According to new research from the UBC Sauder School of Business and Stanford University, just under half of all unicorns – the infamous start-ups valued at more than $1-billion – don’t deserve their mythical title.

In this Q&A, lead author Will Gornall explains his findings and how the new model he developed with co-author Ilya Strebulaev can more accurately estimate the value of venture-backed companies.

Why study venture capital and unicorns?
Venture capital (VC) is an important driver of economic growth and an increasingly important asset class – of all the companies that went public in the United States since the late 1970s, 43 per cent were backed by venture capitalists prior to their initial public offering (IPO).

But, despite the growing importance and accessibility of VC investments, the valuation of these companies has remained a black box. These financial structures and their valuations can be confusing and are grossly misunderstood not just by outsiders, but even by sophisticated insiders.

What did you find in your research?
We found that the average highly-valued venture capital-backed company reported a valuation 49 per cent above its fair value. But, when the valuation was recalculated using the financial model developed by Ilya and I – which derives a fair valuation of each class of shares of VC-backed companies by taking into account the intricacies of contractual cash flow terms – almost half of these companies lost their unicorn status, with 11 per cent being overvalued by more than 100 per cent. Some unicorns have made such generous promises to their preferred shareholders that their common shares are nearly worthless.

This is happening because current valuations make a misleading assumption: that a company’s shares have the same price as the most recently issued shares. This oversimplification significantly inflates valuations, since the most recently-issued shares almost always include perks not found in previously-issued shares. Specifically, we found that 53 per cent of unicorns gave their most recent investors either a return guarantees in IPO (14 per cent), the ability to block IPOs that did not return most of their investment (20 per cent), seniority over all other investors (31 per cent), or other important terms.

What is the danger of such widespread overvaluation?
With the reported valuation of these unicorns totaling over $600 billion, the interest in VC as an asset class has increased substantially. A number of the largest U.S. mutual fund providers, such as Fidelity and T. Rowe Price, have begun investing their assets directly in unicorns. In addition, third party equity marketplaces like EquityZen allow individual investors to gain direct exposure to these unicorns. While the total present VC exposure of mutual funds, at around $7 billion, is small compared to the size of the mutual fund industry, there has been a ten-fold increase in just three years. In 2015, Fidelity invested more than $1.3 billion into unicorns, more than any American VC fund invested that year.

The current method of valuations allows a company with falling valuation to issue a new round with sufficiently generous terms, meaning an overly rosy picture. Our findings also have implications for the rank and file employees of VC-backed companies, who often receive much of their pay as stock options. Our analysis finds that these employees are receiving much less than they think they are in fair-value.