A couple of professors out of Stanford University and the University of British Columbia are out with a new, fresh look at the intricacies of venture capital valuations (Squaring Venture Capital Valuations with Reality, National Bureau of Economic Research Paper #23895). Their topic is unicorn valuations, and specifically whether so-called unicorn valuations are frequently overvalued. Before discussing their results, what would you guess their conclusions are? Would you guess – simply out of preconceived notions or an expert guess – that companies achieving unicorn valuations are typically overvalued or undervalued? Remember, investors that agree with unicorn valuations are usually sophisticated investors, not some new guy off the street. Take your guess.
Valuations
The authors reviewed 135 venture capital-backed private companies with a post-money valuations of $1 billion or more. The value of the unicorn was determined using financial terms from legal filing and reported post-money valuations. Overall, they find that, on average, unicorn firms are overvalued by 50 percent, with 15 of the firms studies being over 100 percent overvalued, compared to their fair market value.
Their findings are based upon calculations of values for each share class, which produces lower valuations because most unicorn companies offer recent investors preferred status, such as IPO return guarantees (14 percent), vetoes over down-IPOs (24 percent), or seniority to all other investors (32 percent). Investors with common stock shares lack such protections and are thus, on average, around 58 percent overvalued. Interestingly, after adjusting for these valuation-inflating measures, around half of all unicorns eventually lose their unicorn status.
Here’s a look at the valuation figures by percentage overvalued. the peak occurs around 25 percent, meaning that 25 of the 135 valuations were overvalued by around 25 percent. Interestingly, none of the authors’ sample firms were undervalued, representing a potential flaw in the study.
Source: Gornall and Strebulaev (2017)
The following figure provides another view of the results. The blue line represents the fair value of the unicorn companies. The orange line is the post-money valuation. Unsurprisingly given the authors’ views on valuations, the fair value of the unicorn companies is always less than the post-money valuations.
Source: Gornall and Strebulaev (2017)
Conclusion
In an interesting look at the intricacies of venture capital valuations, authors William Gornall and Ilya Strebulaev find that unicorn companies – companies with post-money valuations of greater than $1 billion – are frequently overvalued, and that even sophisticated investors often do not understand the workings of specific venture capital valuations. Overall, the authors find that, on the average, unicorn firms with venture capital-backing are highly overvalued, perhaps by around 50 percent. So, the next time you think it is or would be cool to be a venture capital investor, remember that it’s highly likely that many of the deals you come across will be terrible financial investments. Invest with caution.
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