TheChek News Flow

When a venture capitalist coined the concept “unicorn club” in 2013, it referred to software start-ups valued at $1 billion or more—just 39 at that time.

“We like the term because, to us, it means something extremely rare, and magical,” Cowboy Ventures founder Aileen Lee wrote in a column for Techcrunch. Four years later, the rarity—and the magic—has worn off. Today, Dow Jones VentureSource tracks 170 unicorns in its database.

Equity investors once held high hopes for these companies to come to market and become the next Facebook or Google. But in recent years, the unicorns have preferred to raise funds behind closed doors. Just 32 have gone through with initial public offerings since they became a class unto themselves, according to VentureSource, and they have tended to be smaller names. Large companies like Uber Technologies, Dropbox, Lyft, Spotify, and Airbnb have so far spurned the public market.

As the private companies become household names, they face questions about their workplace cultures, business models—and valuations.

The unicorn experience is teaching us an unexpected lesson: The public markets remain the best place to achieve long-term corporate success.

Uber and some of its private investors have learned that lesson the hard way. The company, already worth a reported $68 billion, struggled to find a new CEO after ousting Travis Kalanick, its combative co-founder. Ultimately, the company persuaded Dara Khosrowshahi, Expedia’s longtime chief and once the highest-paid public-company CEO in America, to take the job.

The new boss now says the company will go public in 2019. For Khosrowshahi and Uber, it could be their hardest task yet.

IPOS WERE ONCE the obvious path for any private company that reached a $1 billion valuation. But public markets are no longer a siren song. The median age of tech companies going public last year was 10.5 years, according to Jay Ritter, a University of Florida professor who studies trends in initial public offerings. In 1999, the typical tech company was four years old at its market debut.

The maturation of IPOs has generally been a good thing, taking risk out of the system. The drawback is that the rewards have been simultaneously reduced.

Each round of private financing decreases the chance that public investors will benefit from the next Facebook or Google. “Time is your enemy when it comes to rate of return,” says Kathleen Smith, principal at Renaissance Capital, a manager of IPO-focused exchange-traded funds.

Leading mutual fund managers have adapted to the new reality. They’re not waiting for companies to grow up; instead, they’ve dug into the private markets, searching for growth. Fund giants Fidelity and T. Rowe Price have led private fund-raising rounds for unicorns, such as Dropbox, Airbnb, and WeWork.

The dearth of companies making their trading debuts is an unusual feature of what has been a record run for the stock market. In the heady 1990s, there were an average of 436 IPOs per year in the U.S., based on Ritter’s data. Last year, there were just 74. A number of reasons have been cited, including increased regulations and scrutiny for public companies, as well as the deluge of private capital.

But there’s another reason. Retail investors are saying: “We don’t need you anyway, at least not at those prices.”

Instead, investors have generally chosen to stick with passive strategies, rather than make big bets on new, speculative companies.

“The interest in just getting low-cost exposure to the market is crowding out the appetite for IPOs,” says Andrea Auerbach, a managing director at Cambridge Associates who advises pension funds and other institutions on private investments.

There’s a price for everything, however, and U.S. investors are still willing to participate in the occasional initial offering. The problem for many unicorns is that they have priced themselves out of the market. They’ve raised too much money at valuations that are simply too high.

The dynamic has complicated the transition for many of the high-profile unicorns that do end up making the public jump. GoPro (ticker: GPRO), Snap (SNAP), and Blue Apron Holdings (APRN) have become billboards for the overhyped unicorn. The stocks have each shed more than 20% from their IPO prices.

INVESTORS HAVEN’T FORGOTTEN their experiences during the dot-com bubble or the financial crisis, notes Renaissance’s Smith. “The days of the stock jock are over,” she says. “So what we have left is a more astute set of investors. And they’re driving for return. That’s probably a good change for the IPO market.”

For some unicorns, public disclosures leading up to the IPO have revealed underlying business issues—problems that had been hidden away. Blue Apron’s prospectus showed that the company was spending too much to acquire customers even as those customers were spending less on average.

“It took five minutes of reading the S-1 to see there was a problem,” says David Strasser, a former sell-side retail analyst who is now a managing director at the venture-capital firm SWaN & Legend.

