Going from start-up to $1 billion+ valuation, in a short period of time, is something all entrepreneurs, employees, investors, and other stakeholders dream about. This fascination with “unicorn status” has led unicorns and their investors to stretch the boundaries of conceivable valuations. In 2009 there were just 4 unicorns, as of writing this post there are 152.
As the number of unicorns grow, valuations increase into the $10 billion+ range, and larger more traditional investors get involved (mutual funds, hedge funds, sovereign wealth or corporate investors vs. VCs), unicorn financing structures have gotten more complicated. The recent IPO of tech unicorn-Square, Inc. got many to notice what is known in the investment community as a ratchet.
Investopedia defines ratchets as;
An anti-dilution provision that, for any shares of common stock sold by a company after the issuing of an option (or convertible security), applies the lowest sale price as being the adjusted option price or conversion ratio for existing shareholders.
Law firm Fenwick & West LLP noted that “Approximately 30% of unicorn investors had significant protection against a down round IPO“. Examples of unicorns with ratchets in their funding transactions include Lyft, Chegg, Box Inc, and more. There are many different types of ‘ratchets’ but the general idea is that if a company raises capital, gets acquired, or goes public at a lower valuation than a previous “ratchet round”, investors get their earlier investment valued at the new round’s lower valuation (or a discount to that new lower valuation).
Ratchets are essentially steroids for unicorn valuations. TechCrunch points out that;
It’s increasingly common in mega rounds to build in protections such as IPO ratchets. It’s a sort of win/win for companies and investors. Companies get their shiny unicorn valuation (which helps with recruiting, in addition to being the vanity metric du jour), and investors get some downside protections
So what does this all mean? It means that many unicorn valuations aren’t “real” rather, they are fantasy portrayed by investors and founders. As with most fairy tales, those telling the story (investors, founders) know its not real but those listening to the story (retail investors, employees, media, etc.) may be enchanted by the tale. Unfortunately, when things go wrong, employees and others in the dark on unicorn ratchets are left “holding the bag” (see my previous post, “When Unicorns Die, Employees go to Hell.“) . Perhaps we call these companies unicorns because their valuations are as fictional as unicorns in the traditional sense.
Ben Kotch is a managing director and investment committee member at Acquis Capital, LLC, a private investment firm that specializes in acquisition funding. He has extensive experience with both private and public companies. Ben graduated with an economics degree from Bentley University where he concentrated in entrepreneurship and law.
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