By: Joshua M. Newville, William Dalsen and Alexandra V. Bargoot of Proskauer
The recent IPOs of Snap, Inc. and Blue Apron indicate that while the IPO pipeline continues to flow, there may be a cautionary tale for “unicorns” – venture-backed companies with estimated valuations in excess of $1 billion.
After Snap went public in March, it posted a $2.2 billion loss in its first quarter, yielding a 20% same-day drop in stock price that erased much of the company’s gains since its IPO. A snapshot of Snap’s stock price shows the obvious risks faced by late-stage investors in unicorns. High valuations are not a guarantee of continued success, particularly where historical performance and profitability are lacking. Although one commentator recently asked: “Are Blue Apron and Snap the worst IPOs ever?”, there is plenty of time for those stock prices to recover, especially in the months after their insider lockup periods expire.
Less well-known is how those risks can create conflicts that lead to litigation in the private fund space. The unicorn creates a dilemma for the private fund backing it. On the one hand, an exit through a public offering is desirable as demonstrating cash-on-cash return is generally better than maintaining an illiquid holding, particularly when the company is facing the potential for down round funding to survive. On the other hand, going public puts the unicorn’s financials in public view, and employees and private funds risk losing big if the company cannot sustain its predicted value.
Ultimately, a choppy IPO outlook for unicorns will lead to tightening of markets. As more unicorns linger and fall into distress, some will fail, leading to litigation. Overly optimistic valuations lead to inflated expectations, especially those of employees expecting a payout and investors expecting gains. Below are some types of disputes that can arise.
Employee claims: Employees paid in common stock may sue in the event of a dissolution or bad sale ahead of a public offering. As in the case of former unicorn Good Technology, a bad sale may involve a payout on the common stock that amounts to only a fraction of its estimated value. Employees of Good Technology (who held common shares) filed claims asserting that the company’s board breached its fiduciary duties by approving the sale. They alleged that the board (whose members represented funds that owned preferred shares) favored the preferred over common shareholders. While the case has been slow to progress, its outcome will inform the market whether such suits will provide viable recourse when employee shareholders believe their interests have been disadvantaged.
SEC Scrutiny: As we’ve previously noted, valuation-related regulatory risks increase as the time lengthens between purchase and exit. The SEC’s exam and enforcement staff have been focused on valuation of privately held companies for years. Further, the SEC sees itself as a protector of investors, even when those investors are employees of a private startup. We are likely to see a disclosure case against a pre-IPO issuer relating to Rule 701 under the Securities Act. That rule requires disclosure in certain circumstances of detailed financial information to employees in connection with certain stock or option grants. This would lead to a spillover effect for funds that have supported those companies.
Claims arising in an acquisition: If the company is fortunate enough to reach some liquidity in a private sale, the acquiring company may pursue litigation against the board or other investors. The buyer may later allege fraudulent inducement and breach of contract on the grounds that the company and its investors misrepresented the company’s value. In addition, investors can often break even in a merger by holding preferred shares with liquidation preferences. However, like employees, investors still may sue the board or the company to try to recover a better return on their investment.
Fund LP/GP disputes: Unicorns are no different than other portfolio companies, in that when they fail, there may be disputes between a fund’s GP and its LPs. Those claims may vary. For example, the fund’s designee on a failed unicorn’s board of directors will typically owe fiduciary duties to both the portfolio company and the LPs. An LP may allege that the board representative favored the interests of the company over the interests of the LPs, or failed to adequately address or disclose concerns raised to the board level. Furthermore, LPs may allege that the fund manager failed to address the potential for conflicts between the adviser and the funds.
While unicorns can generate extraordinary returns for early investors, they may also carry increased litigation risk even when they are successful. In addition, as more unicorns linger and fail to achieve successful exits, there is a higher likelihood that investors or employees will seek to recoup losses through litigation. Fund managers should keep in mind the potential for these conflicts before a unicorn stumbles. Addressing these relationships at early stages of the investment can help minimize litigation risk.