Blue Apron is down 69% since going public just four months ago.

A discerning public market—and the lack of IPOs—is the best argument left that stocks have yet to hit the bubble-like levels of the late 1990s. The irony is when a market correction does arrive, it could make it harder for companies to go public.

Nine years into the current bull market, there are signs that the broader IPO market is bouncing back. Newly issued stocks have performed relatively well. The Renaissance IPO ETF (IPO), which holds companies that have made their debut over the previous 24 months, is up 34% this year, more than double the broad market’s return.

Last month, a unicorn even shone after its public debut. Shares of MongoDB (MDB)—a cloud database provider—have risen 24% since the stock’s Oct. 18 offering. At a recent $30 per share, the company is worth $1.5 billion, still 17% less than the private market valuation it reportedly fetched in January 2015.

More prominent unicorns will go public, but investors are likely to remain discriminating—a clear contrast from the lavish private markets.

FOR NOW, IT’S HARD to blame entrepreneurs for holding back on IPOs. The flood of private capital has changed the calculus. In one example, Japanese conglomerate SoftBank Group has raised over $93 billion for a technology investment fund. Those dollars alone exceed the $84 billion in total proceeds raised in U.S. IPOs since the start of 2015.

Founders like to say it’s not just the money. Freed from the burden of quarterly disclosures, Wall Street analysts, and shareholder votes, private markets have been deemed more-hospitable terrain.

IAC Chairman Barry Diller has spun off nine public companies, but at a recent Wall Street Journal D.Live event, he said: “There’s no reason to be public unless you need capital. And, by the way, almost all these companies do not need capital.”

Uber is able to hold off on an IPO until 2019, largely thanks to SoftBank’s largess. Last week, the ride-sharing firm reportedly accepted a new round of funding from the Japanese giant. According to media reports, SoftBank is investing up to $10 billion, with $1 billion coming at a $68 billion valuation, matching the headline value that frequently gets attached to the company.

Most of SoftBank’s investment, though, would come at a lower valuation, with the company buying shares from existing investors. The complex transaction illustrates the dance that’s happening behind private doors.

As unicorns soar in value, the firms have faced increasing pressure to keep those valuations growing, even when the fundamentals might not support them. Often, that means finding ways to entice late-stage investors.

New rounds of fund raising tend to include preferred stock that comes with greater downside protection.

Academics from Stanford University and the University of British Columbia spent 2½ years studying these preferences and found widespread use of them in Silicon Valley. The perks include strong liquidation preferences in the event the company goes broke, or guaranteed returns at the time of the IPO, should shares be priced lower than expected. In 24% of the unicorns studied by Stanford Prof. Ilya Strebulaev, preferred shareholders can effectively block an IPO from happening.

“The average unicorn in our sample has eight classes, with different classes owned by the founders, employees, VC funds, mutual funds, sovereign wealth funds, and strategic investors,” Strebulaev and University of British Columbia Prof. Will Gornall wrote in their study.

The terms get hashed out in private. Generally, all the public hears is the headline valuation that emerges from the agreement. But Strebulaev argues that those valuations are frequently misleading, since the latest class of stock carries preferential terms that don’t apply to the company’s existing private stock. New private investors are willing to make investments above fair value because of the powerful economic benefits that come with preferred stock—benefits that don’t apply to the common shares held by employees.

Strebulaev and Gornall conclude that headline valuations overvalue unicorns by 50% on average. Their analysis knocks nearly half of the unicorn club back below the $1 billion mark.

ACCORDING TO PAT GRADY, a partner at venture-capital firm Sequoia Capital, there has been a notable increase in fancy fund-raising terms in recent years. “There’s a lot of financial engineering that people can do to create a valuation that looks like a big number, but actually feels like a much smaller number for the new investors,” Grady says. “That’s something people will do if the founders are really focused on having that big headline valuation.”

He adds: “It’s an unfortunate game of brinkmanship where, at the margins, everybody wants to feel like they’re worth just a little bit more.…Eventually, we end up in this place where lots of companies have lots of unhealthy structure.”

