Unicorns Are Rare. This Study Suggests They Should Be Even Rarer

For startups, achieving unicorn status is a big deal. Companies valued at more than $1 billion look more formidable to competitors, customers, and recruits—and less like the fly-by-night startups they may actually be. Thus, for the past three years, startup founders have asked investors to grant them billion-dollar valuations, regardless of whether they’re worth that by any traditional business metric.

Now, a study from the National Bureau of Economic Research concludes that, on average, unicorns are roughly 50 percent overvalued. The study, by researchers at the University of British Columbia and Stanford, examined 135 startups valued at $1 billion or more. Of those, the researchers estimate that nearly half—65—should be more fairly valued at less than $1 billion.

Why such big disparities? In order to get to unicorn status, most of the companies accepted funding with strings attached, terms that reward the latest investors at the expense of early investors and employee shareholders. Those conditions include separate share classes, which give some shareholders more rights than others; veto rights, which allow certain investors to vote against an IPO priced below the last private valuation; and IPO ratchets, which give certain investors more shares in the event of a disappointing IPO price.

Who Gets Paid First

The most significant terms are liquidation preferences, which mandate that, in the event of a sale or IPO, the company’s most recent investors earn a certain return—ranging from their principle to, in extreme cases, four times their initial investment—-before any other shareholders receive anything. That can mean that if the company doesn’t sell for a multiple of its last valuation, shares owned by employees and early investors are worthless.

Startup founders often accept these terms knowing they may be able to successfully negotiate a good outcome for themselves in an acquisition, even if the acquisition is disappointing. For example, the CEO of Practice Fusion, a medical-records startup which recently sold to AllScripts for $100 million—significantly less than its last reported valuation—is set to make millions in the deal while mid-level employees’ shares were worthless, according to CNBC. The company has had as many as 450 employees but had shrunk to half that by the time of the sale.

Likewise for student-loan startup Earnest, which sold to Navient for half of its last private valuation in October. Employees, some of whom paid thousands of dollars in taxes to exercise their stock options, got nothing in the sale. But CEO Louis Beryl and co-founder Ben Hutchinson negotiated a package of up to $10 million each including earn-outs as part of the deal, according to several people familiar with the situation. Three other Earnest executives earned “parachute” payments, and fewer than a dozen employees holding preferred shares earned small payouts. But mid-level employees, most of whom owned common shares, were left with nothing. Earnest had 150 employees at the time of the sale. A representative from Earnest declined to comment on the deal’s terms.

This disparity in outcomes raises important questions about how startups value themselves. Typically, a startup’s valuation is calculated based on the value of the latest shares issued. But if some shareholders, including employees, are less likely to see a payout than other shareholders, shouldn’t those shares be worth less? And if most of a startup’s shares are worth less, shouldn’t that difference be reflected in the startup’s valuation?

Startups are “selling a fully loaded BMW and taking that price and putting it across all cars on the lot, because that’s the most recent sale,” says William Gornall, of UBC, one of the study’s co-authors. “They’re giving their employees base level Kias and they’re assuming they’re worth the same as the BMW.”

Gornall says it’s important that employees—the Kia owners, essentially—who may think their shares are worth more than they are understand their company’s share structure. “If professional investors are misinterpreting these terms that’s one thing, but real people are basing their lives around this stuff,” he says.

Sifting Through Filings

Gornall and co-author Ilya Strebulaev of Stanford set out to assess how different share structures affect a company’s valuation. With a team of three lawyers and three law-school students, they sifted through Certificate of Incorporation filings in Delaware. Those rarely reviewed documents contain specific deal terms, but they’re hard to interpret: They don’t use standard language, companies often omit information, and they only reflect share sale authorization—not the number of shares actually issued. In some cases, filings from the company’s most recent funding were not available.

To estimate a value for each company, the authors considered a wide range of potential outcomes, from IPO and acquisition to failure. They took into account the volatility of venture investment returns, the rate at which venture-backed startups exit, the probability of IPO, and prevailing interest rates. For the exit rate and IPO probabilities, the researchers used data from more than 10,000 companies spanning decades from VentureSource.

