I have previously written on Unicorn valuations and the false impression that the last private equity round’s price multiplied by all the prior issued shares (all with different liquidation preferences and other terms) is the equivalent of what the company is worth as a whole across all its shareholders.

With the potentially dramatically lower IPO valuation of WeWork compared to its many prior lofty capital raises, many market commentators have pondered the financial impact to those most recent investors who must be disappointed that their investment is seemingly “underwater.”  I remain amazed at the incredible misunderstanding and misanalysis of these private rounds as companies transition to the public arena.

When discussing public company valuations, the math is relatively easy.  There is a price per share and a known number of shares owned by the shareholders. Multiply them together and you have the equity value of the company.  For actively traded companies, this is a reasonable representation of what the company is worth since any shareholder could sell their shares for that price thereby receiving their piece of that valuation.  However, this methodology applied to private companies with multiple classes of preferred shares with various rights and preferences that differ from each other wrongly implies that each share is worth the same as the shares sold in the last round.

One of the most important things that an IPO accomplishes is that it simplifies the capital structure into (generally) a single common stock.  The several rounds of convertible preferred stock go through a mandatory conversion into common stock (the same stock that the IPO investor will receive) on the basis of the preferences of each preferred round.

Early in my investment banking career I learned that prospectuses are written “as if” the IPO has been completed.  In other words, the prospectus details what the company’s capitalization will be immediately upon completion of the IPO, not what existed just prior including all the conversions of the various preferred stocks. It’s “as if” the preferred stocks never existed.  The IPO investor doesn’t need to know what the terms of the now nonexistent preferred stocks were in order to make an informed investment decision.

So why is this important?  The implication of the media coverage of WeWork or any other Unicorn going public is that the most recent investors, who invested at lofty valuations, are being hurt (losing money) because of the substantial decline in the value at which the underwriters are proposing to price the IPO relative to the valuation at the time of their investment.  While it is true that a lower valuation means the shareholders in aggregate have something that is worth less, it is not true that all the classes of shareholders share pro rata in the decline in valuation.

Most of the fundraising rounds that result in Unicorn status have liquidation preferences, which include provisions protecting against the IPO price not equaling or exceeding the price the investor paid.  Although it is difficult to find out, and is not a required disclosure in the prospectus, the preferred investor usually builds in a minimum return for itself by having liquidation preferences that the IPO triggers.

Although the mechanics may differ, here is an example of one situation with which I am familiar.  The new investor agrees to a seemingly extraordinary valuation where financial professionals wonder how the investor ever expects to make an adequate return on its investment.  In this case, the investor built in a guarantee that it would receive a return of 3x on its investment.  Normally the number of preferred shares an investor receives is equal to the investment divided by the price per share paid (valuation divided by fully-diluted shares). Each share of preferred stock has the right to be converted into common stock on a 1-to-1 basis.  However, the liquidation preference in this case guaranteed that the value of the common stock the investor would receive at the time of the forced IPO conversion would be worth not less than 3x the investment. Let’s say the IPO is done at a valuation exactly equal to the valuation at which the preferred investor bought his shares. Instead of receiving one share of common for each share of preferred, the conversion ratio is adjusted so that each preferred share receives three shares of common.  While in theory the “flat round” seemingly means everyone has maintained their value; in reality, the preferred has increased the value of what it owns at the expense of all the other shareholders.

This is a reasonably simple example.  Now apply this same technique to each of five or more rounds of preferred, each with its own liquidation preference applied in order of priority of earlier rounds of investment.  The consequences are further magnified in a “down round” where the valuation is cut in half.  Instead of receiving three common shares for each share of preferred, they receive six common shares in order to receive the equivalent of 3x their investment in common stock value.  This increases the percentage of fully-diluted common shares the former preferred shareholders own and decreases the percentage owned by the original common shareholders.  The fall in valuation is borne by the earlier investors, not the later preferred investment rounds in this example.

The point is that the consequences of a down round or reduction in the IPO valuation are not shared equally across all investors.  In fact, it is likely that the investors who paid the highest prices/valuations are probably still making a substantial return on their investment while the earlier rounds (especially the founders) are absorbing most of the decline in value.