The story of Unicorns

Since there is nothing to do in the markets, here is an insider view of the tech Unicorns, what you won't find in the media because even financial writers aren't aware of the details.

The current darlings of Silicon Valley (which is increasingly becoming just SF) are the so-called Unicorns (companies whose private valuations are over $1B - Snapchats, Ubers, etc., are the more well known ones).

Most people on the outside think it is insane and reminiscent of the dot com bubble. In some ways, they are right. In some ways, not. They are not going to burst the same way taking down everybody because they are better designed to fool the markets and capitalize on the "greater fool" system of market valuation we have. For example, they have respectable later stage investors like Fidelity investing in well publicized uber rounds of billions of dollars valuation not just Russian Mafia or Chinese black money. That gives a sign of approval that the business must be real when they do the IPO. Especially, unlike the dot com burst, not all of them get to be unicorns only a select few which suggets that someone has done the weeding out. So, why would Fidelity get to invest in such "risky ventures" at these lofty valuations? Because they are really not risky at all for such late stage investors. It is a win-win for everyone involved except for the greater fools who get stuck with the stock after the IPO.

When you do a financing round, each such round is governed by a contract which can vary from round to round. Typically the companies issue private, unregistered preferred stock in exchange. The investor negotiates the amount of shares they get and that determines the valuation of the company. So, if a company takes in $100M in financing to effectively give away 10% of the company (post funding) to the investors coming in that round, the company has been valued at $1B. The assumption is that the new investors have done sufficient due diligence because they would want as much of the company as feasible and have a vested interest in keeping valuations as low as possible. This is more or less what happens in earlier rounds. Except what happens in later rounds is something completely different. Because of two not so well advertised items in the contract - accumulating interest on the investment and what are known as Liquidation Preferences for that round.

All preferred investors get an accrued interest on the investment typically in 6-8% per year range that gets added to their stake in the company (not payable in cash until there is an exit event like IPO or acquisition). In this extended low interest environment, making 6-8% on your cash is attractive for most money managers (forget the exit bonanza if it happens). But what about the risk? Aren't they risking all of their money? This is where liquidation preferences come in. The liquidation preferences in any round sets the priority on how the proceeds are distributed over the many tiers of preferred shares, the latest round owners typically having preference over the earlier ones.

The most common ones give the preferred shares a choice when there is an exit. They can either opt to convert all of their preferences to common including accrued interest stakes and get a proportionate amount OR exercise their rights to get their money back with interest. The latter requires the invested amount to be paid off with accrued interest from the proceeds starting from the latest and going through the various layers until you run out of proceeds (a poor exit) or every preferred share gets their money back with interest. This is the option taken in the worst case scenario where the exit was smaller than the funding rounds and so preferred get the money back in order of preference and there may be little or nothing left over for the lowest preferred or the common that founders and employees with stock options hold. In good exits, the preferred shares get converted to common which is what the founders and employees with stock options have. The proceeds are proportionately distributed for the common shares. In a really good exit, everyone gets a return for their shares. In really bad funding terms for common stockholders, preferred shares may be able to exercise both.

The VCs need the big returns from an exit because they have so many investments that go nowhere. But the calculation for the later stage investors like Fidelity is completely different. They want to make a decent above market return for money sitting around (and there is lots of it available for investment) in an environment where making 6-8% annually is diffcult without significant risk. So, unicorns give them an option.

Say you have $100M to invest and looking for 8% annual returns. Pick a startup like Snapchat or Uber that already has enough buzz and traction that even in the worst case is likely to be acquired at more than $100M. If you invest in a later round (especially in what you understand to be the last round of financing) with liquidation preference for your capital, you are unlikely to lose your capital (it is not entirely risk-free but manageable). Get 6-8% annually in deferred interest with a strong likelihood that you will get all of your money back even in worst case scenario exit and hit the jackpot with a 2-3x return if it is a successful exit. You don't really care much about the valuation because you are not really counting on the latter jackpot which would be icing on the cake. The company needs big valuations to make the IPO with very high valuations giving the impression that it is already highly valued by smart investors. So, sometimes they strike a deal even if the company doesn't need the money but needs the high valuation event.

That in a nutshell is how Unicorns get created.

I will post in a few weeks on the downside of it and why SF might be at significant risk from a fallout of this game (like most games they are not sustainable) even more shocking to its lofty real estate valuations than a big earthquake.