Are Unicorns Overvalued?

Startups strive for the magic $1 billion valuation to become a so called “unicorn”, but even when they do, is it always justified? In many cases, not so, at least according to one recent study from the National Bureau of Economic Research and researchers from the University of British Columbia and Stanford.

Here’s a breakdown of their findings:

  • Background: The researchers analyzed 135 US startups with reported valuations above $1 billion and compared them with their own valuations by using “financial terms from legal filings”.
  • Process: They calculated the fair value of the companies and the values for each share class on the day of their latest financing round. They found, however, that the startups yield “lower valuations because most unicorns gave recent investors major protections such as IPO return guarantees (14%), vetoes over down-IPOs (24%), or seniority to all other investors (32%)”. In other words, they agreed to terms that benefit the latest investors to achieve a valuation above $1 billion, hurting earlier investors and employees.

    After all, new investors are senior to more than half of all the outstanding shares on average, and “new preferred shares are always senior to all common shares”. Even preferred shares can take a back seat, however, as “new investors are also senior to some existing preferred shareholders” in 66 out of 135 unicorns and “new investors are senior to all the existing shareholders” in 43 unicorns.

    Therefore, “the value of unicorns and their shares is extremely sensitive to the contractual terms given to investors”. This can favor a small group of “privileged investors” while “many other stakeholders cannot easily view them and certainly cannot understand the valuation implications”.

  • Results: The researchers found that reported unicorn post-money valuation average 50% above fair value and note that “common shares lack all such protections and are 58% overvalued”. Additionally, almost half (65) of unicorns lose their unicorn status after “adjusting for these valuation-inflating terms”. This overvaluation stems from the fact that the most recently issued preferred shares have strong cash flow rights: “Companies where the most recent preferred shareholders have stronger rights are overvalued the most”.

    The researchers also discovered a wide variation in the degree of overvaluation: “while the 10 least overvalued companies are overvalued on average only by 13%, the ten most overvalued companies are on average overvalued by 170%”.

  • Examples: Airbnb received a public valuation of $30 billion as of September 2016, while the study differed by 13% by giving it a $26.1 billion valuation. Uber did not have as wide of a difference as other unicorns with a $68 billion public valuation (as of June 2016) and $60.6 billion valuation by the study (11% disparity). By contrast, the study valued BuzzFeed at $1.08 billion compared to the public valuation of $1.7 billion, a 37% difference. The study also valued Magic Leap at $3 billion versus a public valuation of $4.5 billion as of February 2016, a 33% difference.

The upshot: the study believes many of the startups they reviewed should have lower stated valuations because the protections associated with some of their shares dilute the value of other equity holders. The researchers also stressed the importance of all parties involved in deals whether it be investors or employees having full information of share structures because they are not all worth the same. This is important not just for those impacted by the deal, but when assessing venture capital deals generally because “variations in terms can correspond to large variations in value”.

*You can read the full study and see the way the researchers valued other startups here, and read a great analysis by Wired here.