Private capital makes unicorns look beautiful, but beware the horn

Share

It's hard to imagine a financial headline that could strike fear into the hearts of both pre-teen girls and moms working in high finance. Presumably it would look something like, "Justin Bieber appointed head of TD Bank, engaged to Kourtney Kardashian."

But this week has given us something truly terrifying to both audiences: multiple news outlets proclaiming that unicorns are being slaughtered.

Poor unicorns! From the Bible to Bay Street, they can't catch a break.

Unicorns – that is, private market companies with valuations of over $1-billion – have recently seen large mutual funds such as BlackRock, Fidelity and T. Rowe Price significantly decrease their internal valuations. It's a stock market crash for companies that aren't traded on the stock market.

This is weird: How did we end up in a universe where unicorns exist, and a large dip in the value of some of the biggest companies in the world manifests itself not on the TSX or NYSE, but on the balance sheets of mutual fund companies?

The reason has to do with the legal regimes that govern large companies. As an approximation, business law is a series of Russian nesting dolls. The tiny doll in the middle is the law of contracts. Contracts are, at their core, about binding parties in a way that allows a court to enforce the promises they made to one another.

This is a very desirable thing. Without binding contracts, it would be hard for people to do business – economic relations would be insecure and uncertain, more Hobbes than Adam Smith. As such, contract law goes back to time immemorial.

Of course, writing contracts is hard work. Parties have to negotiate terms and then expend resources articulating those terms in a decipherable way. Moreover, a contract would be a prohibitively expensive way of protecting an entrepreneur from liability – a business can incur liabilities much larger than their assets or the assets of their owners, and negotiating a series of contracts that protects from such liabilities is nigh impossible. As a business enterprise grows, it needs another kind of law: corporate law.

Our corporate statutes set out the default rules of a corporate contract that addresses these issues. Without even thinking about it, businesses that incorporate are governed by a set of rules that are relatively sensible and efficient. If shareholders want, they can enter into contracts modifying some of these rules but, if they don't, they can rely on corporate laws to give them rules of operation, limited liability and, if you're a minority shareholder, the protection of fiduciary duties.

However, corporate law alone doesn't address the problems created by companies attempting to raise capital from a large number of investors. In the 1930s, individuals would sell shares in companies backed by little more than the "clear blue sky."

To prevent these frauds and to preserve faith in markets, governments enacted the first securities laws. Disclosure requirements in particular formed the backbone of the so-called "Blue Sky Laws" by forcing companies to disseminate accurate information about their business, these laws not only protected investors, they vastly improved market efficiency by giving large numbers of investors access to information that they used to better price stocks.

With each additional legal regime governing a business, legal compliance costs increase. Securities laws are particularly onerous both from a compliance standpoint and a governance standpoint. Securities laws also encourage executives to worry a little bit less about corporate vision and a little bit more about quarterly returns.

If only there was a way of accessing public market-like capital without public market-like compliance costs. And, there is.

Securities laws apply to all shares at all times. Therefore, for a company to issue shares without having to provide onerous disclosure, it has to issue shares under an exemption. Luckily, most of these exemptions are intuitive. Generally, companies can issues shares to founders, family, friends, employees and others without forcing the company to comply with securities law disclosure requirements.

However, by using "private issuer" exemptions, companies can also issue shares to a small number of "accredited investors" – crudely, high-net worth persons, both natural and corporate who, subject to certain rules, can be issued shares without forcing the company to disclose information to the market as a whole. People who are, presumably, savvy enough with their money to invest with limited disclosure.

However, there's a wrinkle here: Large institutions can invest massive sums of money into private companies without the company "going public" and becoming subject to the costs of being a public company. Members of the general public can get a piece of the action by investing in a large entity that's allowed to buy private shares.

Unicorns exist because venture capital firms, mutual funds and others have pulled money out of public markets to buy private-company shares under a securities law exemption. And yet, even with minimal disclosure, large private companies don't seem to do appreciably worse than public market companies. Mostly, it's just that when they lose value, it's on mutual fund balance sheets and not on the ticker tape.

Unicorns have found a way to raise large amounts of money by existing in a fantasy world where they can attract capital like a public company.

Aesthetically, it's neat to watch companies find capital market innovation lurking in almost 100 years of intricately linked legal regimes. So, yes, the world of unicorns is a world that's making us ask questions about securities laws and fiduciary duties, and maybe a few investors will get gored by their unicorn pets. But the ability for private companies to access capital may also allow innovative companies to stay innovative.

Just remember, unicorns aren't just beautiful: they also have horns.

Adrian Myers is a lawyer at Torkin Manes LLP.