Contrary to popular belief, which includes believing in unicorns, most unicorns’ valuations are a myth.
And like most good myths there are lessons to be learned, especially from stories where unicorns die.
The private companies whose valuation exceeds $1 billion have been called unicorns do exist sometimes in reality, but more often than investors and the public realize just on paper.
Not surprisingly, the divining rod that separates reality from fantasy is honest accounting and simple math.
It’s not a long and winding path to get to the truth about a unicorn’s real valuation, it’s straightforward.
Here’s the truth behind unicorn valuation myths and how to calculate reality from fantasy and avoid financial ruin…
A Unicorn’s Path Is a Manipulative Financial Feat of Mythic Proportions
It’s about successive rounds of private money invested in companies by venture capital firms, hedge funds, giant investment pools like Softbank’s $100 billion Vision Fund, and mutual fund companies like Fidelity Investments and T. Rowe Price.
Angel investors and venture capitalists usually fuel startups’ early rounds of funding. Other classes and types of investors come in later in what’s known as successive “rounds.”
Each new round of funding, identified by letters, as in series A, B, C, D, E, results in an updated valuation of the company.
While the valuation of the invested-in company can be the same from one round to the next, that’s not usually the case.
Sometimes, for various reasons none of them are positive for the company. New money coming in gets assigned a lower value than previous investment rounds, known as a “down-round,” that reduces the total valuation of the company.
More often than not, however, each new round of funding results in a higher valuation of the company.
That’s understandable because new money wants in as the company’s value appears to be increasing.
Quite often, the last round of funding that a company gets, costing the last investor or group of investors more than any previous round cost, boosts the company’s valuation substantially before it looks to sell shares to the public in an initial public offering, IPO.
To an untrained eye the increasing valuation of a private company based on successive rounds of investment at higher and higher prices for the securities purchased means that the company is increasingly valuable and likely a good investment based on the trajectory of its ascending valuation path.
It doesn’t mean the company is necessarily increasingly profitable. The company could be increasingly profitable or increasingly unprofitable losing more money every year or quarter at the same time that it’s getting additional series funding rounds.
While it doesn’t make sense to the uninitiated that investors would pay up to own shares in a private company that’s losing money, it makes sense if you understand how the valuation game is played and why it’s played the way it is.
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The generally accepted way to value a private company receiving successive rounds of funding is to multiply the price per share the latest round of investment costs times the total number of fully diluted shares of the company.
As each new series of funding costs later stage investors more per share, it makes sense that the value of the company is greater for all shareholders and the company’s total valuation increases.
But that generally accepted method is a fantasy.
That’s because not all “shares” are equal.
Different rounds of investment are often assigned different rights. Some new shares may come with different voting rights, cash flow and control rights, or downside protection.
Not all shareholders are equal. Some shareholders’ shares, usually the later stage investors’ shares, are more valuable and as a result are assigned a higher price at the time of issuance.
But that’s not taken into consideration when assigning a valuation to the company.
The simple solution is to take the per share cost of the last round and multiply that times all the shares of the company, including common shares, convertible preferred shares that are assumed to be converted into common shares, and options that are assumed to be converted into common shares, to account for as many shares as possible.
That’s how successive rounds of funding elevate the valuation of private companies without regard to their profitability or the company’s completely different classes of securities.
On Tuesday I’ll tell you what happened to a lot of the companies that late-stage investors helped “bid-up” before they IPO’d and where they are today.
I’ll tell you what really happened to WeWork.
And I’ll tell you how to separate the wheat from the chaff to not get burned yourself and how to properly value companies coming to market.