The Data And Deal Terms Behind VC Unicorns by PitchBook
When Aileen Lee of Cowboy Ventures coined the term “unicorn” in late 2013, startups valued at $1 billion or more were still a rarity. Not anymore. The number of U.S.-based startups hitting that mark skyrocketed in 2014 and nearly doubled through August of this year. In less than two years, the VC industry has transformed a mythical creature into a somewhat common one.
Earlier this year, Fenwick & West, a Silicon Valley law firm, published a valuable and well-received study that dove into the financing terms of 37 U.S.-based unicorn rounds. Bouncing off Fenwick’s work, we wanted to dive a bit deeper and get more specific, looking at a select few raw financing terms and holding them against our valuations database. Beginning on page 7, we’ve laid out a table of terms that reflects those findings, and throughout the report try to shed light on their significance against our own data.
If nothing else, we think the terms behind recent unicorn valuations muddy the waters a bit around the bubble debate. There’s little doubt that valuations are frothy, especially in the U.S. market. But some data points make more sense given our findings. For example, investors in recent unicorn rounds have bulked up on downside protections in pre-IPO rounds to avoid being burned if a company later drops below its IPO price. That quasi-insurance against a downturn has made investors less apprehensive about joining massive financings, helping explain the sheer rise in unicorns over the past year.
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Between 2006 and 2014, the median late stage VC valuation rose nearly in tandem with the Russell 2000 Growth Index, a fair proxy for the U.S. tech market. Beginning this year, though, the median late stage VC valuation significantly quickened its pace against the index. Because new investors are so well protected in the event of IPOs and/or acquisitions, valuations would need to fall by big margins (upwards of 90% of some cases) before investors come up short. Downside protections also help explain the divergence in unicorn rounds and unicorn exits. Through June, unicorn rounds have outnumbered unicorn exits in the U.S. by a 4-to-1 margin.
With the terms behind these unicorn rounds somewhat insulated from broader market conditions, it’s not as surprising to see investors agree to back them.
By and large, the terms behind recent unicorn rounds shows a pronounced focus on downside protections with relatively moderate upside benefits.
To paraphrase Ms. Lee, the valuations we’re seeing today pose risks to investors if they can’t be sustained in the public markets. Knowing that, investors have sought safety in unicorn rounds, demanding pre-determined gains and/or valuations once IPOs or acquisitions become possible. In effect, private investors have allotted themselves better downside protection than is available for later investors that buy the stock once the companies go public. Should those companies keep raising money in the private markets, it wouldn’t be surprising (or too worrying for investors) if down rounds ticked up a bit, since those investors won’t feel the impact. Founders will, however, as will the company’s employees; liquidation preferences set in late stage rounds can affect the stock options for employees further down the totem pole.
Even without stronger upside benefits, investors at the late stage could be settling for sturdier downside protections for a number of reasons. Their own LPs could be putting pressure on them to get involved in well-publicized unicorn rounds, or because non-traditional investors like mutual funds are forcing their hands by leading those rounds in the first place. They may also be trying to protect their own portfolio stakes and investing at higher valuations, as long as those protections are firmly in place.
IPO protection terms
After several recent IPOs rose before eventually falling below their offering prices, investors in more recent unicorn rounds have restructured their terms to protect themselves from getting burned. Most of the terms featured here include either minimum, predetermined IPO valuations, or valuations at or above the original unicorn investment round price. Some recent IPOs, notably those of Hortonworks, Box and New Relic, took haircuts on their offerings, going public at share prices below their previous, private financing rounds. We did an analysis earlier this year and found that a significant number of tech companies (at the time) were taking haircuts in their IPOs.
It will be interesting to see what impact added downside protections will have on that trend going forward. Should markets trend downward, the floors established by investors might not be feasible, at least in the near-term. With startups raising “private IPO” rounds over the past two years—amidst better market conditions—it’s possible that preference for private financing will continue if the public markets show signs of instability.
Acquisition protection terms and liquidation preferences
Downside protection is even stronger in the event of an acquisition. Every filing we researched included liquidation protection over common stock, and in some cases included senior liquidation protections over earlier series investors. With those senior liquidation protections in place, paper valuations would need to be significantly overvalued versus the acquisition price before those unicorn investors lost money on their investments.
See full report below.