New Prime Unicorn Index Tracks Private Companies on the Road to IPO

Index uses Lagniappe Labs’ proprietary valuation and pricing data to track top-tier, private companies with Unicorn or near-Unicorn status

SHREVEPORT, La.–(BUSINESS WIRE)–Lagniappe Labs has launched a new, equally-weighted price return index that tracks the performance of some of the most notable privately-funded companies based in the U.S. In partnership with Prime Indexes, Lagniappe Labs created the Prime Unicorn Index as a tool to benchmark the aggregate performance of private companies who have achieved or are approaching the $1 billion valuation level. The index uses Lagniappe Labs’ proprietary research and difficult-to-source, objective data to determine true valuations of privately-funded companies in a measureable and verifiable way.

Unicorns like Uber, AirBnB, Lyft, SoFi and WeWork are well-known to investors as private companies with valuations in excess of $1 billion. While there are over 200 Unicorn companies across the globe with a combined value of over $730 billion, the Prime Unicorn Index currently includes 85 companies Lagniappe Labs has classified as a Unicorn or Approaching Unicorn based on hard-to-secure public filings and data, including federal and state filings and company disclosures. The index universe will include only U.S.-based private companies with valuations at or exceeding $500 million.

“Valuations of private companies do not need to be subjective or opaque, and in fact, an official valuation can be derived when using the right data,” explains Ross Barrett, Co-Founder of Lagniappe Labs and founder of the Prime Unicorn Index. “We differentiate ourselves in our data standards and practices by using difficult-to-access information to assign an official value to these private companies that is not available anywhere else.”

As more high-performing companies defer or eliminate plans to go public, the demand for information about and investment exposure to this growing portion of the American economy has soared. The Prime Unicorn Index aims to offer investors a means to evaluate the private company space before these highly-valued firms go public.

“In today’s market environment, there is tremendous opportunity and investor interest in the private company space. However, there is very little in terms of concrete, trustworthy information for investors to act on,” explains Kris Monaco, Co-Founder of Level ETF Ventures and the firm’s related Prime Indexes business. “The companies in the index are the same businesses modern investors are using and touching on a daily basis. They are riding Uber to work, using AirBnB to book their next vacation and taking advantage of WeWork spaces to run their small business. There is a great deal of interest in these companies, and the Prime Unicorn Index is designed to help capture that enthusiasm.”

The index will serve as a benchmark for performance and valuation among private companies and for the creation of financial products. Index values are calculated daily and distributed weekly. The index will be rebalanced quarterly to reassess companies whose values may have fallen below Unicorn status or those who have gone public.

“The Prime Unicorn Index is to private companies what the S&P 500 Index is to publicly-traded companies,” adds Barrett. “We believe investors will look to the index as a way to determine the strength and overall value of private companies where they’re seeking exposure.”

For more information, please visit PrimeUnicornIndex.com or contact info@primeunicornindex.com.

About The Prime Unicorn Index

The Prime Unicorn Index is an equally-weighted price return index that measures the share price performance of U.S. private companies valued at $500 million or more. The Index was launched by Lagniappe Labs and Level ETF Ventures. The index uses Lagniappe Labs’ proprietary research and difficult-to-source, objective data to determine true valuations for privately-funded companies in a measureable and verifiable way.

About Lagniappe Labs

Lagniappe Labs is a financial technology company specializing in the development of financial products and trading software for alternative investment professionals. The company has compiled millions of data points on privately funded companies using disparate data sources, providing investment professionals with detailed analysis of private company valuations, share prices, and securities sold.

About Prime Indexes

Prime Indexes creates financial indexes that solve problems for both professional and self-directed investors. Our index designs focus on emerging trends in the exchange-traded fund (ETF) industry, and our founders have participated in the creation and launch of over a hundred financial products and indexes across all major asset class. Prime Indexes are used as the basis for innovative new investment solutions for investors, and use intuitive design principles so that new investment products can ultimately provide low-cost, efficient, and convenient access.

Contacts

Gregory FCA for the Prime Unicorn Index
Marissa Foy Comerford, 610-228-2104
unicornindex@gregoryfca.com

Snap Judgment: Unicorns Under Pressure and Addressing Risks of Private Lawsuits

 

 

By: Joshua M. NewvilleWilliam 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.

Can Foreign Partners Now Exit Partnerships Tax Free?

Guest article by Elizabeth L. McGinley,  Michele J. Alexander,  Anne E. Holth – Bracewell LLP

In Grecian Magnesite Mining v. Commissioner1 (“Grecian Magnesite”) the Tax Court held that a non-U.S. partner’s gain from the redemption of its partnership interest was neither U.S. source income nor income effectively connected with a U.S. trade or business (“ECI”), despite the partnership’s conduct of a trade or business in the United States. The foreign partner was “therefore not liable for U.S. income tax on the disputed gain.” This taxpayer victory is significant primarily because the Tax Court’s decision rejects longstanding Internal Revenue Service (“Service”) guidance and addresses ambiguities in the rules governing partnership and international taxation.

