Why Your Favorite Unicorn Might Be Overvalued by 50% (and What It Means for the VC Ecosystem) - In Depth Review

We’ve all seen the headlines: “Startup X joins the unicorn club with a $1 billion valuation.” But what if those valuations were seriously inflated? A landmark study by William Gornall (UBC) and Ilya A. Strebulaev (Stanford GSB), “Squaring Venture Capital Valuations with Reality,” suggests that the numbers we see splashed across tech media often misrepresent the true economic value of venture-backed startups.

Their findings have major implications for founders, employees, investors, and LPs. Here’s the story simplified through my lens.

1. The Problem with Post-Money Valuations

Startup valuations are usually based on the most recent funding round:

Latest preferred share price × total fully diluted shares = post-money valuation (PMV).

This assumes that every share in the company is worth the same as the new preferred shares just sold to investors. But that’s simply not true.

• Preferred shares usually come with special rights: liquidation preferences, IPO ratchets, seniority over other investors, automatic conversion exemptions, etc.

• Common shares, held by founders and employees don’t have these protections and are worth far less.

When you treat them all equally, you overvalue the company.

2. Key Findings: Unicorn Valuations Are Inflated

The study analyzed 135 U.S.-based unicorns (startups valued at $1 billion or more) as of mid‑2017 and reconstructed their capital structures from legal filings. The results were staggering:

• Average reported valuations were 50% higher than the “fair value” calculated using an economic model.

• Nearly half of all unicorns (65/135) would lose their billion-dollar status if valued correctly.

• 15 unicorns were overvalued by more than 100%.

• Common shares held by founders and employees, were overstated by 58% relative to preferred shares.

Below I have coded a violin plot in Python (Anaconda/Jupyter Notebook) incorporating Table 5 and Figure 1 data from the paper.

"This violin plot compares the return distributions of preferred vs common shareholders in downside exit scenarios (50%, 75%, and 90% below PMV)."

"Note: Common shareholders’ mean returns are -63% (50% below PMV) to -99% (90% below PMV) vs preferred shareholders’ -32% to +6% over the same scenarios."

How Figure 1 and Table 5 are incorporated:

1. Table 5 Data:

2. Table 5 provides the numerical return distributions for common and preferred shareholders in down exits (50%, 75%, and 90% below PMV).

3. For each scenario, we used the mean, median, and percentiles (25th and 75th) to model the return distributions.

4. These were used as the data inputs for the violin plot.

2. Figure 1 Context:

• Figure 1 shows how common share options are systematically mispriced compared to their "true" value (black line) when using headline PMV or simple rules of thumb (red and blue lines).

• This violin plot builds on that by showing why common shares are overvalued: Table 5's downside scenarios show how common shareholders lose nearly everything in distressed exits, while preferred retains value.

3. Graph Logic:

• Each violin shape shows the distribution of returns for preferred (light green) vs common (light blue) across the three downside scenarios.

• The width of each violin reflects the concentration of firms at each return level: thicker around the median, thinner at extremes.

• Medians are marked by the black horizontal line.

4. Takeaway:

• The violin plot visually connects Table 5's quantitative return disparities to Figure 1's conceptual mispricing:

• PMVs treat common and preferred as equally valuable, but in downside exits, common shares collapse in value (often -100%) while preferred may retain or even gain value.

• This structural disparity is at the core of the overvaluation problem.

Below I have coded a box plot in Python (Anaconda/Jupyter Notebook) incorporating data from Table 6 from the paper.

• Q1 (24%): 25% of unicorns had overvaluation ≤ 24%.

• Median (37%): Half of unicorns were overvalued ≤ 37% (and half were more).

• Q3 (59%): 75% of unicorns had overvaluation ≤ 59%.

• Upper whisker (100%): The upper range of most observations before considering them extreme outliers.

• Outliers: Unicorns overvalued beyond 100% (e.g., 111%, 130%, 150%, and 170%).

