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Beware the rise of the 'zombiecorn'

October 23, 2017 View comments (2)

Too much of a good thing. You know the idiom.

It can be applied to the big trend in venture capital over the past few years: The rise of unicorns (i.e., companies with private valuations of at least $1 billion). Since the term was coined four years ago, the population of US unicorns has soared—from 40 to more than 120, according to PitchBook data. Cumulatively, the number of US unicorns increased 16x since 2008. And the cumulative unrealized value of current US unicorns is around $575 billion.

So, what's the rub, you ask?

How about lengthening hold times as exits become problematic? Or evidence of widespread overvaluation? All of this leads to the impression that many of these unicorns are becoming zombified: Too big and too old, a type of value-trapping abomination that goes against the laws of nature—or at least how private markets traditionally functioned (as a conduit into the public markets or an acquirer).

I call them "zombiecorns."

The first characteristic is old age as exits become scarce and the population grows, testing the ability of the private markets to push these companies through the typical capital lifecycle—gestating from seed, growth, expansion and, eventually, an IPO, acquisition or some other type of exit. So, they stagnate on the path but keep getting bigger until it becomes a problem for investors, founders and employees who want liquidity. Sort of like a kidney stone.

PitchBook's data analysts, digging into the numbers, have found that VC-backed companies tend to generate the bulk of their value between three to five years after their first funding round with diminishing returns afterward.

The rise of direct secondary market activity is one potential solution, as early employees and other insiders seek ways to monetize their stakes in their zombiecorns. Overall VC time to exit has increased 20% since 2008. And the median age of US unicorns has increased from around two years in 2008 to nearly eight years now.

With public markets in rarefied air, notching new record highs amid one of the quietest, volatility-free periods in history, why is this happening? Why haven't the likes of Uber, Slack, WeWork and Airbnb IPO'd already? Partially, because they don't have to.

With capital so cheap and plentiful, it's easy to push deeper and deeper into VC funding rounds with Series H and beyond. VC dry powder has accumulated as capital inflows outpace deal volume. Moreover, despite a recent drop off in unicorn valuation step-ups from the highs of 2013 and 2014, Series D+ valuation rounds have been outpacing the performance of the Russell 2000 index, according to PitchBook research.

That has given zombiecorns increased leverage over their investors, resulting in a trend toward founder-friendly terms with less equity participation and a louder say on the timing of any exit, such as an IPO, in recent years. Or non-exit, in their case.

And finally, new research by Will Gornall at the University of British Columbia and Ilya A. Strebulaev at Stanford suggests aggregate unicorn valuations are overstated by 50% above fair value when one compensates for various distinctions between common and preferred shares and "riders" granted to late-stage investors. These provide for different cash flow and control rights, including IPO return guarantees, vetoes over down-IPOs, and seniority over other investors.

These are rights not granted to common share investors, or even to investors in previous rounds or classes of preferred shares. Yet the standard "post-money valuation" metric used throughout the VC industry assumes they're all equal, in quality, to the last class of shares issued.

The 10 worst offending unicorns, according to Gornall and Strebulaev, have an average overvaluation of 170%. And after adjusting for valuation-inflating riders, nearly one-half of unicorns would lose their status.

This overvaluation premium is the likely reason that many unicorn IPOs have disappointed lately, as plain vanilla common shares open for trade and lose the vicarious valuation premium they enjoyed being associated with preferred shares with unique rights. Companies that have struggled since going public include Cloudera (NYSE: CLDR), LendingClub (NYSE: LC), Blue Apron (NYSE: APRN) and many others.

Roku, Inc. (NASDAQ: ROKU) looks particularly vulnerable, despite a post-IPO rally and solid growth prospects, with a calculated overvaluation of nearly 300% for its common shares, per the report.

The trend is made worse by a tendency, like with Snap (NYSE: SNAP), for emerging tech companies to strip their common shares of the voting rights typically assigned—a move that ensures insiders maintain control, even after the IPO, but renders these shares "common-lite" in comparison and thus less valuable.

Add it all up, and you can see why many unicorn insiders have allowed their companies to mutate into zombiecorns: Why risk the popping of the pre-IPO valuation bubble when investors are still throwing money at you? Better to stay private, keep raising money and avoid all the noise of being a public company.

It's like how Jacques—the well-known cynic in Shakespeare's "As You Like It," where the phrase "Too much of a good thing" was first used—decided to stay in the forest. This came after concluding life soars in the seeking of "bubble reputation" and ends in "mere oblivion, sans teeth, sans eyes, sans taste, sans everything."

Like a zombie.

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