The fortunes of some of tech's biggest superstars are waning--and that has many venture capital investors nervous. Now it seems the Securities and Exchange Commission is anxious too.

In recent days, the federal agency has launched an investigation into the methods mutual fund companies use to place values on such high-flying companies. The investigation, first reported by the Wall Street Journal on Wednesday, is part of a regular monitoring that the SEC conducts of mutual fund companies. But its focus on institutional holdings in unicorn companies is particularly well-timed, as numerous questions have arisen in recent months over whether such companies can continue to support their extraordinary valuations, some of which have stretched into the billions of dollars.

In recent weeks, mutual fund company Fidelity has reportedly marked down the share price of messaging app company Snapchat by 25 percent, and it slashed the share price of the cloud human resources provider Zenefits by 48 percent. Meanwhile, more unicorns are having trouble justifying their valuations when they face the public markets. Cloud storage company Box, for example, saw a 30 percent drop in its $2.4 billion valuation shortly after its January initial public offering this year. More recently, payments provider Square saw its $6 billion valuation bid down to $3 billion prior to its IPO on Thursday.

The issue is particularly important to mutual funds because their investments in these privately held companies aren't easily resold. That means if valuations suddenly sink, the fund company is on the hook without the option of selling shares. Those fluctuations can wind up endangering the entire portfolio, as fund holders could panic and look to unload their shares. 

While the net outcome of the investigation is likely to bring more transparency to a previously opaque pricing process, the ripple effects on other startups could be profound--pushing down valuations and funding rounds universally, financial experts say.

"Some extremely high valuations recently have come under pressure," says Steven Wallman, a former SEC commissioner and founder of Folio Investing, a brokerage and institutional investment advisory in McLean, Virginia. He adds that the trend may be one factor that prompted the investigation. However, the real purpose of the probe, Wallman says, is to unravel why there are such pricing disparities to begin with. 

One reason why mutual funds are suddenly attracting so much interest is their importance to the general investing public, as they hold trillions of dollars worth of assets. Mutual funds have traditionally invested in baskets of publicly traded securities, which collectively make up the fund's net asset value, or daily share price. However, mutual funds may also invest up to 15 percent of fund assets in non-liquid investments, such as privately held startups. In recent years, an increasing number of tech startups have turned into big-time investments opportunities for VCs, and as a result, these funds have wanted to get in on the action to bolster investor returns too. And as the value of unicorns has grown, so too has their weight in many mutual fund portfolios.

Even so, these late-stage private companies are not publicly traded, and therefore are open to conjecture regarding their valuations. That causes added confusion and discrepancies in the value that mutual funds place on their private shares. For example, mutual fund company Fidelity reportedly prices its Uber shares $33.32 a share. Hartford Financial Services Group prices them at 35.67 a share, and Blackrock values the company's shares at $40.02.

The dilemma for Fidelity and Hartford, says Drew Nordlicht, partner and managing director of Hightower Advisors in San Diego, is whether to make subsequent investments at their own price threshold, or to use Blackrock's 20 percent higher valuation, which means a dilution of their own shares.

"It's a much harder decision to make than if you are a public company with a discount," says Nordlicht.

And while this whole conundrum may seem like something that's limited to mutual funds and unicorns, it's not. All startups are likely to start tripping when it comes to taking on new rounds of financing, because investors are likely to demand lower valuations, Nordlicht says.

"The discounts will be larger, and the number of unicorns that take down round valuations either in their next private financing or in the public market will be larger," Nordlicht says. "And the natural recurrence of this, most likely will be that [non-unicorn] companies also struggle to get refunded."

Here are three things to keep in mind if you're looking to get funding in this new world.

1. Trumpet your achievements.

In the coming year, investors will return to basics when they value your company, and they will want to see evidence of growth in profits and revenue, Nordlicht says. So if you're reaching for the highest valuation you can, and you've increased revenues, and doubled your customer base in the past year, obviously you need to talk about it.

2. Play the field.

Seek out multiple term sheets and multiple offers, as competition will naturally drive up your valuation, Nordlicht says. 

3. Transparency will benefit you.

The SEC's focus on clear pricing is ultimately a good thing for markets, says Wallman. It will give public investors more faith in their investments, and it could take some air out of the tech bubble. That means less potential danger to the larger economy from a sudden event, such as was seen when the Dotcom bubble popped in 2000.

 

Published on: Nov 20, 2015