Unicorn sightings have become the rage from Silicon Valley to Wall Street, but not everyone thinks these mystical creatures bring magic to the market, according to a recent New York Times article. 

Over the last 15 months, the number of tech companies valued at over $1 billion, called unicorns, has doubled to 102 according to PitchBook Data. The Times questions how young companies land these meteoric valuations, and whether the associated costs are worth it.

Later IPOs, Late Stage Investors

Compared to companies founded in the 1990s dot-com bubble, today’s startups are waiting longer to go public, allowing private investors a chance to grab a stake before the company IPOs. According to Rick Kline, a lawyer with Goodwin Procter who works closely with startups, companies want to attract these late-stage investors in order to boost valuations by as much as 10-25% prior to an IPO.

The dirty little secret: In order to lock in late round private funding, companies have been reducing risk to investors by ensuring a certain return when the company goes public. Called structuring or ratcheting, these terms provide late-stage investors protection in the form of discounts on shares or a larger portion of stock if the company is valued lower than in their last round of private funding. If they are valued less, those late stage investors get more shares at a lower cost--but the company and other investors shoulder the burden.

Startup Box Does The Unicorn Valuation Dance

These terms, usually not disclosed, can inflate valuations. The Times cites Box as an example of a unicorn that protected late-stage investors at the expense of the company and other investors.

Box attracted late stage funding in July 2014 that valued the company at about $20 per share, or a valuation of $2.4 billion. In the event of a lower public valuation, Box agreed to terms that guaranteed late-stage investors additional shares, as well as a discount on the eventual price. In January 2015, when Box was valued at $14 per share--or $1.67 billion total--the investors were entitled to about 58% more shares, and at a discounted price of $12.6 per share.

As a result, early stage investors in Box got a watered down stake in the company, and the cloud software company came away with fewer investors, making them more vulnerable in the case of financial instability. According to venture investors interviewed for the article, the cost of this extra insurance should impact the company’s valuation, but implied costs are not typically taken into account.

The Takeaway

Relying on a unicorn valuation can be detrimental to young companies if the underlying profits aren’t there. Attracting investors by promising a unrealistic return is a dangerous bet for a company to make. As Daniel Ciporin of Canaan Partners warned in the Times: “I think entrepreneurs get starry-eyed about the high valuations and don’t realize they come with all sorts of caveats if everything doesn’t work perfectly.”