They found that the biggest unicorns, including Uber, Airbnb, WeWork, Palantir, Pinterest, Lyft, and Dropbox—have the fewest special terms attached to their shares, and therefore tend to be less overvalued by their formula. All of those companies were overvalued by 21 percent or less, according to the study. (SpaceX is an exception; its $10.5 billion valuation from 2015 is overvalued by 59 percent due to terms that favor its most recent investors.)

Augmented-reality company Magic Leap was valued at $4.5 billion following a 2016 round of funding. But the funding came with strings: some shares are granted seniority over others in a sale, and certain investors are guaranteed a payout in an IPO. Considering those factors, the study estimates that Magic Leap should have been more fairly valued at $3 billion, one-third less. A Magic Leap representative declined to comment.

Student-loan startup SoFi, with deal terms including cumulative dividends (meaning certain investors must earn a certain dividend before others are paid out), liquidation preferences, and an IPO return threshold, was overvalued by 27 percent in its $3.6 billion valuation in 2015, according to the study Ecommerce site Fanatics, worth $2.7 billion in 2015, is overvalued by 64 percent due to seniority and an IPO return threshold. A SoFi representative declined to comment and Fanatics did not respond to a request for comment.

The study included companies that have since been bought or gone public. Meal-kit delivery service Blue Apron, which carried a private valuation of $2.1 billion, had a fair value of $1.6 billion, according to the study. The company went public in mid-2017 at a valuation between those two figures—$1.89 billion. Since then, Blue Apron’s CEO and co-founder has resigned and the company’s struggles to retain customers have sent its market capitalization down to $577 million.

As their name implies, holders of preferred shares get preferences over other shareholders. But Gornall and Strebulaev determined that some deal terms hurt preferred shareholders as well: In 66 out of the 135 companies studied, new investors were also “senior to” (meaning they get paid out first) some existing preferred shareholders. In 43 of the companies, new investors took preference over all existing shareholders, including preferred shareholders.

The differences in terms are often not clear when shares are sold on the secondary market, either. The study notes that secondary sales of common stock in Wish, an ecommerce site valued at an estimated $3.7 billion in its 2015 round of funding, do not warn potential investors that the company’s preferred shareholders have strong protections. Wish investor Digital Sky Technologies retains the right to get its money back in any exit other than an IPO and the right to keep its preferred liquidation preference in an IPO unless that IPO provides the firm a 150% return. That means if Wish is sold for $750 million—a deal that would rank among the country’s top e-commerce sales—preferred investors like DST would get their money back but common shareholders would get nothing. Wish did not respond to a request for comment.

Not every startup has accepted onerous terms. Roy Bahat, head of investment firm Bloomberg Beta, says his firm has had at least one portfolio company turn down a billion-dollar valuation, opting instead for an investor offering standard deal terms at a lower price. “When a startup takes a higher valuation in exchange for complicated terms I always start worrying that they're in trouble," he says.

Betterment, a New York City-based financial advisory startup that has raised $275 million in venture funding, fielded investment offers that valued the company at more than $1 billion. But those offers came with unattractive deal terms including IPO ratchets, and the company opted to take the lower valuation, sans terms. “Whenever we’ve been raising capital, its been an absolute priority to secure terms that were as clean as possible for the benefit of our team,” says CEO Jon Stein.

Nihal Mehta, a general partner at Eniac Ventures, says that when late-stage investors negotiate special preferences for themselves, it hurts earlier investors, including his firm, which typically invests in a startup’s first round of funding. He and his partners try to coach founders “to take reasonable terms with valuations they can grow into,” he says. “We believe strongly founders should not optimize for valuation.”

Bradley Tusk, who invests in startups through his venture fund Tusk Ventures, says his firm has declined to re-invest in some of its own portfolio companies because of onerous deal terms and high valuations that will hurt the returns of early investors like him. Increasingly, those situations are driving early stage investors like him to sell shares on the secondary market, before the company sells or goes public, he says. “Getting out sooner is starting to make more sense.”

How Overvalued Are the Unicorns?

A study found that many private companies valued at more than $1 billion should carry smaller valuations, because they conditions attached to some of their shares make other shares less valuable. Here's a sample of the disparities identified in the study:

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