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After a Down Round: Alternatives for Employee Incentive Plans

*Excerpted from VC Experts Encyclopedia of Private Equity & Venture Capital


Employee Incentive Plans for Privately-Held Companies

Despite the recent improvement in capital markets activity, many small, privately-held technology companies continue to face reduced valuations and highly dilutive financings, frequently referred to as “down rounds.” These financings can create difficulties for retention of management and other key employees who were attracted to the company in large part for the potential upside of the option or stock ownership program. When down rounds are implemented, the investors can acquire a significant percentage of the company at valuations that are lower than the valuations used for prior financing rounds. Lower valuations mean lower preferred stock values for the preferred stock issued in the down round, and as preferred stock values drop significantly, common stock values also drop, including the value of common stock options held by employees.

Consequently, reduced valuations and “down round” financings frequently cause two results: (i) substantial dilution of the common stock ownership of the company and (ii) the devaluation of the common stock, particularly in view of the increased aggregate liquidation preference of the preferred stock that comes before the common stock. The result is a company with an increasingly larger percentage being held by the holders of the preferred stock and with common stock that can be relatively worthless and unlikely to see any proceeds in the event of an acquisition in the foreseeable future.

In the face of substantial dilution of the common stock and significant devaluation in equity value, companies are faced with the difficulty of retaining key personnel and offering meaningful equity incentives. Potential solutions can be very simple (issuing additional options to counteract dilution) or quite complex (issuing a new class of stock with rights tailored to balance the concerns of both investors and employees). Intermediate solutions range from effecting a recapitalization that will result in an increase in the value of the common stock to implementing a cash bonus plan for employees that is to be paid in the event of an acquisition. Each approach has its advantages and disadvantages, and each may be appropriate depending on the circumstances of a particular company, but the more complex alternatives can offer companies greater flexibility to satisfy the competing demands of employees and investors. This article briefly reviews three of the solutions that can be implemented-the use of additional optionsrecapitalizationsand retention plans (cash and equity based).

Granting Additional Options

The simplest solution to address the dilution of common stock is to issue additional employee stock options. For example, assume that, prior to a down round, a company had 9,000,000 shares of common and preferred stockoutstanding and the employees held options to purchase an additional 1,000,000 shares. Also assume that, in the down round, the company issued additional preferred stock that is convertible into 10,000,000 shares of common stock. On a fully-diluted basis (i.e., taking into account all options and the conversion of all preferred stock), the employees have seen the value of their options reduced from 10% of the company to 5%, or by 50%. In this case, the company might issue the employees additional options to increase their ownership percentage. It would require additional options to purchase in excess of 1,000,000 shares to return the employees to a 10% ownership position, although a smaller amount would still reduce the impact of the down round and might be enough to help entice the employees to stay.

If the common stock retains significant value, the grant of additional options can be an effective solution. It is also relatively straightforward to implement; at most, stockholder approval may be required for an increase in the optionpool. In many cases, however, the aggregate liquidation preference of the preferred stock is unlikely to leave anything for the common holders following an acquisition, particularly in the short term. In that event, the dilution of the common stock becomes less relevant – 5% of nothing is the same as 10% of nothing. Companies with this kind of common stock devaluation will need to consider more intricate solutions.

Recapitalizations

If the common stock has been effectively reduced to minimal value by the down round, a company could increase the common stock value through a recapitalization. A recapitalization can be implemented through a decrease in the liquidation preferences of the preferred stock or a conversion of some preferred stock into common stock, thereby increasing the share of the proceeds that is distributed to the common stock upon a sale of the company. This solution is conceptually straightforward and certainly effective in increasing the value of the common stock. In most cases with privately-held venture capital backed companies, however, the holders of the preferred stock are the investors who typically fund and implement the down rounds and in nearly all cases the preferred stockholders have a veto right over any recapitalization. Accordingly, implementing a recapitalization would require the consent of the affected preferred stockholders, which may be difficult to obtain, particularly because the preferred stockholders may not like the permanency of this approach. In addition, a recapitalization can be quite complicated in practice, raising significant legal, tax and accounting issues.

Retention Plans

Another approach is the implementation of a retention plan. Such plans can take a number of forms and can use cash or a new class of equity with rights designed to satisfy the interests of both the investors and employees. These solutions are more complicated, but also more flexible.