📊 Notes for Box Plot of Unicorn Overvaluation (Based on Table 6)

What this graph shows: This box plot visualizes the percentage by which post-money valuations (PMVs) overstate the fair value (FV) of unicorn companies. It highlights how widespread and significant overvaluation is across the sample.

• The box represents the middle 50% of unicorns (interquartile range):

• Q1 (25th percentile): 24% overvaluation

• Median (50th percentile): 37% overvaluation

• Q3 (75th percentile): 59% overvaluation

• The whiskers extend to values close to 100% overvaluation, covering the bulk of the sample.

• Outliers (dots beyond the whiskers) are unicorns with extreme overvaluation greater than 100% (e.g., 111%, 130%, 150%, and 170%). These are cases where PMVs more than doubled the fair economic value.

Where the data comes from:

• Table 6 from Gornall & Strebulaev (2020) provides the statistical summary of overvaluation (∆V) across 135 U.S. unicorns:

• Mean overvaluation: 50%

• Standard deviation: 42%

• 25th percentile (Q1): 24%

• Median: 37%

• 75th percentile (Q3): 59%

• These data points were used directly to construct the box plot.

• Figure 1 in the paper complements this graph conceptually: it shows how the mispricing of common shares versus preferred shares is systemic, and this box plot quantifies the extent of that mispricing across the sample.

How to interpret this:

1. Half the unicorns studied are overvalued by at least 37% (median).

2. A quarter of unicorns are overvalued by at least 59%.

3. Some outlier unicorns are overvalued by more than 100% – their PMVs more than double their fair economic value.

4. This structural overvaluation stems from preferred-share protections (liquidation preferences, IPO ratchets, seniority) that the headline PMV ignores.

Takeaway: This graph illustrates why the “unicorn” label is often misleading: PMVs systematically overstate the true economic value of companies, especially for common shareholders (founders and employees).

References:

• Table 6: Summary of Unicorns’ Fair Values and Post-money Valuations

• Figure 1: True Value vs. PMV Mispricing Framework

Below I have coded a histogram (non-continuous) plot in Python (Anaconda/Jupyter Notebook) incorporating data from Table 6 from the paper.

Histogram: How Much Are Unicorns Overvalued?

This histogram shows how much unicorns’ post-money valuations (PMVs) overstate their fair economic value (ΔV), based on the 135 U.S. unicorns studied by Gornall & Strebulaev.

How the bins were constructed (from Table 6):

We used the percentile breakdown from Table 6 and divided the sample into five bins:

1. Bin 1: ≤ 24% overvalued (Q1 and below)

2. 25th percentile (Q1) = 24%

3. Number of unicorns: 34 (25% of 135)

4. These unicorns have the smallest gap between PMV and fair value.

2. Bin 2: 25%–37% overvalued (Q1 → Median)

• 50th percentile (Median) = 37%

• Number of unicorns: 34 (the difference between the 50th percentile and 25th percentile: 68 – 34)

• These unicorns are moderately overvalued, just above the lower quartile.

3. Bin 3: 38%–59% overvalued (Median → Q3)

• 75th percentile (Q3) = 59%

• Number of unicorns: 33 (the difference between 75th percentile and 50th percentile: 101 – 68)

• These unicorns fall in the "upper middle" band of overvaluation.

4. Bin 4: 60%–100% overvalued (above Q3 but ≤ 100%)

• Number of unicorns: 19

• These unicorns have significant overvaluation but are not in the extreme outlier category.

5. Bin 5: > 100% overvalued (outliers)

• Number of unicorns: 15 (extreme mispricing cases where PMV is more than double the fair value, e.g., 111%–170% overvalued)

• These cases are the clearest examples of how investor protections and PMV methodology distort headline valuations.

Total sample = 34 + 34 + 33 + 19 + 15 = 135 unicorns.

What the histogram shows:

• Three-quarters (101 of 135 unicorns) have ΔV ≤ 59% (i.e., PMVs overstate fair value by up to 59%).

