Hunting the unicorn

The Securities and Exchange Commission has nudged unicorn valuations slightly higher on its watch list after concerns there was no consistency in methodologies used by private fund firms. The regulator wants to see more uniformity among managers when it comes to assigning a price to a start-up, but has not taken action – yet.

A study by the University of British Columbia and Stanford University found about half of private companies with valuations exceeding $1 billion – unicorns – would not have earned the title without the use of complex stock mechanics.

The study looked at 116 unicorns founded after 1994 with average valuations of $2.7 billion. Researchers found that 11 percent of companies used preferential stock to boost their valuations to more than twice what they would be worth using fair value estimates.

“Regulators will examine whether actual valuation practices were consistent with disclosures to investors, review gaps between stated valuation policies and practices, and scrutinize inconsistencies in applying those policies. The SEC is already focused on potential issues concerning auditor independence,” law firm Proskauer Rose writes in a client note.

Headwinds increase the risk of issues. Discussion of a unicorn bubble will likely fuel SEC scrutiny of valuation practices, according to legal sources. Burst bubbles tend to turn the spotlight on securities laws and regulators, which are then criticized for being too passive and reactive. To counteract this, the SEC will train the searchlight firmly on a manager’s valuations policy if there is a unicorn failure.

Playing it safe
Private fund firms should, first of all, review their general valuations policies and procedures and ensure their unicorn valuation methodology is in line.

“It’s about doing things consistently, with the consistent application of the valuation technique. It’s never bad to revisit your policies and procedures. Just make sure you feel comfortable there’s sufficient detail to support your rationale and the conclusions you have reached,” says Rajan Chari, a partner at Deloitte and co-author of the annual Deloitte Fair Value Pricing Survey.

Being able to demonstrate you stuck to the methodology is vital if the unicorn is devalued.

“Any significant devaluation of unicorns is likely to amplify the scrutiny of valuation practices, particularly of funds with significant exposure to unicorns. Fund investors will almost certainly focus on sponsors’ adherence to their own valuation policies, as well as discrepancies in valuations between private funds and mutual funds,” Proskauer says.

One of the main differences between valuing unicorns and other companies is that the fund has few parameters and must determine for itself what a market participant would think, who those market participants are, and what the ultimate exit for the investment may end up being.

To avoid the wrath of the regulator, a fund manager must ensure they are being realistic about their unicorn valuations.