Cash Bonus Plan

In a cash bonus plan, the company guarantees a certain amount of money to employees in the event of an acquisition. This amount can equal a fixed sum or a percentage of the net sale proceeds, to be allocated among the employees at the time of the sale, or it can be a fixed amount per employee, determined in advance. Allocations can be based on a wide variety of parameters, enabling a high degree of flexibility. Often these plans have a limited duration (such as 12 to 24 months, or until the company raises a specified amount of additional equity).

A cash bonus plan is easy to understand, provides the employees with cash to pay any taxes that may be due and can be flexible if the allocations are not determined in advance. However, there are a number of hurdles. Many acquisitions are structured as stock-for-stock exchanges (i.e., the acquiring company issues stock as payment for the stock of the target company) because such exchanges may be eligible for tax-free treatment. A cash bonus plan may interfere with the tax-free treatment and, thus, may reduce the value of the company in the sale or may be a barrier to the transaction altogether.

A cash bonus plan can also be problematic in that it requires cash from a potential acquirer in the event there isn’t sufficient cash on hand in the target company. A mandatory cash commitment from an acquiror may also make the company less attractive as a target. Typically, a cash bonus plan can be adopted (and amended and terminated prior to an acquisition) by the board of directors, although a cash bonus plan creates an interest that may in effect be senior to the preferred stock, which requires consideration as to whether the consent of the preferred holders is required.

New Class of Equity

A stock bonus or option plan utilizing a new class of equity, although more complicated, shares many of the benefits of the cash bonus plan, but avoids some of the major disadvantages. A newly created class of equity, such as senior common stock or an employee series of preferred stock, permits the use of various combinations of rights. The new class of equity can be entitled to a fixed dollar amount, a portion of the purchase price or both. These rights can be in preference to, participating with or subordinate to any preferred holders, and the shares may be convertible into ordinary common stock at the option of the holders or upon the occurrence of certain events. Referring to our earlier example, the company might return the employees to their pre-down round position by issuing them senior common stock entitled to 10% of the consideration (up to a certain amount) in any sale of the company. Although a return of the employees to their pre-down round position may not be acceptable to the preferred stockholders and may not be necessary to keep the employees incentivized, the new class of equity can be tailored to fit whatever balance is acceptable to the investors.

This type of approach has several advantages. First, unlike a simple issuance of additional options, it gives real value to employees that were affected by a devaluation of their common stock. Second, unlike a cash bonus plan, it does not require an acquiror to put up cash when they purchase the company and the acquirer is less likely to discount the purchase price. Third, unlike a cash bonus plan, it will not affect the tax-free nature of many stock-for-stock acquisitions. Finally, it provides certainty to the participants, who know exactly what they will be entitled to receive upon a sale of the company.

The main disadvantage of creating a new class of equity, at least from the employees’ standpoint, is that the employee will either have to pay fair market value for the stock when it is issued or recognize a tax liability upon such issuance, when they may not have the cash with which to pay the taxes. This disadvantage can be partially ameliorated by the use of options for the new class of equity, rather than issuing the new equity up front, which at least allows the employee to control the timing of the tax liability by deciding when to exercise. Moreover, for many employees an option may qualify as an incentive stock option under federal tax law, thus allowing the employee to defer taxation until the sale of the underlying stock. A new class of equity will also be somewhat more difficult for most employees to understand, at least when compared to traditional common stock options.

In addition, a new class of equity adds complexity from the company’s perspective. It may raise securities and accounting issues, and shareholder approval of an amendment to the company’s charter will be required. At a minimum, it will require more elaborate documentation than some of the simpler alternatives, such as a cash bonus plan, and thus it will likely be more expensive to implement at a time when the company may be particularly sensitive to preserving its cash. A new class of equity may also result in future complications such as separate class votes or effective veto rights in certain circumstances. As with the other solutions that address the devaluation problem, there may be resistance from the existing preferred holders, whose share of the consideration upon a sale of the company would thereby be reduced.

These complexities are surmountable and companies may find that they are more than balanced by the advantages that a new class of equity provides over other solutions in addressing issues of reduced common stock valuations and dilution.

What Will VC’s Want For A Security: Common Stock? Preferred Stock? Debt? Warrants?

Written by: Joseph W. Bartlett/VC Experts Founder

As one programs any financing, as in corporate finance generally, the objective is to make 2 + 2 = 5; that is to obtain added value for the issuer. In the course of a financing, the insiders are attempting to raise the maximum amount of money for the minimum amount of equity (“equity” meaning claims on the residual values of the firm after its creditors have been satisfied). A corporation will issue at least one class of common stock because it must; many firms stop there; they pursue the simplest capital structure possible in accordance with the KISS principle (“Keep it Simple, Stupid”). However, in so doing, the corporation may close down its chances to pursue the added-value equation (2 + 2 = 5) because that equation involves matching a custom-tailored security to the taste of a given investor. The top line of the term sheet will ordinarily specify the security the VCs opt to own; the following discussion takes up the most common possibilities.

