Unicorns

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CBInsights recently held a webcast that offered a recap of 2018 events affecting the fintech sector. Global fintech investment reached a record at $39 billion in 2018. Venture-backed fintech deals declined in the fourth quarter of 2018 but remain high compared to historic levels. Early stage fintech deal share declined compared to 2017. There are now 39 fintech unicorns globally, valued in aggregate $147.37 billion. There were 16 fintech companies that joined the unicorn ranks in 2018. There were 52 fintech financing rounds that each raised in excess of $100 million. Only three fintech unicorns undertook IPOs in 2018. CBInsights identified ten fintech trends to watch in 2019. Outside of the United States, fintech startups are applying for bank charters. Fintech companies are continuing to strengthen their regulatory compliance efforts as regulatory scrutiny has increased. Fintech startups are providing access to new asset classes and fintech companies are becoming more entrenched in the real estate and mortgage markets. CBInsights predicts that mega-rounds will delay IPOs.

In “Squaring Venture Capital Valuations with Reality,” authors Will Gornall and Ilya Strebulaev developed a valuation model for venture capital-backed companies that relies on terms of financing rounds that were gleaned from public filings. Using these reported valuations, the authors then calculate values for all share classes for each of the 135 US unicorns in the study sample set. In doing so, the valuation of shares of common stock is adjusted down to reflect the fact that reported valuations relate to preferred stock and the holders of preferred stock receive significant contractual and economic benefits that are not shared by the common stock. The authors point to certain valuation practices that may lead to incorrect conclusions, such as the post-money valuation approach often used by VC funds. Also, the authors note that often in arriving at valuations, the valuation may be based on the value of the most recently issued series. Usually the most recently issued series of preferred stock is senior to all previously issued and outstanding series of preferred stock, making prior series less valuable by comparison, but instead many models would ascribe the per share valuation of that senior security to every share of the other series. Using their valuation model, the authors find that 65 of the 135 unicorns lose their status as unicorns when considered based on fair value. The authors note that a lack of information regarding the differing contractual terms associated with the outstanding series of stock contributes to the overvaluation. The lack of transparency may be problematic as private secondary markets continue to grow, and as ownership of stock in privately held companies becomes dispersed. The full report can be accessed here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2955455

The recently published MoneyTree Report provides an overview of venture capital investment trends. In 2018, VC-backed companies raised $99.5 billion, an increase in annual funding of 30%, despite a decline in the number of deals. In 2018, the number of early-stage deals declined, but the number of later-stage deals increased. There were 184 “mega-rounds” completed in 2018, or funding rounds of $100 million or more. Globally, there were 382 mega-rounds completed in 2018 although overall financing activity globally declined in 2018. There were 55 companies that attained unicorn status in 2018. At year-end 2018, there were 140 venture-backed unicorns. By sector, Internet companies led with 540 deals completed in the fourth quarter raising $9.1 billion. This was followed by 162 healthcare financings and $4.0 billion. Fintech-related funding increased 38% in 2018 over 2017.

CB Insights recently published its seventh annual Tech IPO Pipeline Report.  The report notes that in 2013, the median time between first funding and IPO for U.S. VC-backed tech companies was 6.9 years compared to 10.1 years for tech companies that went public in 2018.  As we have noted in previous posts, tech companies continue to raise more significant amounts of funding prior to undertaking their IPOs.  In 2018, tech companies raised, on average, $239 million before undertaking their IPOs, which is almost 1.4x the amount raised in 2017, and over 3.7x as much as 2012 figures.

The number of new private tech unicorns has outpaced the number of tech IPOs in 2018.  After 2014, tech IPOs declined significantly and have remained at those depressed levels, with only 19 tech IPOs in 2018.  By contrast, there were 45 tech companies that became unicorns in 2018.  The mega-round financing trend, wherein companies raise over $100 million per round, was also prevalent in the tech-sector, with almost 120 mega-round financings completed in 2018.

Tech-focused private equity firms continue to acquire majority stakes in tech companies that are nearing liquidity opportunities, whether IPOs or M&A exits.  However, M&A exits continue to replace IPOs.  The report cites as examples Qualtric, Adaptive Insights, and AppNexus.

According to a recent research report by CB Insights, in the third-quarter of 2018, there were 375 VC-backed equity financings that raised over $5.64 billion for fintech companies globally. In total, 1,164 fintech financings have been completed in 2018, through October 31, raising over $32.6 billion in offering proceeds.  Approximately 40% (462) of these deals are from U.S. issuers.  Payments, alternative lending, and capital markets tech companies accounted for the majority of fintech financings, with 169, 145 and 141 deals completed in 2018, respectively.

The fintech sector also continues the trend of late-stage financings for companies that wish to remain private.  In the United States, there were 17 mega-rounds, or financings of over $100 million each, completed by fintech companies. There are now 34 fintech unicorns globally, valued at $117 billion, in aggregate. 21 of these unicorns are U.S. companies, with four having completed mega-rounds in 2018.

To read CB Insights’ full briefing report, click here.

