And if the special side deals that most unicorn companies offer to certain investors — more on this sleight of hand in a moment — are taken into account, almost half of the companies would fall below the $1 billion threshold.
“These financial structures and their valuation implications can be confusing and are grossly misunderstood not just by outsiders, but even by sophisticated insiders,” Mr. Strebulaev and Mr. Gornall wrote in a report on their research, describing most private investments as a “black box.”
That black box increasingly has relevance not just to gossips in Silicon Valley, but also to public investors. Big mutual fund companies like T. Rowe Price and BlackRock have aggressively begun investing in unicorn companies in recent years on behalf of public investors — yes, you may own a stake in Uber and not even know it — helping to increase the valuations even further.
And even the big public mutual funds, the researchers contend, are not properly valuing the assets. “It is inappropriate to equate post-money valuations and fair values,” the professors said, explaining how, more often than not, public funds use the headline price that comes after a round of financing, and don’t distinguish between various types of shares.
One of the many ways that some companies inflate their valuations, for instance, is by offering certain investors guaranteed valuations in an initial public offering. In other words, if a company doesn’t reach a certain valuation at the time of an I.P.O., it will issue the investor more shares to make up the difference between the guaranteed price and the one that was attained. Effectively, all the other common shareholders end up paying the difference — and often don’t know it.
“Shares issued to investors differ substantially not just between companies but between the different financing rounds of a single company, with different share classes generally having different cash flow and control rights,” the researchers said.
Mr. Strebulaev said he was shocked when he dug into the contracts of the different fund-raising rounds. “The overvaluation is so large because many of these companies use sophisticated contracts that benefit some investors at the expense of other investors,” he said. Without identifying a particular company, he said some of the deals were “mind boggling.”
Worst of all, he said, he believes that “the people who are hurt the most are employees.” He said that in many cases employees didn’t understand that the value of the options they had been granted were disconnected from whatever the latest headline valuation of their employer might be.
When Mr. Strebulaev first circulated a draft of his paper, he said, “a number of companies contacted me, or, rather, their general counsels contacted me.” He encouraged them to point out mistakes or factual errors. “I haven’t heard back from them,” he said.
To cite one example from the research: In 2015, Appdynamics issued a Series F round with special terms for certain investors, including “a provision offering a 20% bonus in down I.P.O.s,” meaning one that fell in price. Legg Mason, already an investor, then revalued its shares in the company at a higher price, “despite not being eligible for the 20% bonus,” the professors wrote. “These examples are representative of common industry practices.”
In another example, the professors found that sometimes a fund-raising round painted an overly “rosy picture.” As an example, the professors used a particular fund-raising round from nearly a decade ago for SpaceX, arguing that “SpaceX’s value actually fell in 2008” while its reported valuation went up. The researchers said investors that year “were promised twice their money back in the event of a sale, with that claim senior to all other shareholders.”
“That guarantee increased the price those investors were willing to pay for SpaceX shares,” the professors said, “but did not alter its true value.”
Still, the professors were quick to say they did not believe that these terms were meant to manipulate investors.
And therein lies the rub: It is not clear that the intent of these “headline” valuations is to trick anyone. But they may very well be doing just that.