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The Unicorn’s Dilemma

For startups seeking to join the ranks of “unicorns”- private companies with billion-dollar valuations- the venture capital climate has never been more favorable. The number of private companies receiving billion-dollar valuations has ballooned in recent years ((Evelyn M. Rusli, Startup Values Set Records, Wall St. J. (Dec. 29, 2014, 7:50 PM), and as of 2015, a record 41 companies have received exactly such a valuation. ((See Leslie Picker, Risking Your Neck to Run With the Unicorns, N.Y. Times: Dealbook (Nov. 4, 2015),

However, these sought-after valuations are not without their costs. Startups are often forced to provide investors with extreme downside protections to obtain them and they often fail to reflect the company’s true value. ((Id.)) The result of these seemingly innocuous concessions is a dramatic misalignment of interests between founders and investors, particularly in the context of IPOs. ((Id.)).

The recent downturn in public markets has increased the likelihood that a unicorn will experience a significantly reduced valuation in the event of an IPO. ((Id.)) While this risk looms large for founders concerned about the company’s financial strength, the down-side protections afforded to late-stage investors insulate them from that risk and may even make certain down-round IPOs lucrative for them. ((Id.)) With this dynamic at play, founders may find themselves under enormous pressure from their investors to pursue an IPO even if it would significantly reduce the company’s valuation.

Founders, conversely, have naturally been more inclined to stay private longer in hopes that doing so could buy the company time to fortify its private market valuation and thereby avoid a down-round IPO. ((Id.)) However, in addition to potentially alienating a company’s investors, this strategy also carries a high risk in terms of employee morale. In privately held companies, it is common for employees to be compensated with equity or stock options to make up for their not receiving a full market-rate salary. ((Joseph S. Tibbetts, Jr. & Edmund T. Donovan, Compensation and Benefits for Startup Companies, Harv. Bus. Rev., Jan. 1, 1989, While this conceptually provides these employees with the opportunity to reap the benefits of the company’s growth, their ability to do so is extremely limited while the company remains private. This is because private companies, seeking to carefully manage the distribution of their shares, often significantly limit to whom and under what circumstances stockholders can sell off their shares in the company. ((See Dan Primack, Uber Plays Hardball With Early Shareholders, Fortune (June 20, 2014, 10:00 AM), Hence, so long as the company remains private, employees may be largely impeded, if not outright prohibited, from cashing out their equity. In light of this issue, equity-holding employees who have patiently waited for the opportunity to benefit from their gamble on the company’s financial prospects are likely to chafe at the company opting to remain private and put off an IPO.

Under this pressure from employees and investors, startups with untenably high valuations may be placed in the position of having to choose between two incredibly unfavorable options. Such is the unicorn’s dilemma: risk destroying the company’s value in a down-round IPO or stay private and risk alienating investors and key employees.

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Joe Dalia