- [Narrator] Unicorns are getting haircuts.
Unicorns are high-flying startups valued
at over a billion dollars, but these companies
are seeing their valuation shrink when they go public.
Payment processor Square took
a three billion dollar IPO haircut in 2015.
Cloud computing company Domo took
over 1.7 billion dollars off the top in 2018.
And the latest high-profile haircut came
this year from The We Company.
WeWork's parent company got a virtual buzz cut,
lowering its valuation by 32 billion dollars
before the company withdrew its IPO.
Private investors have infused these companies with cash,
betting they have the potential to corner their markets.
Private valuations have become an accepted yardstick
for what these companies are worth on the public market.
But many investors believe these valuations
often overstate a firm's likely true worth.
Here's how that can happen.
Private startups seeking investments typically undergo
a series of funding rounds, where investors,
usually venture capital and private equity firms,
provide cash in exchange for equity in the company.
Each new round of fundraising sets
a new valuation for the company.
These valuations are usually based on several factors,
including market size, revenue, and management.
Some investors and analysts contend
that the entire process tends to carry
a bias towards higher prices, because private markets
are filled almost exclusively by investors
who want their stakes to appreciate.
What makes private markets different is that they
generally aren't subject to the skepticism
that's common in public markets.
Private funding is fueled by optimism.
Private investors, unlike their public counterparts,
typically are constrained in their ability
to sell their stake in the company, and they can't bet
against the stock by selling it short.
There are a number of factors
that often make private market valuations higher.
One popular way of enticing investors
is to offer them preference shares,
securities that offer perks above and beyond
the ownership stake conferred by common stock.
Preference shares are often sold
to private-run investors and are more valuable
than the common shares that are typically sold in an IPO,
which helps explain why private market valuations
often end up higher than public market ones.
One common form of preference stock sold
in early funding rounds comes with a liquidation preference,
which ensures investors can get back whatever they invested,
even if the company is sold at a lower valuation.
A second preference stock feature, known as ratchet,
means early investors can get additional shares
if the company does an IPO at a lower price
than the one at which they bought in.
But during a valuation, these higher share classes
are valued equally to common stock,
even though they aren't entitled to the same payoffs,
making common stock appear more valuable
than it actually is, bloating a company's valuation.
Square was valued at six billion dollars
after its last round
of funding before going public.
But a study found that special promises
to late-round investors had inflated this valuation.
The study calculated Square was
actually worth 2.2 billion dollars,
close to the 2.6 billion dollar valuation
the company received for its IPO.
A second reason for high valuations
is that private companies aren't subject
to the strict accounting practices
that public companies must use.
They are far freer to present investors
with nonstandard data that paints a rosier picture
of their financial health.
The We Company presented investors
with a metric called community-adjusted EBITDA.
It excluded many of its major expenses, including rent,
making the companies losses appear smaller.
In entering public markets, companies agree
to report standard numbers based on rules set by the SEC.
This enables investors to more
accurately compare different firms' finances.
Private market valuations can be a useful data point
for investors, but the rude awakening that firms
like The We Company have received at times
is making many analysts and portfolio managers
increasingly skeptical of those big numbers,
and forcing unicorns to take a little or a lot off the top.
(soft music)