Do not be taken in by mythical unicorns

There has been a typical lack of self-awareness with which the technology industry has embraced the word “unicorn”. The term, which is used to denote a private company valued at more than $1bn (£770m), has been seen as a badge of honour, an elite club that demonstrates that a start-up has made it. In the tech industry, where other measures such as profitability are not so valued, unicorn status is perhaps the major aspiration.

Champions of the innovative young companies in east London and elsewhere have boasted about the number of new unicorns being created each year with a straight face.

A recent report by Investeurope claimed there were 15 in the UK alone. It has been a great source of pride for supporters of British tech that more unicorns exist on these isles than anywhere else in Europe. Even the Government is getting in on the act; last week, it proposed that a national investment fund be set up that would boost spending on tech start-ups. The Treasury says it wants more unicorns: last week’s consultation on the matter laments that we underperform globally when it comes to producing billion-dollar start-ups.

Not many seemed to find it silly to be judging our success in creating young companies based on how many were associated with make-believe creatures from fantasy worlds. But as a recent study points out, an awful lot of tech unicorns are as imaginary as the fairytale animals they are named after. Will Gornall and Ilya Strebulaev of the University of British Columbia and Stanford University, in a paper titled Squaring Venture Capital Valuations with Reality studied 116 US companies valued at $1bn that had received venture capital funding since 2004.

By developing a new financial model, they studied the “post money” valuation of unicorn start-ups against one more akin to how we value public companies, and found that on average, unicorns puff up their valuations by 49pc.

How does this happen? Start-ups are not lying about how much they are worth, but confusion exists because almost all unicorn-level investment rounds are a lot more complicated than basic equity investments. Take a private company previously valued at $500m. A major venture capital firm might offer to invest in it at double the previous share price, purportedly valuing it at $1bn. But that investment comes with strings attached. They might seek guaranteed returns when the company goes public, liquidation preferences, or the ability to block a flotation.

Their shares will be worth much more than those owned by early investors or employees who have none of these protections. And yet when it comes to valuing the company, old shares are treated as equal to new ones, which is how we arrive at a billion-dollar valuation. That this sort of thing goes on in the venture capital world is well known, but the scale of it has not been laid out until now. Almost half of the unicorns studied were actually worth less than $1bn when a fairer valuation was applied to them, according to the study.

Overvaluation extends to the most high-profile private tech companies. Uber is typically referred to as having a $68bn valuation when the reality is closer to $61bn, according to the study. Airbnb should be worth $26bn, not $30bn. More than one in 10 firms was overvalued by more than 100pc. Take Square, the payments company. It was given a $6bn valuation in 2014, its final round before it went public, but this came with such onerous terms that researchers said a fairer value would be $2.2bn.

Overvalued start-ups matter for a couple of reasons. First, it means the productive tech experts that work for them and are paid partly in company shares often believe they are earning a lot more than they really are.

Another is that it discourages unicorns from seeking further cash, often at a lower valuation, because the guaranteed returns they have promised previous investors would dilute the shareholdings of employees and founders. Above all, it shows that we should stop treating the number of unicorns we produce in this country as a measure of success.

As often as not, they are as mythical as their namesakes.

‘We should stop treating the number of unicorns we produce as a measure of success’