About half of “unicorns,” or venture capital- (VC) backed startups with reported valuations above $1 billion, are overvalued by 49% above assessed “fair value” – an unbiased estimate of a company’s potential market price – while common shares are overvalued by 59%, according to a new study released by UBC Sauder and Stanford University.
With reported valuations totalling over $600 billion, there are more than 200 unicorns around the world, and 113 unicorns are based in the U.S., the study said. The study’s financial model used the most recent financing round price and the financing terms to infer the fair value of 116 unicorns and found that 53 out of 116 lose their mythical “unicorn” status when their valuation is recalculated. Thirteen companies are overvalued by more than 100%.
“Overvaluation arises because the reported valuations assume all of a company’s shares have the same price as the most recently issued shares,” said the study. “In practice, these most recently issued shares almost always have better cash flow rights than the previously issued shares, so equating their prices significantly inflates valuations.”
A company’s reported value, or post-money valuation, is calculated by multiplying the per-share price of the most recent round by the fully-diluted number of common shares. An example from the study is Square Inc. (NYSE: SQ). After its October 2014 financing round, Square had a total of 388 million fully-diluted shares. Multiplying that total by the share price of $15.46 yields a post-money valuation of $6 billion. The study’s financial model found the company’s fair value to be $2.2 billion – meaning the company is overvalued by 171%.
While the post-money valuation formula works well for public companies, which generally have a single class of common equity, VC-backed companies typically create a new class of equity every 12 to 24 months when they raise money, said the study. For these companies, there are different share classes generally having different cash flow and control rights owned by the founders, employees, VC funds, mutual funds, sovereign wealth funds and strategic investors. Investors in these companies are given convertible preferred shares that have both downside protection, via seniority, and upside potential via an option to convert into common shares.
“Historically, most successful VC-backed companies went public within three to eight years of their initial VC funding,” said the study. “More recently, many successful VC-backed companies have opted to remain private for substantial periods of time and have grown to enormous size without a public listing. Companies such as Uber, AirBnB, and Pinterest have been valued in the tens of billions of dollars – fueled by investor expectations that these companies will become the next Google or Facebook.”
The study also found that 53% of unicorns have given their most recent investors either return guarantees in initial public offerings (15%), the ability to block IPOs that do not return most of their investments (20%), seniority over all other investors (31%) or other important terms.