According to the Wall Street Journal, as of January there were 147 technology companies each worth more than $1 billion, with an estimated aggregate valuation in excess of $500 billion. Some 58 of these so-called unicorns were admitted to this one-time elite club in 2015 alone. But what is this information really telling us? A closer look shows that these billion-dollar-plus valuations may not be as bullish as they seem. And the danger of lower valuations may actually be good news for M&A.
More than $175 billion has been raised by unicorns, according to an article published Jan. 18 in VentureBeat. Much of the money was invested using convertible preferred stock with highly structured terms. Those terms gave investors significant downside protection in the event of a decline in valuation. They often included liquidation preferences in excess of the money invested and price adjustments if a liquidity event were to send the valuation below the last round of investment. In other words, some of the unicorns achieved their billion-dollar-plus valuations by agreeing to accept downside protection terms in exchange for higher “headline” values.
One example is the November 2015 IPO of smartphone credit card processing provider Square, which was priced at $9 per share on the New York Stock Exchange. The price was a significant discount to the $15.46 per share that late-stage investors paid for the company’s preferred stock only 15 months earlier. Because of the structured nature of that financing, which included guaranteed return requirements at the time of the IPO, preferred-stock investors were issued an additional 10.3 million shares—valued at nearly $93 million at the IPO price. Those additional shares were initially worth roughly $135 million when the stock closed up 45 percent on its first day of trading. Now, however, Square is trading closer to its IPO price.
“A closer look shows that these billion-dollar-plus valuations may not be as bullish as they seem. And the danger of lower valuations may actually be good news for M&A.”
Macroeconomic trends are partly to blame. In the first three weeks of 2016, the Standard & Poor’s 500-stock index declined approximately 7.6 percent, while the technology-centric NASDAQ fell nearly 8.8 percent, approaching correction territory before slightly recovering.
The drop in valuations and increased market volatility of public companies, as well as global economic uncertainties, are negatively affecting the comparable valuations of private unicorn competitors. For example, online peer-to-peer loan platform Lending Club and cloud storage provider Box have each lost more than 50 percent of their value since they began trading in December 2014 and January 2015, respectively. Prosper Marketplace, a competitor to Lending Club, was valued at $1.9 billion in April 2015 when it raised $165 million in its series D preferred share financing.
Similarly, Dropbox, a Box rival, was valued at $10 billion in January 2014. While these companies continue to grow like their public competitors, it is questionable whether they still justify their prior valuations. Until these companies raise additional capital in the private markets, try to tap the public markets or pursue an exit through an M&A transaction, these lower valuations will not be crystalized.
“There is blood in the water,” Jim Breyer of venture capital firm Accel Partners told Business Insider during an interview at the World Economic Forum in Davos, Switzerland, in January. “We are entering a 90-10 situation for the unicorn class of startups with billion-dollar valuations: 90 percent of the startups will be repriced or die, and 10 percent will make it.”
The Ripple Effect
What does this mean for these unicorns and other technology companies? While some are strong, well-capitalized and growing, others are not, with many continuing to lose significant amounts of cash from operations in the foreseeable future. Healthy companies with sufficient cash on their balance sheets that spend capital prudently should be able to reverse any near-term loss in value before they need to raise more capital from private investors or the public market.
Less well-capitalized ventures will need to raise additional money on terms that may not be as favorable as before. And these new funding rounds may trigger downside protection terms afforded to prior-round investors. It’s a slippery slope from there. First, the downside protection terms can adversely impact earlier investors because they are further down the liquidation stack and often do not have the same downside protections as later-stage investors. In addition, because of the lower valuations, employee option grants and founder shares lose value, impacting morale and increasing the risk of staff leaving for greener pastures.
Many of these tech companies, unable to tap the private or public markets, will turn to M&A for liquidity. As such, we expect many unicorns to be acquired by large strategic buyers at valuations that in recent years were too expensive to make economic and strategic sense. That’s where the good news comes in. Because of this, we anticipate a strong year of M&A activity for venture-backed technology companies.
And there is more good news. The rising number and value of unicorn companies have also driven up the valuations of early- and mid-stage companies as earlier-stage investors seek the next big opportunity. As values adjust in later-stage companies, we can expect to see similar declines in valuations in the early- and mid-stage sector, though to a smaller degree, due to the longer investment horizon for these companies, as well as a more challenging environment to raise capital. Many new private equity and venture funds that have recently raised fresh capital will be well-positioned to capitalize on this resetting market as existing fund managers focus on dealing with their current portfolio of companies.
As a result, we expect 2016 to continue to be a strong year for M&A; the leading differentiated technology companies delivering unique solutions will continue to access the private markets, and for some, the public markets.
Michael Mitgang is managing director at WGD Partners LLC, a Silicon Valley-based financial advisory and investment firm focused on providing tailored merger and acquisition, capital raising and other advisory services to emerging growth and middle-market technology companies. He brings more than 20 years of experience as an investment banker, investor, adviser and board member to his work advising technology clients. He can be reached at email@example.com.