, which attracted $ 275 million in venture financing, received investment offers with a company valuation of more than $ 1 billion, which, however, was accompanied by unattractive conditions, including guarantees for investors regarding IPO Therefore, the company preferred to accept a lower rating - but without any conditions. “When raising capital, the first priority is to provide conditions that will work in the best possible way for the benefit of our team,” said CEO John Jon Stein.

Nihal Mehta, general partner of Eniac Ventures, says that if investors in the later stages of financing get privileges for themselves, it harms previous investors, including his company, as they usually invest in the first round of financing. Together with partners, Nihal is trying to teach startup founders "to accept reasonable conditions with ratings that they can grow to." “We believe that founders should not try to increase their grades by any means,” he says.

Investor Bradley Task(Bradley Tusk), which finances startups through its own venture capital fund, Tusk Ventures, says his company refused to re-invest in some companies due to onerous conditions and high ratings that worsen the situation of previous investors. This state of affairs is increasingly forcing investors who invested in the early stages to sell shares in the secondary market before the company is sold or enters the stock market. “It’s increasingly wise to get rid of stocks early,” says Bradley.

How overrated are unicorns?

The study showed that many private companies worth more than $ 1 billion should have a lower valuation, since the conditions applied to part of the shares make the rest of the shares less valuable. Here are examples of identified inconsistencies in the study:

Airbnb
DATA EVALUATION: SEPTEMBER 2016
PUBLIC ASSESSMENT: $ 30 billion
EVALUATION IN THE STUDY: $ 26.1 billion
DIFFERENCE: 15%

BuzzFeed
DATA EVALUATION: NOVEMBER 2016
PUBLIC ASSESSMENT: 1.7 billion
EVALUATION IN THE STUDY: 1.08 BILLION DOLLARS DIFFERENCE
: 57%

Cloudflare
EVALUATION DATE: SEPTEMBER 2015
PUBLIC EVALUATION: 3.2 BILLION DOLLARS
EVALUATION IN RESEARCH: 1.59 BILLION DOLLARS DIFFERENCE
: 101%
Comments: SINCE LAST ATTRACTION FUNDING CLOUDFLARE annual revenue increased by 500%

Dropbox
DATA EVALUATION: JANUARY 2014
PUBLIC ASSESSMENT: $ 10.4 billion
EVALUATION IN THE STUDY: $ 8.6 billion
DIFFERENCE: 21%

Fanatics
DATA EVALUATION: AUGUST 2015
PUBLIC ASSESSMENT : $ 2.7 billion
EVALUATION IN THE STUDY: 1.65 BLN DOLLARS
DIFFERENCE: 64%

Flipboard
DATA EVALUATION: JULY 2015
PUBLIC ASSESSMENT: 1.3 billion
EVALUATION IN THE STUDY: 700 MLN
DIFFERENCE: 86%
COMPANY COMMENT: FLIPBOARD OF GROWING YEAR YEAR, AND THIS ASSESSMENT IS AN INCORRECT REPRESENTATION OF THE CURRENT POSITION SRI COMPANY

Magic Leap
EVALUATION DATE: February 2016
PUBLIC ASSESSMENT: $ 4.5 billion
EVALUATION IN THE STUDY: $ 3.0 billion
DIFFERENCE: 50%

Uptake
DATA EVALUATION: October 2015
PUBLIC ASSESSMENT: 1.1 billion
EVALUATION IN THE STUDY: 382.6 MLN
DIFFERENCE : 187%

WEWORK
ASSESSMENT DATE: MARCH 2017
PUBLIC ASSESSMENT: 18 BILLION DOLLARS
EVALUATION IN RESEARCH: 15.27 BILLION DOLLARS DIFFERENCE
: 18%

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