Late-Stage Protection for Investors Can Inflate Start-Up Valuations

Acquisitions of unicorns, i.e. young tech companies valued at over $1 billion, were a hallmark of 2014. These acquisitions continue to be surprising both in their enormity and frequency. For example, Facebook Inc. acquired the messaging group WhatsApp Inc. for a whopping $19 billion, and then also acquired virtual reality company Oculus VR Inc. for $2 billion. Google Inc. acquired smart-thermometer marker Nest Labs Inc., and other investments, for $3.2 billion. Microsoft Corp. acquired Minecraft game maker Mojang AB for $2.5 billion.

The billion-dollar tech startup was once the stuff of myths, but now such valuations and acquisitions seem to be everywhere; this being primarily the result of innovative, disruptive technology. These deals largely reflect the need and want for non-traditional programming.

The proliferation of start-up technology companies valued at over $1 billion has been endorsed by advocates as a sign of robust innovation and questioned by critics as an indication of dangerous overvaluation. Currently led by the smartphone powered car-hailing service Uber at $41 billion and the home-rental website Airbnb at $10 billion, the global ranks of unicorns is steadily climbing. According to Pitchbook Data, unicorns have more than doubled to 102 in the past fifteen months.

Among the unicorn excitement, less noticed is that the reported valuations of many $1 billion plus young tech companies have been inflated by the terms of the private investments that set those valuations before any initial public offerings of stock. There is often little or no disclosure of these terms . Increasingly, venture investors demand that late-stage financing terms include extra protections, such as a discounted price of any initial offering, a baseline minimum return on investment or extra shares if the company later raises money at a lower valuation.

For example, consider the cloud software provider Box Inc. In July 2014, the company raised $150 million from two investors, Coatue Management and TPG Capital, at $20 a share—a reported valuation of $2.4 billion. Under the investment terms, Coatue and TPG had extra protections—both investors were entitled to receive additional shares if Box later went public at a lower price, and a 10 percent discount to the I.P.O. price to boot. In January 2015, when Box priced its initial offering at $14 a share (as opposed to the Coatue-TPG purchase price of $20), the lower price dropped the Coatue-TPG purchase price to $12.60 a share and increased the number of shares received by 58 percent. Box Inc.’s current stock market value is about $2.1 billion. Such protections, which Box disclosed because it had already filed plans to go public, are controversial.

The protections, known among investors as structuring or ratcheting, can inflate a unicorn’s indicated valuation anywhere from 10 to 25 percent. Moving forward, it will be interesting to see the impact of these late-stage investor protections.