What Will Happen To VC Unicorns? by PitchBook
VC Unicorns – Overview
At this point, it’s fair to confess a distinct fatigue when it comes to discussion of VC unicorns-private companies valued at $1 billion or more. After a few years of intense scrutiny of their ranks, it’s easy to presume that pretty much all that needs to be said about unicorns has been said. Particularly in the context of the slowly ongoing reset in venture capital, the prevailing narrative seems familiar: The pace of unicorn formation has slowed as the current crop focuses on sustainably growing—with some struggling more than others—while those that can are still raising considerable sums in nontraditional ways.
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But any over-hype and familiar trends shouldn’t dissuade us from recognizing just how unprecedented the unicorn phenomenon still is, especially as it may signify a seismic shift in the role the venture capital industry plays in private markets in general. It’s not a coincidence that in the current era of nontraditional monetary policies and seemingly stagnant economic growth that a slew of unicorns emerged, characterized by their rapid growth, massive funding and reluctance to go public. Private markets are simply more alluring to investors nowadays, and as for businesses, the sheer volatility in public markets is just the first of many incentives to stay unlisted. Public offerings are expensive and time-consuming, and if sufficient private capital is available to fuel growth initiatives, why undergo the intense scrutiny?
It’s not that founders have changed in their honed focus on growing their businesses, it’s that for the first time, investors are willing to fund private companies at a higher rate than ever before. The promise of explosive growth in the current sluggish macroeconomic landscape was and is seductive–the fact many unicorns seemed to be actually scaling the heights originally envisioned during the dot-com era only added fuel to the fire.
The problem is, of course, that it’s rather difficult to actually disrupt. Building a sustainable business is hard enough—changing a whole industry renders it more difficult by an order of magnitude. To take a topical example, witness Theranos’s very publicized struggles, or the attrition slowly unrolling in the food and meal kit delivery space. But how to reconcile the VC slowdown with the figures below and above, where 2016 has seen the most youthful unicorns yet and record sums still invested in the likes of Uber?
First off, to reiterate, the rate of new unicorn formation has distinctly slowed, so it’s only the proven, extant crop that are primarily responsible for continued fundraising. The general explanation that a capital-rich environment is causing a concentration among safer prospects at the late stage only partially explains such continued unicorn funding. As alluded to in our most recent Valuations Report, late-stage companies with sufficient financial means are able to access lines of credit or other financing alternatives beyond simply raising another strictly traditional venture round that would only further complicate capital structures and potential liquidity. On top of that, secondary markets to alleviate unicorns’ relative illiquidity have evolved, enabling employees and earlier investors to achieve some returns. Combine that with an intensified focus on fundamentals and more investor-friendly terms and it becomes clearer why some firms are still ponying up capital to back unicorns, as most potential concerns are addressable. In short, there are ways and means for unicorns to keep raising for some time, and some will continue to do so. Billion-dollar businesses don’t fold overnight—it’s probable we’ll see still-significant sums raised by unicorns in the remainder of the year, although it’s important to note that companies are becoming unicorns more sedately in 2016, per the valuation step-ups below.
Plus, at this point, the potential for a surge in tech M&A must be considered. The list of companies that can buy unicorns is short, but the incentives can be compelling for many, ranging from revitalizing core businesses with new product lines to economies of scale. Taking prices into consideration, by this time next year some of the unicorns in this report will have been acquired—Unilever is in talks to buy The Honest Company, for example, although if that deal does close at a discounted valuation it doesn’t bode too well. But for most, an IPO remains the most likely exit avenue. The window in 2016 is narrowing—with uncertainty around the political landscape and an interest rate rise, it’s likely to shut unless some follow Nutanix’s lead and price soon. Accordingly, 2017 is shaping up to be quite the year for potential unicorn IPOs. Although, in conclusion, it’s not inconceivable that some unicorns simply stay private for as long as possible, achieving whatever liquidity they need to through somewhat unorthodox means such as secondary markets or even, perhaps, buyouts by private equity firms with established tech investment theses.
The following six pages contain a dizzying array of information conveyed in semi-legalese that can be hard to parse. While meant to be a resource for your personal consultation in the future, we’ve summarized some of the key findings in this section.
By and large, as noted in the prior edition of this report, there remains a considerable focus on downside protection. For example, The Honest Company has a detailed breakdown of different stock series’ conversions in its IPO protection terms: “Series C converts upon proceeds of $70 million, Series D at $100 million. If the IPO share price is less than $33.82, the Series C and D conversion prices shall be adjusted to equal the product of (c) the Series C or D original issue price (OIP) as applicable, and (b) the quotient of the series C or D OIP/Series C/D target price.”
Qualtrics, in turn, has preferred shares converting into common upon an IPO with a price per share of at least 2x the Series E OIP. Interestingly, Qualtrics happens to have a reversal of the usual “last in, first out” order of stock liquidation when it comes to acquisition protection terms. Series A stock goes first, then Series B and C share pari passu, then Series D and, finally, Series E. As the company has only had two completed venture financings, however, that preference makes sense.
Every single unicorn in the tables following this section had the standard weighted average antidilution adjustments for future financing protection, so, accordingly, we simply removed that column in order to highlight more interesting, varying provisions. Especially in the current climate, and given the heft of unicorn financing rounds, senior liquidation protections abound, with a select few such as Social Finance possessing equal sharing by all series of preferred stock ratably, with protection over common stock. SoFi also has fairly detailed IPO protection terms, with each share of Series A, B, D, E and F automatically converting upon a public offering of not less than $15.78 per share and aggregate proceeds of not less than $100 million.
Although in general the conclusions to be drawn from the following tables are the same as in the last Unicorn Report—investors are protecting themselves in an uncertain climate yet, as they are still willing to finance unicorns in the first place, the terms are not overly indulgent one way or the other—what’s interesting is that one can pinpoint certain terms of recent financings of unicorns in particular industries and glean insights. For example, when it comes to dividends, it’s intriguing to assess which companies have been sweetening deals, although dividends are often not much more than just that, sweeteners.
Magic Leap has non-cumulative dividends at the rate of $1.84 for Series C, $0.92 for Series B, $0.10 for Series A and $0.0773 for seed. Although not the most sizable of dividends within the subsequent unicorn tables and relatively standard at about 8%, the weighting helps signify the level of risk in Magic Leap’s financings, as judged by participants. Zoox actually has one of the higher Series A share non-cumulative dividend allotments in absolute terms at $4.13 per share per annum, although that is also 8% of OIP.
When it comes to participation, most unicorns have non-participating provisions. However, a few exceptions exist: Sprinklr has all of the remaining proceeds available for distribution to stockholders duly distributed among shareholders of Series B, C and common stock, for example. Interestingly, when it comes to multiple liquidation, only four unicorns in the following tables have any. The Honest Company has Series A and A1 receiving 1x their OIP, Series B 2x, Series C 1.43x and Series D 1x, all before common shareholders receive anything. Qualtrics and DocuSign also have multiple liquidation preferences, while Tanium technically has none but their Series F shareholders have a liquidation price that is much lower than OIP: $0.027.
All in all, most of the upside benefits are in the form of dividends of varying favorability. IPO auto converts are applied for about half the unicorn sample, with the other half having automatic conversions at OIP. The range of upside benefits exemplify how investors in unicorn financings have assiduously sought to garner protection in both defensive and more immediately beneficial forms, given the inherent level of risk.
Unicorn League Tables