The lure of the big number

By L.S.

HUNTING unicorns used to involve entrapment by a virgin. Now it requires merely the writing of large cheques. Hardly a week passes without a promising tech startup earning a valuation of more than $1 billion from venture capitalists, so becoming a “unicorn” in tech parlance. There are now more than 100 such firms. But doubts about such valuations are growing, even in Silicon Valley.

It is easy to see why promising startups (and their backers) want to become a member of the unicorn club. It helps entrepreneurs gain credibility—their greatest hurdle—with future investors, business partners and, most importantly, their most talented staff. Even mid-ability app developers have lots of choice in the job market today. Research shows that they are more likely to opt for, or stay at, a firm that is worth more than $1 billion. And unicorn investors, often big hedge funds, help startups postpone their initial public offering (IPOs) and avoid demands from public investors for instant profits.

Yet high valuations come at a price, says Fenwick & West, a law firm. It has analysed 37 unicorn deals and found that all included terms to protect investors against losing money—in particular, putting them first in line to get their money back if the company is sold. Such “liquidation preferences” are not nefarious, nor new. But they mean that unicorn valuations are not directly comparable to public-company valuations, says Barry Kramer, one of the authors of the study. If a public company loses half of its value, investors lose half of the money they put in, he explains. But should this happen to a unicorn, investors may not lose anything—as long as the total value of the firm does not fall below the amount protected by the liquidation preference.

Such conditions can create conflicts between shareholders in a startup. An investor who has put in money at a high valuation and protected it with a liquidation preference may be less inclined to accept a good takeover offer than earlier investors, including the founders, who may have received shares at a much lower valuation. Worse, liquidation preferences and other terms may mean that founders end up with nothing if their company is sold off very cheaply. “This is why it is so crazy to me that many entrepreneurs today are focused on valuation. They are willingly trading terms for a high number,” Heidi Roizen, a Silicon Valley venture capitalist, wrote in a recent blog post.

There also may be further problems down the line. If no one is willing to buy these firms (either in a public offering or a takeover) in the future at high valuations, unicorns will lose their sparkle. But both kinds of buyer are currently in short supply. Only two venture-capital-backed companies have gone public in the first quarter of 2015, yet 20 unicorns were born in the same period, according to CB Insights, a research firm that keeps track of such things. Worries have started to reverberate around the sector. Marc Andreessen, an influential Silicon Valley venture capitalist, has said he is “shocked” by how few tech-firm takeovers there have been in recent years. Under pressure from activist shareholders, he says, public companies have become “extremely risk-averse”. Or perhaps the mythical creatures on offer are just too expensive.