• One-quarter (34 unicorns) are overvalued by more than 59%, and 15 of them are extreme cases with overvaluation > 100%.

• The median overvaluation is 37%: half the unicorns studied are overvalued by at least this amount.

Reader takeaway:

• Most unicorns are meaningfully overvalued. Even in the "best" bin (≤24%), a company’s PMV still overshoots fair value by nearly a quarter.

• Founders and employees holding common shares are most exposed. PMVs assume common and preferred shares have the same value, but preferred shareholders’ contractual protections (liquidation preferences, IPO ratchets, seniority) explain why the gap exists.

• Extreme cases (>100%) highlight systemic distortion. In some companies, PMVs more than double the economic value because the preferred shares that set the PMV are so heavily protected.

Data sources:

• Table 6: Summary of Unicorns’ Fair Values and Post-money Valuations (ΔV).

• ΔV = Percentage by which post-money valuation (PMV) overstates the true fair value (FV).

3. How Investor Protections Distort Valuations

Protective clauses in investor agreements skew the valuation narrative:

• IPO ratchets (minimum guaranteed returns) can inflate valuations by 56-75%.

• Liquidation multiples >1x can increase overvaluation by 42-94%.

• Automatic conversion exemptions, seniority rights, and participation rights all further tilt the playing field.

Example: Square’s 2014 Series E round valued the company at $6B, but its fair economic value was closer to $2.2B a 171% overvaluation.

Below I have coded a bar graph in Python (Anaconda/Jupyter Notebook) incorporating Table 4 data from the paper.

Prevalence of Special Contract Terms (Table 4) from the paper

Data Source:

• Table 4 in the paper: Prevalence of Special Contract Terms.

• The table reports the percentage of unicorns (out of 135 analyzed) that include specific protective clauses in their investor agreements.

What this Graph Shows:

• This bar chart shows the prevalence (percentage) of major contractual protections given to the latest investors in unicorns.

• Key protections include seniority, liquidation multiples >1x, participation rights, cumulative dividends, IPO ratchets, and any major protection.

Details of Each Category:

• Seniority: Investors having preferred liquidation seniority over other investors.

• 49% had seniority over some investors.

• 32% had seniority over all previous investors.

• Liquidation Multiple > 1x: 6% of unicorns had liquidation preferences above 1x their investment.

• Participation: 13% of unicorns included participation rights (investors get liquidation preference + share in remaining proceeds).

• Cumulative Dividends: 7% included dividends that accumulate over time.

• IPO Ratchet: 14% included ratchet provisions (downside protection in IPO pricing).

• Any Major Protection: 56% of unicorns offered at least one of these major protections.

Why This Matters:

• These clauses substantially tilt economic value toward preferred shareholders and away from common shareholders (founders, employees).

• Explains why headline post-money valuations (PMVs) often overstate the true economic value of common shares: the protections reduce downside risk for preferred investors.

 Graph Construction Logic:

• Each bar represents one type of contractual term, and its height represents the percentage of unicorns (from Table 4) that include it.

• Color coding alternates between light blue and light green for readability.

• Values are labeled directly above each bar.

Reader Takeaway:

• More than half (56%) of unicorns had at least one major protective term, and many had multiple.

• These terms protect investors but can dilute common shareholders significantly during downside exits.

• Combined with findings from Table 6 (overvaluation) and Table 5 (downside losses), this shows the systemic imbalance in venture capital valuations.

4. Why This Matters

These inflated valuations don’t just mislead the press. They have real-world consequences:

• Employees may think their equity is worth more than it actually is.

• LPs and secondary investors could be mispricing risk and over-allocating capital.

• Founders can face harsher terms down the line when the true economics catch up.

5. What Should Founders and Investors Do?

For Founders:

• Understand the real value of your common shares.

• Be aware of how investor protections can dilute your economic outcome.

• Negotiate with a long-term view, not just for vanity valuations.

For Investors:

• Don’t rely solely on headline PMVs when benchmarking portfolios.