The problem, according to multiple insiders, is that fancy terms pit the private investors against one another. The preferences given to a late-stage investor can dilute the stakes of earlier ones and employees.

Grady says that Sequoia tries to avoid those situations. “The more financial engineering you do, the less aligned you are with founders,” he says.

It also creates an opaque capital structure that few outside the boardroom understand. Strebulaev’s team, including Stanford colleagues and outside lawyers, pored through the unicorns’ certificates of incorporation. In some cases, it took the lawyers 12 hours to make sense of one document, Strebulaev says.

WHILE PUBLIC COMPANIES sometimes issue multiple classes of stock, they’re usually differentiated by voting power, not economics. With private companies, there’s basically no limit on the terms investors can request.

There’s no federal regulation requiring disclosure of the terms either. Strebulaev says he got lots of calls after he published the study, adding, “There is one organization that has not called me so far, and that is the SEC.”

He says that disclosure regulations for private companies should be updated, given that public investors are now often invested in unicorns—sometimes unknowingly—through mutual fund holdings.

“Determining cash-flow rights in downside scenarios is critical to much of corporate finance, and the different classes of shares issued by VC-backed companies generally have dramatically different payoffs in downside scenarios,” the paper contends.

Robert Bartlett, a law professor at the University of California, Berkeley, who specializes in securities regulation and corporate finance, says the difference between share classes is no secret among Silicon Valley venture capitalists. “It’s common knowledge that the common is worth less than the preferred,” he says.

Publicly, though, that knowledge is getting overlooked. “No one is drawing the distinction,” Strebulaev tells Barron’s.

IAC’s Diller put it more bluntly at last month’s Wall Street Journal conference: “It’s the absence of dealing with multiplication, division, addition.”

Some investment managers still care about the math, hoping to benefit their shareholders in the process. Henry Ellenbogen, a T. Rowe Price fund manager, has been buying preferred private shares for several years in his New Horizons mutual fund.

T. Rowe often leads the investment, taking the role of a late-stage VC firm. “We’re the ones that set the valuation on the asset,” Ellenbogen says. “We know, based on our view of different rights, what we think each share class is worth. When we do valuation, we absolutely adjust for it.”

He notes that common stock generally carries a 10% to 20% discount to preferred shares. But in some cases, as private companies struggle to raise money, they’re forced to give more-favorable terms to new investors. “The preferences get more onerous, and the gap between the common and preferred gets wider,” he says.

In October 2014, Square (SQ) raised $150 million. At the time, the deal was reported to value the company at $6 billion, up from a previous $5 billion. But to secure that higher valuation, Strebulaev notes that Square made a big promise: Series E investors were guaranteed $18.56 per share if the company went public.

A year after the Series E fund raising, Square did go public, at just $9 a share, valuing the company at $2.9 billion.

Eventually, Square did reach that $6 billion value—but it was 18 months after its public debut. Since then, Square has been one of the few public unicorn success stories, and IPO investors who stuck with the stock have been rewarded. It’s up 250% in the past 12 months, giving the company a market value of $16.5 billion. It took a public listing to square Square.

Cloud-storage firm Box (BOX) is another of those rare unicorns—a start-up that reached $1 billion, went public, and managed to grow its stock, post-IPO, despite some early turbulence. After a 57% rally this year, Box is now worth $2.9 billion. The company went public in January 2015 at $1.7 billion.

CEO Aaron Levie says he can appreciate what private companies are going through and why they’re hesitant to go public. “My state of mind four or five years ago was, ‘Let’s push off being public as long as possible,’ ” he says.

“The thing you imagine is, all of a sudden, once you become public, everybody only cares about the quarter and everything is going to be run for short-term returns,” Levie says. “That’s the brand that Wall Street has, for better or worse.”

But he says he has learned the benefits of public ownership: “There is a way to drive near-term performance and long-term strategy and innovation. Those things don’t have to be mutually exclusive.”

As for the increased scrutiny and the obligations around disclosure, Levie has found positives there, as well. “You just begin to run your company in a more disciplined fashion, operationally, organizationally, even culturally,” he says. “You start to care about a lot of things that when you were private you could be a little bit looser with.”