All shares of unicorn companies are not treated equal before they go public. The common shares of unicorns are systematically undervalued relative to their preferred shares up to the IPO date, when the prices of both classes converge.
For example, common shares of Uber Technologies UBER, +0.00% were sold to a private equity fund in 2015 at a 25% discount to the valuation of its preferred shares in a round just before that sale.
We found this systematic disparity in our analysis of the 21 U.S.-based unicorns that issued both common and preferred shares during the few years before they went public in the 2015-2017 period. But the IPO documents of other unicorns going public in this period disclosed no recent sales of preferred shares.
Why this disparity? The pre-IPO prices of preferred shares issued by unicorns are relatively high because they provide important rights not enjoyed by common shareholders. Preferred shares usually have a specified dividend rate, which accrues until actually paid. If the company does well, preferred shares of unicorns typically may be converted to common at the IPO or other favorable event. If the company does poorly and must be wound down or sold, preferred shares typically have liquidation rights — which give them a minimum return before the common shares receive any of the proceeds.
By contrast, pre-IPO unicorns tend to undervalue their common shares because they are issued as part of employee incentive arrangements. Most unicorns issue common shares in the form of stock options or restricted stock to attract and retain key employees. To avoid harsh penalties under the federal tax code, these common shares must be issued at “fair market value”. Nevertheless, companies have an incentive to keep this price as low as feasible to maximize the potential upside for their employees.
These systematic biases in valuations have significant implications for investors who are interested in the growth of unicorns. First, don’t believe what you read in the press about the huge value of a unicorn based on a recent sale of its preferred. The valuations reported by the press are often determined simply by multiplying the total number of a unicorn’s shares at that time by the price per share of the recently sold preferred. However, this price is inflated since the preferred receives liquidation and other special rights.
For example, Square SQ, +0.92% raised $50 million in 2014 by selling Series E preferred shares at $15.46 per share. Multiplying this price by Square’s total number of outstanding shares at the time, the financial media reported a $6 billion post-money valuation. Yet the Series E preferred had special rights not afforded to other Square shareholders. Holders of Series E would receive at least $15.46 per share in an acquisition or liquidation, and at least $18.56 per share in an IPO.
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Second, check to see how your mutual fund or other investment vehicle is valuing its holdings in unicorns after their recent sales of preferred. Funds may hold multiple classes of shares in the same unicorn. When it issues a new round of preferred at a high price, funds tend to increase their valuations of all types of shares of the unicorn. But the latest preferred is likely to have special rights that make it worth more than common shares or earlier rounds of preferred.
For instance, AppDynamics sold a Series F round of preferred in 2015 with what is known as an IPO ratchet. That ratchet promised a 20% bonus on any down IPO — at a price below that of the Series F round. Yet, Legg Mason reportedly increased the valuation of its Series E preferred shares, although they did not have the 20% bonus promised to the Series F preferred.
Third, understand that the historic prices of common shares included in the IPO documents are probably understated. Every prospectus for a company selling stock to the public must disclose the key terms for pre-IPO sales of securities of the company — usually going back several years. But remember that most, if not all, of the pre-IPO sales of common stock were actually grants of restricted shares or stock options to key company employees. As explained above, companies tend to suppress the value of these share grants to maximize the upside.
From September 2016 through August 2018, 68 U.S. companies completed IPOs after awarding employees options to buy about $1.5 billion in common shares in the year prior to the IPO. However, the actual value of those common shares was estimated at $2.2 billion based on a valuation model developed by two finance professors, according to an article in the Wall Street Journal. The article quotes a valuation expert, Dan Eyman, who often works for startups: “What we aim for ... is to try and get you the lowest possible answer that is defensible against an audit.”
In short, while many unicorns deserve high valuations, investors need to be discerning in reading media reports and prospectuses about these companies. If the valuations of unicorns are based on the latest sales of preferred stock, they are probably too high; if they are based on recent grants of common shares to employees, these valuations are probably too low. The best solution is for unicorns to use a weighted-average value of their common and preferred shares.
Robert C. Pozen is a senior lecturer at MIT Sloan School of Management and a senior fellow at the Brookings Institution. Kevin Downey and Ming Liu, MIT undergraduates, contributed to this report.
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