In the past year the creation of “unicorns”—startups valued at $1 billion or better—doubled from 4 to 8. It raises a question: Are we really minting twice as many great companies as we were just a year ago?
The short answer is no.
What has increased are the deals where big brand VCs overpay for shares to drive a company’s value to Unicorn levels—on paper, anyway. It’s a strategy that can pay off for the big brand VCs, who’s returns are guaranteed, but at the expense of the other investors.
It is a legal form of market rigging, and unless you are a big brand you can prepare for the wins to come off of your high-flying unicorn investment, and for it’s value to come crashing back to earth. In fact, it’s already beginning—but I’ll get to that in a minute.
To see how this works, take a look at Square, which makes a mobile phone credit card reader and processes card payments for tiny businesses.
Helmed by Twitter CEO Jack Dorsey, Square was a VC darling nearly from the start. In 2012, after it’s D series round of funding, Square was valued at $3.25 billion. Two years later, after its E series round of funding, it was up to $6 billion. It’s a remarkable jump when you look at how investing traditionally worked.
In the past, investors from early stage angels to later stage VCs, argued for the lowest price possible on shares in a company it invested in to get a greater percentage of ownership for their money.
Now, when a late stage VC comes along, it may seek to overvalue a company—paying more than it may really be worth—basically agreeing to say the company is worth billions, even if it isn’t.
Why the turn around, offering top dollar for shares, instead of trying to strike a bargain?
At Square, their E Series investors were a pretty canny lot, including the Government of Singapore Investment Corporation (GIC), Goldman Sachs, and Rizvi Traverse Management.
When big players like those pay a higher valuation, it makes other investors think the big players know something. After all, these guys are insiders—they must know something no one else does, right? That perception magically drives the share price up. The company’s profile rises, it gets even more press, and it becomes easier to bring in new investors. Or to be less charitable, to lure in suckers.
But wait, won't GIC, Goldman Sachs, and Rizvi Traverse Management take it in the gut if the shares are overpriced?
Nope. Because those Series E investors were protected by a mechanism called a ratchet, which guarantees their returns.
TechCrunch did a good job unpacking Square’s S-1 filing, which showed that Square Series E investors paid $15.46 per share for Preferred Stock. The ratchet guaranteed the Series E investors an IPO price of at least $18.56, roughly a 20 percent profit.
If the IPO went out at less than $18.56 per share, Square had to give Series E investors more shares, enough to reach the equivalent of a 20 percent profit.
When a company issues more shares, it means each share is worth less. So investors not covered by the ratchet have their profits funneled to the Series E guys.
The reason I keep harping on big brand VCs, is because they are pretty much the only ones who can use this strategy. They have enough money to make big purchases that get them sweetheart deals, and they have big enough reputations that they can influence what the rest of the market is willing to pay.
Indeed, when Square went public in November of 2015, it’s IPO price was $9. Ryan Mac at Forbes did the math, which had Square issuing 10.3 million additional shares to the Series E guys. When the stock traded up 45 percent in its first day of trading, those shares were worth $135 million. That $135 million came out of the pockets of the other investors.
You might think I’ve chosen a particularly outrageous example, but a study by Fenwick & West LLP, a law firm specializing in technology, found that “Approximately 30 percent of unicorn investors had significant protection against a down round IPO.”
This is a particularly bad time to be on the wrong end of that 30 percent. The number of startups taking major value hits is high and growing, which means even more pain for unprotected investors.
CB Insights, an analytical firm, runs a site called “The Downround Tracker.” It keeps tabs on prominent startups that are losing value, whether through a “downround,” in which a company sold equity for less per share than in a previous round, a drop in share price, or a “down exit,” in which the startup was sold for less money than it had raised from previous investors.
According to CB insights, there have been 35 prominent examples of startups suffering some form of downround so far this year. Ten of those are unicorns. To remind you, there have been fewer than 8 new unicorns each year so far.
Among those on The Downturn Tracker is Zenefits, which acts as an internet-based insurance brokerage for small businesses. It had been valued as high a $4.5 billion, but Downturn Tracker recently put it at $2 billion.
A recent New York Times story dissected the drop in value, driven partially by a CEO resignation and examination by insurance investigators, and partially because of unrealistically pumped up prospects.
The Times came to the conclusion that the Zenefits crash was “a defining scandal of the tech boom.”
I wish. The Unicorn Apocalypse has barely begun.