Unicorns and Overvaluation

By Kathryn Song

Many of you have probably heard of Uber, Lyft, Spotify, and SpaceX. These kinds of new tech firms seem to dominate the current business landscape, and all are categorized under one umbrella term: unicorn. Although many unicorns are in the tech industry, this type of firms is not specific to any one industry. Instead, a firm has to meet two basic requirements to be classified as a unicorn. First, it has to be valued at over $1 billion, and second, it needs to be funded privately, meaning that none of these companies have publicly-traded stocks.

Over the recent years, there has been a huge increase in the number of unicorns. In the US alone, there are currently more than 130 unicorns, as compared to around 5 in 2009. This trend is largely due to an increase in the pool of private funding available, as many private investors, such as venture capital firms, are eager to acquire benefits before a company IPOs.

Credit Suisse- Number of Unicorns in the US

However, there have been growing concerns regarding the possible overvaluation of unicorns by venture capitalists. In general, private companies are valued using three methods: Comparable Company Analysis (CCA), Discounted Cash Flow (DCF), and the First Chicago Method.

Comparable Company Analysis hinges on the assumption that similar firms in the same industry have similar multiples. Using this assumption, VCs find the industry average of a multiple to compute the value of the company. One example would be finding the value of the firm by multiplying the industry average EV/EBITDA by the EBITDA of the firm.

On the other hand, Discounted Cash Flow projects the cash flow of a company into the future, and then discounts it back to a present value. The purpose of this method is to take into account the future potential of the company to earn cash.

Discounted Cash Flow formula

Lastly, the First Chicago Method is a combination of the CCA and DCF, except for three different scenarios: best-case, mid-case, and worse-case. For each of these scenarios, the venture capitalist calculates the terminal value of the company using the averages of the multiples of similarly-performing companies in the same industry. Then, the venture capitalist calculates a weighted sum, which is the value of the company, by multiplying the probability of each of the scenarios occurring and the company’s terminal value in each case.

As you can see from the valuation techniques, many of them hinge on assumptions — for example, the assumption that similar firms in the same industry will have similar multiples. This sort of relative valuation can lead to overvaluation if the industry as a whole is doing very well, but the firm itself is not.

VC firms and other private investors may also be aware of this overvaluation, but usually have no reason to stop it. Oftentimes, VCs will enter into investor contracts such as liquidation preference, which gives the VC the right to cash first if the company is ever liquidated (in the case of a bankruptcy or M&A). Thus, the VC does not care whether the company is overvalued, as it will obtain cash either way.

Similarly, VCs often engage in ratchet anti-dilution protection, which is when the VC is guaranteed to always have a certain equity stake in a company. Thus, the VC has no incentive to stop overvaluation, as they will always maintain that percent ownership in the company.

In general, it is important to keep in mind the overvaluation of unicorns, as they are becoming such a prominent part of our current society.