It’s not easy being a unicorn these days. With the financial markets crashing, global consumers retrenching and competition heating up, quite a few so-called “unicorns” (high-flying, new economy tech firms) are likely to be facing difficult decisions in the coming months.
As a January 20th article in the New York Times highlights, the ongoing (and rapidly getting ugly) downturn in the financial markets is almost certain to force a number of unicorns to raise money to support growth at valuations far under their earlier levels. These later, lower-valuation capital raises are known on Wall Street as “down rounds,” and often open up a difficult-to-resolve can of worms for unicorn founders, angel investors and common shareholders.
As reported by ValueWalk, a number of analysts and academics have been arguing for some time we should expect some "thinning of the unicorn herd", and down rounds are likely to contribute to this process.
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Shareholder in-fighting almost inevitable in unicorns with down rounds
In most cases, down rounds wind up pitting the common shareholders against the preferred shareholders. This is because of the way that venture capital investments are usually structured today. Typically, employees and founders end up with common shares with less rights than the preferred shares of the venture capitalists. Preferred shares nearly always have liquidation preferences, and rights that prevent dilution, while common shares do not. Most deals are structured so that preferred shares are convertible into common shares at a price that reflects the valuation of the firm when the investment was made.
Of note, liquidation preferences typically call for preferred shareholders to be paid a minimum payment if a company is sold. Anti-dilution rights mean that when the new money is raised at a lower valuation, investors from earlier rounds are compensated; that is, the conversion price for their preferred shares into common shares is reset at the new, lower value.
Having to compensate for these rights can be very painful for common shareholders. For example, if the valuation falls under the liquidation preference price, the common shareholders will see their whole investment disappear. Even if the valuation does not fall that much, the anti-dilution rights end up virtually always end up penalizing common shareholders.
Keep in mind that a down round also hammers both employees and founders, reducing the value of their shares.
Employees may leave if stakes wiped out by down round
Down rounds also have other consequences. For example, many employees at tech unicorns are not going to stay for long if their equity stake ends up completely wiped out. The majority of employees, especially the most talented, will just move on to another start-up and start over.
Also keep in mind that a down round signals to the market that the firm business model is in trouble. Analysts have noted in the past that a major problem with down rounds is how unicorns can keep employees after wiping out their shares.
Down rounds don't have to wipe out common shareholders; that is actually much more likely to happen if a unicorn is sold at a lower valuation than by raising money in a down round. That said, employees and other common shareholders are almost certain to see the value of their unprotected shares decline in a down round.