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business school research

Eleven of the 116 companies studied were overvalued by more than 100 per cent, researchers concluded.Getty Images/iStockphoto

The Globe's latest report on research from business schools.

Everyone loves a unicorn. These are the young and innovative startups with reported valuations or more than $1-billion (U.S.).

Think Uber, Airbnb and SpaceX – all highly valued companies fuelled by investor expectations that they'll be the next Google or Facebook.

But are these rare creatures really deserving of their mythical status?

Will Gornall, assistant professor of finance at the University of British Columbia's Sauder School of Business, doesn't think so.

According to a financial model developed by Dr. Gornall and Ilya Strebulaev of Stanford University, many so-called unicorns are overvalued.

Drawing from data contained in U.S. legal filings, Dr. Gornall found nearly half of the startups in their study (52 of 116) lose their unicorn status when their valuation is recalculated. The discrepancies vary, but the average company reports a valuation 48 per cent above its fair value, with common shares overvalued by 55 per cent, the researchers calculate.

Eleven companies are overvalued by more than 100 per cent, they conclude.

That overvaluation exists does not surprise Dr. Gornall, who has expertise in examining the complex deal structures behind early-stage companies. Miscalculations are made when current valuations fail to include additional perks not found in previously issued shares, so equating their prices significantly inflates valuations.

For instance, the researchers found 53 per cent of unicorns gave their most recent investors either a return guarantee in their initial public offerings, the ability to block IPOs that do not return most of their investment, or seniority over all other investors, among other important terms.

Still, Dr. Gornall admits, "I was surprised at the level of overvaluation and, moreover, how much it can vary between companies."

Dr. Gornall says the study does not suggest companies are deliberately misleading people. However, the findings do expose widespread confusion around the true value of startups – a particular problem for employees who are often paid partly in stock and options, yet have little clarity around what those options are worth.

The dilemma also extends to investors, he adds, many of whom "appear to lack an understanding of the complexities of venture capital deal structures."

The researchers believe better disclosure in venture capital-backed companies, not just unicorns, is required in the United States as well as Canada, where the federal government is looking to encourage more startup success stories.

More broadly, the study offers a lesson in the importance of paying attention.

"Whether you are talking venture capital financing, negotiating a real estate deal or getting a loan, you need to read the fine print and understand the contract," Dr. Gornall says.

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