Mas­saged math is be­hind star­tups’ in­flated val­u­a­tions

Northwest Arkansas Democrat-Gazette - - MUTUAL FUNDS - JULIE VERHAGE

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.

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