• Apply fair-value adjustments that account for term-sheet protections.

For Employees:

• Ask tough questions about your equity package, especially if you’re at a unicorn.

6. What’s Next?

The paper raises critical questions:

• Are women or minority founders more likely to face harsher investor protections?

• Can AI tools help LPs and founders automatically audit valuation distortions using term-sheet data?

These are the questions we should be asking if we want a healthier, more transparent venture ecosystem.

Bottom Line

Not all unicorns are worth what they claim. By understanding how complex investor terms inflate post‑money valuations, we can make smarter, fairer, and more transparent decisions in the venture capital space.

About the Research

“Squaring Venture Capital Valuations with Reality” by William Gornall and Ilya A. Strebulaev was first published as an NBER working paper in 2017 and later in the Journal of Financial Economics (2020, Vol. 135, Issue 1).

Problem Statement: The paper does not provide a formally worded problem statement but addresses the issue that post‑money valuations (PMVs) of VC‑backed startups, especially unicorns, often misrepresent true economic value. These valuations assume all shares are worth the same as the most recent preferred shares, ignoring protective terms like liquidation preferences, ratchets, and seniority rights

Null Hypothesis: Not explicitly stated in the paper.

Alternate Hypothesis: Not explicitly stated in the paper.

Theoretical Lens: Not formally labeled but the paper uses a structural valuation model rooted in contract theory and option‑pricing methods to account for complex capital structures and investor protections

Variables Studied: The paper does not label IVs/DVs, but it analyzes: 1. Contractual terms: liquidation preferences, IPO ratchets, automatic conversion exemptions, seniority of investor classes, participation rights, cumulative dividends, option pools. 2. Reported post‑money valuations (PMVs) vs. fair economic values derived from modeling. 3. Share‑class value differentials: preferred vs. common shares.

Methodology:

Design: Quantitative cross‑sectional study comparing reported PMVs with modeled fair values.

Sample Size: 135 U.S. unicorns (companies with reported valuations >$1 billion) as of mid‑2017.

Data Sources: Certificates of Incorporation (COIs) and Delaware legal filings to reconstruct capital structures; valuation terms extracted manually due to gaps in commercial databases

Procedure:

- Unicorns identified using CB Insights, Fortune, VentureSource, and Thomson One databases; filtered for U.S. companies founded after 1994 and with VC rounds post‑2004.

- Applied a structural option‑pricing model to compute share‑class‑specific fair values and aggregate company‑level valuations.

- Analyzed how different contractual terms impacted valuation distortions.

- Robustness checks using different model assumptions and sensitivity analyses on exit timing, volatility, and contractual clauses.

Note: The study uses a structural option-pricing model to estimate fair economic value. This model incorporates the payoff functions of each share class under different exit scenarios (IPO, acquisition, liquidation) and adjusts for investor protections (e.g., liquidation preferences, IPO ratchets, seniority). The company-level fair value is derived by summing the fair values of all share classes. This approach allows the authors to account for the option-like nature of preferred-share rights, which traditional PMV calculations ignore.

Notes for readers to understand this research in more detail.

What Are Preferred Shares?

Preferred shares are a special class of equity typically sold to venture investors (VCs) during funding rounds. Here’s what makes them different from the “common shares” that founders and employees usually hold:

• Downside Protection: If the company exits at a low value, preferred shareholders get their money back (sometimes even a multiple of what they invested) before anyone else sees a rupee or dollar.

• Special Rights: These can include:

• Voting and Conversion: Often have voting rights and can convert to common shares under certain events (like IPO).

In short: Preferred shares are like equity + built-in insurance for investors.

How Is Post-Money Valuation (PMV) Calculated?

PMV is the most common headline number you see after a startup funding round. Here’s how it works:

The Formula:

PMV = Price per Preferred Share (in latest round) × Total Fully Diluted Shares (after the round closes)

• Price per Preferred Share: What investors paid in the current funding round (say, $10/share).

