The explosion in the numbers of these companies has also given rise to almost as many explanations for the phenomena, some based on rationality and some on the prevalence of a bubble. The rationality-based explanation for the surge in unicorns is that it has become easier to remain a private business, as private capital markets broaden and become more liquid, while it has become more costly to become a public company, with increased disclosure requirements and pressure from investors/analysts. The less benign argument is that investors are being driven by greed to push up the prices of young companies and that this has all the makings of a bubble. I think there is truth in both arguments and that you can have both good reasons for the increased number of large value private businesses and momentum driven froth in the market. However, I will leave that discussion to those who know more about these young companies than I do, and are more confident in their capacity to detect bubbles than I am.
If the conventional definition of a unicorn is a private business with a valuation that exceeds a billion, how do you arrive at the valuation of such a business? While you have no share prices or market capitalizations for these companies, you can extrapolate to the values of private businesses, when they raise fresh capital from venture capitalists or private investors. Thus, if a venture capitalist invests $100 million in a company and gets 10% of the ownership in the company in return, we estimate a value of $1 billion for that company, making it a Unicorn. There are, however, two problems that get in the way of a good estimation. One is that the capital infusion changes the value of the company, creating a distinction between pre-money and post-money values. The other is that the investor’s equity investment generally comes with bells and whistles, designed to protect the investor from downside risk and these protections can skew the value estimate.
In an earlier post on the offers and counter offers that you see on Shark Tank, the show where entrepreneurs pitch business ideas and ask competing venture capitalists for money, I drew the distinction between pre and post money valuations. If the capital raised in an offering is held by the company, rather than used to pay down debt or owners’s cashing out, the value of the company increases by the amount of the new capital raised, leading to the following distinction between pre-money and post-money values.
- Post-money valuation = Investor’s capital infusion/ Percentage ownership received in exchange
- Pre-money valuation = Post-money valuation – Investor capital infusion
In the example above (where an investor invests $100 million for 10% of a firm), the post-money value is $1 billion but the pre-money value is only $900 million. Thus, companies that are smaller than a billion can make themselves look like billion dollar companies, if they are willing to give up enough ownership in the company and can find investors with deep pockets.
While it is unlikely that you will be able to find an investor to offer $950 million in capital for a business with a $50 million valuation, it does illustrate why post money valuations may not always be comparable across businesses.
Note that the protection works fully when the value of the business is between $100 million and $ 1 billion and only if there is a capital event to trigger it. To value this option, you need three more pieces of information:
- Probability of capital event: Since a capital event is the trigger for the protection, there will be no protection if no capital event occurs, a scenario that will unfold if the business unravels quickly. Put differently, the protection is useless if the business never raises any additional capital. (Since the probability of accessing new capital will decrease as the value of the business drops, especially if the drop occurs quickly, the option value is likely to be overstated.
- Expected time to capital event: The timing of the capital event may not be known with certainty, but to the extent that it can be forecast, you need an expected value. If the protection covers multiple capital events, it is the expected time to the last one.
- Degree of protection: Depending on how it is structured, the protection offered an investor can range from 100% (with full protection) of the dollar capital invested to less (with weighted average).
[drizzle]Assume, for instance, that the investor in the example above (who invested $100 million for 10% of the business) if offered complete protection in an anticipated IPO of the company and assume further that there is a 90% chance of the IPO occurring in one year. For the standard deviation, I used the industry average standard deviation of 72.48%, derived from publicly traded