The more unicorn bubble chatter I hear, the more I think about the 2007 financial crisis and about the mispricing of risk that happened then. At the root of all the bad stuff that occurred was the severe mispricing of mortgage backed securities (MBS) and collateralized debt obligations (CDOs). Loans were pooled into portfolios and then those portfolios were sold off based on tranches of risk. These derivative securities are very complicated and the big three ratings agencies (S&P, Moody’s, Fitch) were providing favorable ratings for them at the time. Everyone went along with the ride until the market wised up. At that moment, they became unsellable “toxic assets”.
“By the end of 2009, over half of the CDOs by value issued at the end of the housing bubble (from 2005-2007) that rating agencies gave their highest “triple-A” rating to, were “impaired”—that is either written-down to “junk” or suffered a “principal loss” (i.e. not only had they not paid interest but investors would not get back some of the principal they invested).” – Wikipedia
To give you the severity of the mispricing:
“Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from the third fiscal quarter (1 July – 30 September) of 2007 to the second quarter (1 April – 30 June) of 2008.” – Wikipedia
So why is this relevant today?
Because it prompts this question: Is there potential mispricing happening in the current tech boom? Here’s a stab at one answer: It’s right in front of the us on the cap tables of unicorns.
Here’s a growth stage fundraise example to illustrate how current valuations happen:
Company A growth round fundraise: $250 million
Shares sold: 10 million
Price per share: $25
Congrats, we just made a unicorn.
If billion dollar valuations have proliferated because investors are increasingly more comfortable with them as long as they get generous downside protection, then the value of that protection has to come from somewhere. It doesn’t appear out of thin air.
That additional downside protection in the form of things such as liquidation preferences and ratchets can negatively affect the other shareholders in any exit scenario that isn’t good to great. Common shareholders have it the worst because they are at the bottom of the totem pole. In other words, the higher share price paid in later stage growth rounds should be partially offset by a decrease in price per share of the earlier classes of stock.
The standard method of calculating market capitalization “breaks” because not all shares are the same. Shares of Series D Preferred should be more valuable than shares of Common, Series A, B, or C.
Instead of the market capitalization calculated above, a “truer” valuation would look something like this, where the price per shares for each class should be discounted relative to the latest round:
Company A example valuation using difference prices per class of stock:
You can see this sort of exercise knocks off a lot from these valuations. If the rise of unicorn valuations are partly explained by the tradeoff of more onerous liquidation preferences and other terms being piled into the later rounds, logic says that the earlier rounds should be discounted relative to the price paid in this round.
Anyways, this is one area where the traditional accounting methods fail to tell the complete story of what’s happening these days in the growth stages of venture capital.
Is this evidence of dangerous bubbles in formation? In and of itself, no, but I’ll leave that open for you all to discuss.