Unicorns

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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.