 

In a recent paper titled “Unicorn Stock Options – Golden Goose or Trojan Horse?” Anat Alon-Beck analyzes the issues arising in connection with stock-based compensation awarded to employees of unicorns given the trend toward remaining privately held longer and the deferral of IPOs, which traditionally served as the principal liquidity opportunities for employees.

The paper notes that for many Unicorn employees, choosing between exercising their options or forfeiting them is difficult.  Valuations for unicorns may be high, so paying the cash exercise price and meeting the tax obligations may be difficult for an employee.  Even if the employee were to exercise, the underlying stock would still be illiquid.  Moreover, for many employees that choose to leave their companies, the standard option terms provide for a limited period of 90 days or so during which departing employees must make a decision whether to exercise.  Given information asymmetries, employees may not have a well-formed view regarding the value of the stock.  Many of these factors appear, according to the author, to be contributing to the high turnover among unicorns.

The author notes that stock-based compensation models were premised on the fact that most entrepreneurial companies had a lifetime of four years or so to IPO.  With an extended timeline to IPO, the author suggests that it may be necessary to formulate a new approach to compensation.  Possible alternatives may include: longer vesting periods, longer periods in which to exercise when an employee departs, back-end loaded options and greater reliance on RSUs.  However, each such alternative has its limitations.  As a result, the author contends that regulatory reform is needed.  First, the author calls for changes to the Exchange Act Section 12(g) threshold to include employees in the holder count and more rigorous information requirements for companies under Rule 701.  Given that the SEC’s Concept Release relating to Rule 701 and Form S-8 generally reflects a predisposition for less disclosure and greater flexibility, the article provides an interesting counterpoint.  As the author notes, current regulations did not contemplate the growth of unicorns and, while increased flexibility for stock-based compensation grants may be useful, it does not address the information disparities or the lack of liquidity for employees and other optionholders.

Since the financial crisis, the IPO market has been somewhat volatile, but in the last few quarters, the market has shown growth. A recent Audit Analytics report notes a number of factors that may contribute to the relatively slow rate of growth of the IPO market, including the abundant availability of private capital (both equity and, increasingly, debt), the overcorrection of the market for historically high IPO valuations, and M&A exits.

Based on data provided in the report, there have been 1,758 IPOs since 2008. 66% of these IPOs were completed after the enactment of the Jumpstart Our Business Start Ups (JOBS) Act.  At the time of this post, there have been 27 IPOs withdrawn in 2018, according to Nasdaq.  The report also notes that there has been a 46% decline in the number of SEC registrants.

Both regulators and Congress have taken steps to ease the burden of accessing the public capital markets.  For example, the report highlights the expanded ability to submit draft registration statements confidentially to all companies, which took effect in July 2017.  Based on Audit Analytics data, the report noted that EGCs made up 70% of all IPOs in the first quarter of 2017, and now EGCs make up almost 90% in 2018.  IPO costs are one of the main reasons for companies deferring their IPOs.

Shifting focus to unicorns, Audit Analytics reported that these companies, which are valued at over $1 billion, made up only 7% of all IPOs in the first quarter of 2018.  In 2017, 10 unicorns went public, which represented 2% of all IPOs completed and in 2016, 11 unicorns went public, representing 5% of all IPOs.

Audit Analytics also looked at total IPO proceeds raised by year, as shown above.  Post JOBS Act, IPO proceeds seemed to steadily increase and then dropped again significantly in 2015 and 2016.  Based on their data, the report notes that the second and third quarters are the strongest for IPO activity, which leads us to believe that 2018 will finish on a positive trajectory.

Read Audit Analytics’ full report for more.

Fintech companies continue the global trend of companies choosing to remain private longer and raising large amounts of capital through private channels.  A recent CB Insights report covered the financing trends of fintech companies for the first half of 2018.  As of the date of the report, there were 29 fintech unicorns valued at $84.4 billion globally.  The second quarter of 2018 valued five fintech companies at unicorn status (over $1 billion).  Three of these new unicorns are based in the United States.

U.S. fintech companies raised $3.2 billion in new capital over 146 deals in the second quarter of 2018, bringing the total number of deals for the first half of the year to 303, raising approximately $5.3 billion.  Compared to Q2 2017, last quarter’s total capital raised increased over 52%.  Not surprisingly, later-stage capital raises made up over 83% of deals in the second quarter, raising approximately $2.7 billion over 74 deals.

There was only one IPO exit by a fintech unicorn in the U.S. in the second quarter of 2018, which raised $874 million.  Globally, M&A exits accounted for approximately 85% of fintech company exits, with 39 M&A transactions, while there were only seven fintech IPOs completed in the first half of 2018.

For more information, read CB Insights’ Global Fintech Report Q2 2018.

On June 12, 2018, Partner Anna Pinedo participated in a panel discussion titled “Hello Private Capital” at the Wall Street Journal’s CFO Network 2018 Annual Meeting in Washington D.C., which focused on the trend of companies toward deferring their IPOs and remaining private, the public policy concerns arising as a result, the effect on the IPO market, the availability of investment opportunities for retail investors, new legal challenges for large private companies, and valuation considerations.