Unicorn Technology Companies Are Special, But What Do Their Valuations Really Mean?

There has been a significant amount of fanfare and concern as the number of private technology startups receiving a valuation over $1 billion (these companies are called “Unicorns”) has eclipsed 100. CB Insights tracks the number of new private companies eclipsing that valuation each year. In 2014, the number of new Unicorns was almost equal to the 3 previous years combined.

Worried investors use this data as evidence that we’re in a bubble for technology companies. The downside protection on the preferred shares that venture capital investors receive make it impossible to compare these investments against public company valuations. It’s important, however, to investigate the underlying value of the preferred stock prior to comparing a private investment that pins Uber’s valuation at $40 billion versus the common stock of any Fortune 500 companies on the public markets.

Total number of Unicorn venture investments since 2011

Preferred Stock Terms

Typically, when a private company sells its stock to investors, those investors receive preferred stock rather than common stock. This preferred stock comes with specific provisions that can be extremely valuable to the investor and can inflate the price associated with the company selling its stock.

Fenwick & West surveyed 37 companies that raised money in the 12 months prior to March 31, 2015 with a valuation greater than $1 billion and provided data that highlights the prevalence of specific terms on Unicorn venture investments. It’s interesting to note that in 75% of these financings, a non-traditional venture capitalists lead the investment. Venture investors typically look for opportunities to capitalize on large multiples against their initial investments to offset the expected losses in the rest of their portfolios. Unlike traditional VCs, the non-traditional investors may be more willing to forgo massive upsides due to the risk profile of their other investments.

In a venture round, investors can demand downside risk while also participating in the upside of a company’s growth. In 100% of the agreements Fenwick & West analyzed, every single one of the investments came with liquidation preferences and anti-dilution terms. Liquidation preferences and anti-dilution terms substantially decrease the risk associated with an investment in a private company. If a venture investor provides a startup with $100 million at a post-money valuation of $1 billion to own 10% of the company and the company provides her firm with a 1x liquidation preference, she is almost guaranteed to recoup a significant portion of her initial investment. That company would need to lose almost 90% of its value prior to her investment resulting in significant losses. The bet that a late-stage venture capital firm is making is much less risky than the one a public investor makes on the common stock of a Fortune 500 company.

The Snapchat Common Offering Is Very Different

In a very rare example of a private company raising a large common stock offering, last week, Snapchat announced that it sold $500 million of common stock. According to sources that Bloomberg spoke with, this common offering was sold at a valuation of $15 billion. This is truly incredible considering Alibaba and other investors will not receive seniority to the earlier investors. There is potentially value locked in the strategic nature of the offering, but this demonstrates a massive valuation on common stock, which is more comparable to the public valuation of this company than earlier rounds were.

In all of the agreements Fenwick & West investigated, the risk adjusted returns on these Unicorn investments is much lower than a similar investment in a public company. Since this is true, the investors are willing to value the preferred shares of the venture-backed company higher than one would value the common stock of the exact same company on the public markets.

Payouts Of A Hypothetical Unicorn Investment

For illustration purposes, I’ve built a hypothetical cap table of a company that recently received a $100 million Series D investment at a $1 billion valuation. This is a very simplistic example (there are no anti-dilution rights included), but drives home the overall point that Unicorn investments are not comparable to public market investments.

The hypothetical 4 rounds invested in the example Unicorn

With these investment terms, the payout structure of the Series D investment (the Unicorn valuation) would be protected against many forms of downside risk. The largest risks to the Series D investment are the startup going bankrupt and future investment rounds that are more senior and are at lower valuation (down-rounds). Bankruptcy is extremely unlikely since any company that raises money at a Unicorn valuation is likely going to be sold prior to bankruptcy. Additionally, these Unicorn investors somewhat protected themselves against down-rounds via anti-dilution provisions. One hundred percent of the investments Fenwick & West surveyed included a weighted-average anti-dilution provision.

If the Series D investors were to put $100 million into a public company, that investor would start losing money as soon as the stock dropped below the price they bought the shares at. For a venture-backed private company, liquidation preferences protect the most senior investors. For example, even though the Series D investors bought preferred shares at a $4.73 price per share, they would not start losing money until the share price dropped below $0.47.

Payout for investors in a Unicorn startup at different exit prices

The two most senior investors would recover all of their money as long as the company sells for at least $0.96.

Senior investor payouts at specific valuations of the hypothetical Unicorn

At each exit valuation, the participation percentage changes as preferred shareholders opt into common stock to capture upside value.

Each preferred investor and common shareholder participates in the exit of the Unicorn at different rates based on the final valuation of the startup

Companies Are Looking For Billion Dollar Valuations

Fenwick & West data demonstrates that many companies are seeking billion dollar valuations and accepting investor-friendly terms to reach those valuations. In a recent article in the New Yorker, an exchange between Mixpanel (not a Unicorn) and Marc Andreesen demonstrates the desire to reach billion dollar valuations. The article mentions an email from Mixpanel’s CEO to his board of directors during which he request a billion dollar valuation. Andreesen’s firm provided the new capital, but at a valuation shy of the Unicorn status — a post money valuation $867 million. Doshi told the reporter that he was sorry they didn’t receive the vaunted valuation, but he believes that “in six or twelve months we’ll be a Unicorn.”

Beyond just hubris, there are several benefits to having a billion dollar valuation. Being a Unicorn provides valuable PR, tells customers, prospects, and employees that you’re a real company valued by some of the brightest minds in finance, and it reduces the cost of capital for the Unicorn’s future acquisitions. With a billion dollar valuation, a company can acquire other startups with its cheaper common equity, even though the stock they will use to acquire the company isn’t worth as much as the preferred shares that carry that value.

Unicorns Are Special, But Some Aren’t Really Worth $1 Billion Today

The companies with greater than a $1 billion valuation are extremely special. Of the 2009 class of seed funded companies, 1.28% have graduated to Unicorn status. This is even rarer when compared to the 57,000 angel-funded companies in that year. These Unicorn companies demonstrated their ability to create enormous amounts of value for their users and customers. That being said, the Unicorn investment cannot be compared to a public company’s common stock valuation because the private investors are receiving preferred shares, which carry a lot of value through terms that protect their downside losses.

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Founder @ParsecTeam. Former director of Product Strategy @newscred. Contributor to @forbes writing about media and technology. Teaching product management @GA

Founder @ParsecTeam. Former director of Product Strategy @newscred. Contributor to @forbes writing about media and technology. Teaching product management @GA