• Fully Diluted Shares: The total number of shares that would exist if all options, warrants, and convertible securities are exercised (including shares given to founders, employees, and all previous investors).

Example:

Suppose:

• New investors pay $10/share in Series C round.

• After this round, the company has 100 million fully diluted shares.

PMV = $10 × 100,000,000 = $1,000,000,000 ($1B “unicorn” status)

The Problem:

• PMV assumes every share (common, preferred, options, etc.) is worth the same as the new preferred shares.

• Reality: Only those new preferred shares have all the protections. Common shares (held by founders/employees) are worth less, because they’re at the back of the line in an exit, and don’t get the downside protection or special bonuses.

VC Insider Perspective: Why This Happens

• Investors like headline PMVs - they signal company growth and success, helping with PR and future rounds.

• Founders may go along to look like they’ve built a unicorn (optics matter for recruiting, media, future fundraising).

• But: In actual value, it’s the contractual protections (liquidation preference, ratchets, etc.) that make preferred shares “safer” and more valuable than common. The press headline ignores this nuance.

Corporate Jargon Summary

“PMV is a blunt instrument that fails to account for the economic hierarchy embedded in venture capital deals. Preferred shares carry downside protection and economic advantages that common shares do not, leading to a systemic inflation of headline valuations across the startup ecosystem.”

Now let us understand it further with a very simple example:

Simple Example: How PMV Is Calculated (and Why It’s Flawed)

The Setup

• Startup ABC is raising money.

• Founders: Own all the company’s common shares before the round.

• New VC investor: Comes in, gets preferred shares.

Before Funding Round

• Founders: 9,000,000 common shares (100% ownership).

• Company value: Not yet assigned.

Funding Round Terms

• Investor puts in: $2,000,000

• Price per share (set by negotiation): $2.00 per share

• Shares issued to investor: $2,000,000 / $2.00 = 1,000,000 preferred shares

After Funding Round

Total shares:

• Founders: 9,000,000 common

• Investor: 1,000,000 preferred

• Total = 10,000,000 shares (fully diluted)

How the Headline PMV is Calculated

PMV = Price per share (in this round) × Total fully diluted shares (after the round closes)

Here:

• Price per share: $2.00

• Fully diluted shares: 10,000,000

So:

PMV = $2.00 × 10,000,000 = $20,000,000

What the media reports: “Startup ABC is now valued at $20M!”

Where It’s Misleading

1. All Shares ≠ Equal

• The VC owns 1,000,000 preferred shares (with protections: liquidation preference, etc.).

• The founders own 9,000,000 common shares (with no protections).

2. What Happens in a Downside Exit?

Suppose Startup ABC is acquired for $2M (the same amount the investor put in):

• Preferred shares with a 1x liquidation preference: The investor gets their full $2M back first.

• What’s left for founders/common shares? Zero. The founders’ 9,000,000 shares get nothing.

But… the PMV said $20M!

• In reality, only the investor is guaranteed their money back in a low exit.

• The founder’s equity is worth less because it has less protection and gets paid after the preferred.

What If the Company Sells for $30M?

• Investor (1x liquidation): Gets $2M first, or can convert to common for 10% (1,000,000/10,000,000).

• $2M < $3M, so the investor converts and takes 10% of $30M = $3M.

• Founders: Get the remaining $27M (their 90%).

Here, the upside is shared. But until the value is high enough, the common shares are worth much less than the “headline” PMV suggests.

Key Takeaways:

• PMV calculation assumes all shares are worth $2 each (the latest price paid by the VC).

• In reality: Preferred shares have downside protection. Common shares do not.

• So: The “headline” number is not the true economic value of all shares—especially not for the founders or employees.

This Is Why PMV Is Misleading

• Looks great on paper: Every share “worth” $2.

• Economic reality: Only the preferred is safe. The rest is at risk.

• So: If you only look at PMV, you dramatically overestimate what founders and employees will get, especially if things don’t go perfectly.

✍️ Call to Action

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• 🔗 Want the full paper? Read it here.

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