Mutual funds are chasing unicorns — and ending up in a valuation fantasyland. That’s the conclusion of a paper examining how funds price their holdings in venture capital–backed private companies like Uber Technologies and Airbnb — commonly referred to as unicorns when their valuations hit $1 billion.
Fund companies, as well as venture capitalists, journalists, and unicorn insiders, are making optimistic assumptions — or calculations that are just plain wrong — when they value such companies, routinely overestimating what they are worth. In many cases, values have been overstated by 100 percent or more.
Indeed, a big percentage of purported unicorns don’t even deserve the moniker, the study says, because their values are less than $1 billion when the calculations are done correctly.
“I’m very concerned that there is a fundamental misunderstanding of what these investments are worth,” says professor Ilya Strebulaev of Stanford University, who coauthored the study with assistant professor Will Gornall of the University of British Columbia. “[Mutual fund companies] are sophisticated in the public markets but they are inexperienced in the private markets.”
The study, “Squaring Venture Capital Valuations with Reality,” shows that by assigning a value to an entire unicorn company based on the price paid in its most recent round of venture financing — the “post-money valuation” — fund companies are ignoring differences in the terms accorded multiple share classes. These terms vary greatly and therefore may change what an investment or entire company is worth.
The professors looked at each company’s certificate of incorporation to see which terms applied to each share class and to give proper weight to the impact of unissued stock options.
A new series of unicorn preferred stock will often carry guarantees that earlier share issues lack. New shares typically get preference over old ones in the event of a liquidation, for example. Often, buyers of a new financing round are in effect promised a minimum return in the event of a sale in the form of additional new shares they will receive. Issuing additional shares to recent investors dilutes the holdings of earlier ones, lessening their value.
Yet valuations by fund companies and others routinely ignore this and assign the same value to all of a unicorn’s share classes, based on the latest round. That’s typically the highest priced — and carries the most advantageous terms.
“Almost all mutual funds hold all of their stock of VC-backed companies at the same price,” the study says. This drastically overvalues the unicorns.
For example, John Hancock’s Small Cap Growth Fund in its November 2015 report valued both the common and Series D 1 shares of DraftKings, a fantasy sports contest provider, at $6.52 each. By the professors’ calculations, the Series D 1 shares are worth 35 percent more because of superior terms and guarantees.
The study also cites Square, the internet payments company. The last venture financing round prior to its November 2015 IPO was a Series E preferred share sale at $15.46 per share. The press trumpeted Square’s post-money valuation of $6 billion. The study pegs the company’s value at the time at less than half that: $2.2 billion. Square went public at about $3 billion.
“If the study is accurate, this is a serious problem,” says Mercer Bullard, a professor at the University of Mississippi School of Law. Inflating the value of such holdings could benefit firms whose fees are determined by assets under management. “This may be used as cover for increasing asset-based fees,” Bullard says.
Faulty values raise questions about the accuracy of fund pricing overall. “Obviously, mutual funds are on the line for valuing assets in their portfolios,” says Kathleen Smith, co-founder of investment firm Renaissance Capital. “If you have someone buying or selling at the wrong price, you have a problem.”
Discrepancies in valuations could be an even bigger issue for VC investors like pensions. Strebulaev says that such investors tend to vacillate between conservative approaches — valuing a company based on the original investment — and the more aggressive post-money valuation. “The truth is somewhere in between,” he says.
Given the possible overstatement of unicorn values, Smith says investors may be misallocating capital to the asset class. “The allocation to alternatives is already greater than it’s ever been,” she says. “There’s no excuse for not doing sophisticated valuations.”