Unicorn valuation post-IPO

Unicorn valuation post-IPO

There is a dip in unicorn valuation post-IPO. The current rise in private markets with more capital available with Venture Capitalists and Private Equity Firms have contributed to rise of unicorns.In fact some of the firms are decalthons with their valuations exceeding $10B.Firms like Xiaomi and Uber, before it got listed were decalthons.
Previously, many startups would raise funding either with their own money or with the help of angel investors.Once they come up with a product that provides a service, they start acquiring customers to increase their growth.Motto of all startups is growth and not profitability. Hence they would require funding to continue to proceed with their growth strategy.There were few channels available at that time to raise funding, hence most startups look at public markets as a medium to raise additional capital to fund their business model.This is the reason, why number of unicorns were far less before.
With low interest rates, VC firms now are able to raise more capital cheaply.Hence they have a lot of dry powder available which they want to invest in startups. With the digital era, technology companies are seen as the major engines of growth, hence more capital is provided to hitech companies to grow their business model.This is the reason, why most of the Unicorns are from technology sector.

Unicorn valuation post-IPO vs pre-IPO

  1. The valuation of unicorn companies by VC firms are generally not supported by facts and evidence, but more by intuition.The reason why this happens is because all startups do not have a history of financials and business information, hence no analysis can be done based on the past details to arrive at the valuation.
  2. Most of the valuation is based on the post money valuation of the last round of capital raised.VC use Pre-Money and Post-Money valuation rounds to arrive at the valuation of a startup.
  3. For instance, if a VC invest 10% stake in startup for $100M, then the post money valuation of the startup after funding is 100/10%=$1B.

Pre-Money valuation = $1B – $100M = $900M

  • The rationale is that this additional funding in the last round has increased the valuation of the startup.The funding that is provided shall be used solely for the growth of the firms and not for repaying debts or a cashout for owners.
  • Post Money valuation cannot be compared across startups as this depends on the stake of the VC firm.Some VC firms have 10% stake and some others may have more than 10%.

Need for Protection clause for VC firms

  1. VC firms which are investing capital in startups do not want their equity stake to get diluted in subsequent funding rounds.For instance, when VC invest 10% for $100M, it would certainly do not want the firm value in future to decline from $1b to $500M.If that happens, VC investment value declines and stands to lose.
  2. To avoid this scenario, VC firms demand a protection mechanism where their equity stakes are not diluted when the value of the firm declines.This is called as Full Ratchet in VC parlance.This clause can only be triggered contingent to the additional capital requirement in future.When the value of startups declines from $1B to $500M, then the VC stake increases from 10% to 20% so that its equity value is not diluted.This protection is extended till the value of firm declines from $1B to $100M, at this point the VC has 100% equity stake in it and can force the startup to liquidate and push the owners from the company.This is the reason why VC have a bad reputation and are sometimes are called as Vulture Capitalists.
  3. When VC asks for a protection clause which is basically an insurance/put option, the VC firms needs to pay a premium for this to the founders.This premium is included in the total valuation.For instance, in the previous example when VC pays $25M as a protection premium to protect against anti dilution, then the true value of VC investment for the startup is $75M for 10% stake which means that the total value of the firm is $750M and not $1B.

Why there is a dip in unicorn valuation post-IPO?

  1. Due to the presence of the protection clause, some VC can overvalue the startups due to the presence of anti dilution protections.Hence many unicorns true values would be much less than its valuation.
  2. Startups founders agree to this Full Ratchet clause because it is a trade off for them to get access to capital which is necessary for the startups to grow.Founders by nature are also extremely optimistic and generally overvalue their company against its true value.So they also agree to this valuation.
  3. In the late stage companies, most of the investors who provide additional capital would do so in order to exit at a higher multiple either thru acquisitions or thru an IPO route.Hence they would decide the time to take the startup public and would start to engage bankers to help them take public.
  4. The public investors generally values the unicorn based on the valuation of latest round of capital raised.Hence they arrive at a offer place based on this without understanding the role of Protection clause mechanism of the VC firm even though these arrangements are described in the prospectus. They also rely on the financial wisdom of the VC firms on their decision to invest in startups and do not do the homework of whether the startup is overvalued or not.
  5. Post IPO, the unicorns are required to adhere to the financial disclosure requirement of the regulators.This increases their compliance costs and also puts them vulnerable to the lack of discipline that they were used to under VC firms.All this leads to quick correction of their equity price in public markets which leads to a huge dip in valuation.

Conclusion

  1. Most of the unicorns that decide to get listed in public markets are valued more than their true value.Sometimes this is done deliberately by VC firms to exit at higher multiple and get a better offer price at IPO.
  2. The presence of anti dilution provisions between VC and unicorns also termed as Full Ratchet in VC parlance is partly responsible for over valuing the unicorn.
  3. The valuation of an unicorn done by VC is based on the valuation of last money round raised rather than the intrinsic value of the unicorn.This also increases the valuation of unicorn.
  4. Unicorn valuatio post IPO are subjected to financial disclosure requirements.When the analysts reviews the firms spending, investments and capital allocation, these overvalued unicorns undergo a sharp correction resulting in a decline in their stock prices.


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