Are billion-dollar ‘unicorns’ more risky for investors?
Not necessarily, according to a new report by Silicon Valley law firm Fenwick & West that analyzed 37 U.S. companies that recently raised money at more than $1 billion.
These companies are called unicorns because a private valuation of $1 billion-plus used to be so rare, it was almost impossible. But now, that’s increasingly not the case.
Many household names fall into this camp, including Pinterest, Uber, Airbnb, Snapchat and Dropbox. As of recently, the Wall Street Journal identified 50 in the U.S., however, that number seems to change weekly. (Related: Unicorn envy: Where is Seattle’s next billion-dollar idea?)
So, the law firm set out to aks one very simple question: Why? Why are investors willing to invest at such lofty prices?
The very short answer is this: Investors are requiring very specific terms that will guard them against losing their entire investment, even in the most extreme circumstances.
First off, here’s the kinds of companies that the law firm looked at: The average valuation was $4.4 billion, and the average percentage increase per share from the prior financing round was 180 percent. Of these financings, about a quarter were led by traditional VCs, and 75 percent were led by mutual funds, hedge funds, corporate investors, etc.
It found that in all 37 investments it analyzed there was one common aspect. Investors asked for liquidation preferences, which would require that they receive their entire investment back prior to common investors receiving any proceeds.
This provides a generous amount of protection to investors, even if the company’s valuation fell off a cliff in the future.
“Since 100% of the unicorn financings had a liquidation preference, valuations of these companies could fall on average by 90% before the unicorn investors would suffer a loss of their investment, and they could withstand an even greater decline if they had a senior liquidation preference over other series of preferred stock,” according to the report.
Besides liquidation preferences, the law firm identified a variety of other terms that protected investors in future investments and even in IPOs. The law firm’s results were first reported on by Re/Code.
