Snap Judgment: Unicorns Under Pressure And Addressing Risks Of Private Lawsuits

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...