Different investors have differing appetites for various combinations of risk and reward. If a given investor has a special liking for upside potential leavened with some downside protection, the investor may “pay up” for a convertible debt instrument. An investor indifferent to current returns prefers common stock. The tax law drives some preferences, since corporate investors must pay tax at full rates on interest but almost no tax on dividends. On the other hand, the issuer of the security can deduct interest payments for tax purposes–interest is paid in pre-tax dollars–but not dividends. The sum of varying preferences, according to the plan, should be such that the issuer will get more for less–more money for less equity–by playing to the varying tastes of the investing population, and, in the process, putting together specially crafted instruments, custom made as it were. A potential investor interested in “locking in” a return will want a fixed rate on debt securities instead of a variable rate; the ultimate “lock-in” occurs in a zero coupon bond, which pays, albeit not until maturity, not only interest at a fixed rate but interest on interest at a fixed rate.

As the practice of tailoring or “hybridizing” securities has become more familiar and frequent, the traditional categories can become homogenized. Preferred stock may come to look very much like common stock and debt resembles equity. In fact, the draftsmen of the Revised Model Business Corporation Act no longer distinguish between common and preferred stock. Moreover, it may be advantageous (again with a view to making 2 + 2 = 5) to work with units or bundles of securities, meaning that an investor will be offered a group of securities, one share of preferred, one debenture, one share of common, and a warrant, all in one package.

Indeed, creativity by sponsors has spawned a variety of novel “securities,” equity and debt, which have played a role in venture capital, the underlying notion being to maximize values by crafting instruments to fit the tastes of each buyer and to capture current fashions in the market. The use of “junk” or “fluffy debt has been the focus of popular attention of late; however, junk bonds debt securities which are less than investment grade and, therefore, unrated are only one species of the complex phyla of hybrid securities invented by imaginative planners. Thus, a given issuer‘s financial structure can perhaps be best envisioned by thinking in terms of layers of securities. The top layer is the most senior: usually secured debt, “true” debt in the sense that the holder is opting for security of investment and “buying” that security by accepting a conservative rate of return, a fixed interest rate, or a variable rate tied to an objective index. The bottom layer is the most junior: common stock (and if the common stock is divided into different series, the most junior series); on occasion, this level is referred to as the “high-speed equity.” The risk of a total wipeout is the greatest, but, because of the effects of leverage, so is the reward. In between are hybrids, layers of securities with differing positions, meaning differing claims on Newco‘s current cash flows and the proceeds of a sale or liquidation of the entire enterprise.

The variables open to the planners include the following:

  • a security can be denominated either debt or equity with different tax consequences to both the issuer and the holders;
  • a security may be senior, or subordinated, or both, as in senior to one level and subordinate to another (the term “subordinated” opens, in and of itself, a variety of possibilities);
  • a security may be convertible into another at a fixed or variable rate of exchange (and convertible over again, as in debt convertible into preferred stock, in turn convertible into common);
  • an equity security may contemplate some form of fixed recoupment of principal, perhaps expressed in terms of a redemption right;

Redemption can be at the option of the issuer, the holder, or both; and the issuer‘s obligations to make periodic payments with respect to a debt security can range from the simple to the exotic–monthly interest payments at a fixed rate to so-called PIK payments (payment in kind, meaning in stock versus cash) tied to the performance of a particular business segment (as in “alphabet stock”). The utility of this structure is that it gives Newco time to fulfill the promises in its pitch book.

All that said, in today’s universe, the market standard is common stock to the founder founders, plus the friends and family. The next round, with the exception noted, is convertible preferred stock. The jump balls are participating versus non-participating, cumulative dividends, etc. But the security is convertible preferred, even in the angel round, which used to be common. The exception is a convertible note in the bridge round, next round pricing. See the Buzz article, The Next Round Pricing Strategy.

For more information on Venture Capital and Private Equity, please visit VC Experts.

Effectively Connected Income and Penny Warrants

Guest post by Nicholas Jacobus and Sung Hwang – Venable LLP

There is a case currently proceeding in the U.S. Tax Court (TELOS CLO 2006-1, Ltd. v. Commissioner, T.C., No. 6786-17, petitions filed 3/22/17) that deals with the question of whether non-U.S. investors inadvertently realized “ECI” from the sale of “penny warrants” (a/k/a “hope notes”).  This is a reminder that careful deal structuring is crucial for funds that have a significant non-U.S. investor base or otherwise have a covenant to avoid income that is “effectively connected” with the conduct of a U.S. trade or business (ECI). 

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