Massaged math is behind startups’ inflated valuations

Unicorns aren’t real, and neither are the valuations ascribed to many of the startups that say they’re worth $1 billion or more.

About half of private companies with valuations exceeding $1 billion, known as unicorns, wouldn’t have earned the mythical title without the use of complex stock mechanics, according to a study by business professors at the University of British Columbia and Stanford University. The tools used to negotiate a higher share price with investors often come at the expense of employees and early shareholders, sometimes drastically reducing the value of their stock.

The chasm between public and private valuations is a topic of increasing prominence following several disappointing listings. Among them is Blue Apron Holdings Inc., which is trading well below the price venture capitalists paid in the last fundraising round.

An often-overlooked explanation for the division is buried in investor contracts. Blue Apron, which delivers meal kits to customers, gave stock preferences to Fidelity Investments and other backers in 2015 in exchange for a $2 billion valuation. The shares included a provision to receive additional equity if an initial public offering (IPO) is set below a target price. Investors took advantage of the mechanism after Blue Apron’s mediocre IPO.

The use of special investor protections has soared in recent years as startups chase dreams of becoming a unicorn. A lofty valuation can build credibility and help recruit talent in a tight labor market. But it has also complicated the already-opaque process of valuing a private business.

The study looked at 116 unicorns founded after 1994, with average valuations of $2.7 billion. Researchers found that 11 percent of companies, including HomeAway and SolarCity, used preferential stock to boost their valuations to more than twice what they would be worth using the study’s fair value estimates. “Our results suggest that more attention should be paid to the contractual terms between investors and companies,” the report said.