Recent Research: Unicorns are routinely over-valued

In a market economy, what people are willing to pay determines something’s value. Airline tickets are a good example. For most of the major airlines, the price to purchase a seat the day of a flight seems to be some multiple of how much the airline thinks they can get away charging versus any drive to actually see the seat used.  This supply-demand principle falls apart though with valuations set for startup companies funded by equity investors, such as angels or venture capitalists.  In the risk capital business, a number of possible factors influences a startup company’s value – most tied to future markets, comparables, or dreams of big exits.  Recent research from the University of British Columbia and Stanford University suggests just how surprisingly risky – and overly optimistic – this approach is.

Will Gornall and Ilya Strebulaev of UBC and Stanford, respectively, reveal their research in a new working paper, Squaring Venture Capital Valuations with Reality. They find unicorn companies – the approximately 200 startup companies for whom venture backers estimate are worth more than $1 billion each – are typically overvalued by 51 percent above the fair value. Among the various asset classes within the unicorns’ investment structures, the research reveals common shares of the unicorn companies are overvalued by 62 percent, on average.

Nearly one-half of unicorns in the model lose their magical horns with valuations recalculated to match a number of issues. Thirteen of the 116 unicorns in the study appear to have been overvalued by more than 100 percent. The authors suggest a select number of later stage investors seem to be aware of the practice and protect themselves from the risk, however. The researchers found “53 percent of unicorns have given their most recent investors either a return guarantee in IPO (15% of the cases), the ability to block IPOs that do not return most of their investment (20%), seniority over all other investors (31%), or other important terms.”

Different equity classes for different investors in venture-based companies is quite common. The authors suggest as many as eight different classes was typical for companies within their sample, varying across “founders, employees, VC funds, mutual funds and strategic investors.”  Setting valuations for pre-profitable companies is already difficult, but the complexity of the ownership structures of VC-backed companies makes it even harder, the authors contend.  They use Square’s Oct 2014 financing round as an example of the complex structure a company may take on with later, larger investments.  Gornall and Strebulaev found a $2.2 billion fair valuation for Square after the financing round rather than the “$6 billion implied by the post-money valuation. Square’s reported post-money valuation overvalued the company by 171 percent.”  

The range of overvaluations found in the study started at 5 percent and went up to 205 percent; the average was 37 percent. Common shares, Gornall and Strebulaev point out, are even more overvalued because they are typically “worth less than any convertible preferred share.” The table accompanying the working paper presents the authors assessment of fair value and the degree of overvaluation for each of 64 companies in the sample.

The authors only allude to the potential downside of overvaluations from a policy perspective and potential impact for economic development goals. The founders, employees and earliest investors (such as publicly backed accelerators, seed funds, venture development organizations and incubators) are the most likely participants in a company’s financing that may be “unaware of their intricacies and do not understand the valuation implications.”