Much of the business news in 2019 reported on privately-held companies with a market valuation of a billion dollars or more – the so-called unicorns. The news, however, was generally not good. The biggest story was the precipitous drop in the planned IPO pricing of WeWork, followed by withdrawal of their IPO and the forced departure of the founder/CEO. Although the struggles of unicorns other than WeWork have been less dramatic, things have not been good over the last few months for them. At last report, Uber’s market cap is about thirty-two billion dollars below its IPO price and Lyft’s market cap is off about ten billion dollars. Many other unicorns are announcing lay-offs and reporting difficulty in raising follow-on rounds. Given the regular posting of new market highs in the Dow Jones average and NASDAQ index and the strong stock performance of more established tech companies, the struggles of the unicorns are especially striking.
A number of dynamics explain the struggles of the unicorns. In the case of WeWork, the market took longer than expected to realize that WeWork is a highly leveraged real estate leasing company, not a technology company, and more troubling, it is a company with substantial related party transaction issues. However, given the broad declines and widespread difficulties of other unicorns, something more fundamental is also part of the situation.
One part of the explanation is classic bubble economics. The last tech bubble was largely confined to publicly-held companies. In contrast, at present we appear to be coming out of a bubble economy in privately-held tech companies. This is due in part to companies delaying IPOs and choosing to remain privately-held much longer than in prior years. This is understandable, given the increased compliance costs and scrutiny of being a public company. The magnitude of the change in how long companies stay private is enormous. The median age for tech companies going public in 1999 was four years, compared to twelve years in 2018. Median sales paint a similar picture – they were about $12 million for tech companies at the time of their IPO in 1999, compared to $174 million in 2018.
The existence of a bubble in privately-held tech companies is becoming widely acknowledged. However, there is another dynamic at work that is less understood – specifically, a systematic over-valuation of VC-funded companies. When a company receives venture capital funding, the VC fund invests a stated amount of dollars for a specified percentage ownership of the company. For example, a VC fund could invest twenty million dollars for preferred shares that represent ownership of five percent of the company’s equity. The tried-and-true valuation is to assume that the company’s value is a simple calculation – if five percent of the company is worth twenty million dollars, then the company must be worth four hundred million dollars.
However, this assumes that the shares issued to the VC investors have the same per-share value as shares in the company as a whole. This makes the calculation simple, but unfortunately it is a false assumption. The shares issued to the VCs are preferred shares that give the investors a broad range of protections not available to the common shareholders. Besides the right to receive distributions ahead of the common shareholders, the preferred shareholders typically have a panoply of other rights such as a minimum IPO return guarantee, board representation, approval of many corporate transactions, tag-along rights, etc. As a result, the preferred shares clearly have a higher per-share value than the existing common shares and any common shares that will be issued upon IPO. Surprisingly enough, the business press continues to use the simple (but misleading) multiplication method of stating valuations of privately-held companies that have received VC funding.
The discrepancy in value between the preferred shares granted to VCs versus common shares is obvious enough. Perhaps this discrepancy is overlooked partly due to challenges in establishing the true value of a company in these situations. Two academic researchers, Prof. Ilya A. Strebulaev of Stanford University and Prof. Will Gornall of the University of British Columbia, performed a thorough and exhausting analysis of the valuation discrepancy. They analyzed 135 unicorns. After reviewing the various preferences granted to the VC investors and adjusting values accordingly, they determined that while the average simplistic reported value of the unicorns they studied was $3.3 billion, the average fair value was $2.6 billion, a twenty-one percent drop in value. When comparing mean values rather than averages, the drop was more pronounced – $1.5 mean reported value versus $1.0 billion mean fair value, or a thirty-three percent drop. An equally telling fact is that after adjusting for the valuation-inflating terms received by the preferred stock investors, almost one-half of the companies in the study lost their unicorn status – 65 out of 135 to be exact.
This systematic over-valuation, while most apparent in the universe of unicorns, applies equally to smaller companies. Companies that have received any investment, no matter how modest the amount, in exchange for issuing preferred stock should incorporate this concept into their internal expected value of their company. In my practice, I see many wide gaps in the value placed on a company by a potential acquirer versus the owners’ perception of value. By taking into account the difference between the widely used but simplistic method of valuation and the more accurate fair value, companies should more easily come to agreement with acquirers regarding company value, which benefits parties on both sides of the table.