No sooner had I penned "Unicorns, Valuation and the Search for Investment Returns" for my compliance blog, I opened the New York Times this morning and discovered an article about so-called unicorns or companies with venture capital ("VC") backing and an estimated valuation of at least one billion dollars. According to the author of "The Hidden Risk of a Billion-Dollar Valuation in Silicon Valley," law school educator and pundit Steven Davidoff Solomon, venture capital firms want to get paid first in the event of a portfolio company sale which is why they negotiate hard to include a liquidation preference before committing capital. He cites a study by law firm Fenwick & West that confirms the prevalence of this downside protection and suggests that it is one reason why VC firms don't balk about what others may decry as valuations that are "too high." Interested readers can click here to download "The Terms Behind the Unicorn Valuations" by Barry Kramer, Michael Patrick and Nicole Harper (March 31, 2015). Professor Solomon points out that this kind of return insurance is a boon for venture capitalists but could be a disaster for founders who may end up with little or nothing if a liquidity event yields too few dollars. In an attempt to avoid this unhappy outcome, founders with sufficient voting power could nix a potential sale. Should that occur, investors then face greater risks due to less liquidity.
What is missing from the various analyses about unicorns and jumbo valuations of private companies overall is a discussion about the potentially adverse impact on institutional investors. In the event that valuation numbers are truly disconnected from economic reality, a limited partner may well end up paying too much in fees to its venture capital fund manager(s). Moreover, any institutional investor that allocates money to venture capital as part of its grand strategic asset allocation design may well fall short of its goals if valuations are "too high." Failure to realize a target return, satisfy a minimum funding ratio rule and/or diversify its portfolio are a few of the "nasties" that could ensue, thereby putting investment committee members at risk for allegedly breaching fiduciary duties.
One response, proffered by researcher Ashby Monk, is for institutions to invest directly and cut out the middlemen. This tact is likely to appeal to the bigger endowments, retirement plans and sovereign wealth funds that can afford to hire staff and put the requisite due diligence and technology infrastructure in place to vet and then monitor its investments. Even then, there is the peril of improperly relying on imprecise valuations that in turn drive so many other decisions.
As Dame Agatha Christie declared, "Where large sums of money are concerned, it is advisable to trust nobody." Investment fiduciaries need to understand how asset managers come up with the valuations they report to their limited partners and how their valuation numbers are revised over time to reflect changing conditions.