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Amid Regulatory Scrutiny of Unicorns, Caveat Emptor

When the Feds come knocking and want to look under the proverbial hood, the unicorns may crash to earth.

Now the regulators are joining the growing chorus on tech unicorns, warning investors and entrepreneurs alike over the dangers of high flying valuations.

That may be a sign of a top.

As reported last week by Bloomberg, Mary Jo White, the head of the Securities and Exchange Commission, speaking Thursday at Stanford Law School, said in remarks that these much ballyhooed as yet non-public startups – you know, the ones valued at a psychological threshold of at least $1 billion – need to have looks taken under the hoods.  What that means is that someone – and by someone the implication is regulators – should determine whether internal controls, and what the newswire termed “investor protections” are as flexible and robust as the growth that has marked the sometimes hyper growth propelling valuation and investment rounds.

Speaking of the unicorns themselves, White noted that “they do not appear to be an endangered species,” and that “the concern is whether the prestige associated with reaching a sky-high valuation fast drives companies to try to appear more valuable [than] they actually are.”

Valuation suddenly (OK, over the past few months, in tandem with continued market volatility) takes the spotlight as the yardsticks employed by private equity firms and venture capitalists have become more temperate, and dozens of firms have lost value among large mutual fund holders marking down estimates and “down rounds occurring.” As the investing world is keenly aware by now, Dropbox got dropped by nearly half a dozen mutual funds, who slashed the numbers they ascribed to their holdings, and even then, the range was far flung, with T. Rowe Price holding on to shares at an estimated value of $9.40, while Hartford Financial proved more sanguine, at $15.20. Who’s right? Hard to tell, and with no real public yardstick, consensus is non-existent.

What about the people who have real skin in the game, and with intimate working knowledge of the daily operations of the firms themselves – the founders and the people who advise them? Key recommendations that come from White include whether the boards have expanded beyond startup mentalities that might be contained within the original investment teams and entrepreneurs. There is a real need for regulatory expertise and knowledge of investor protections – with the prerequisites of accounting and working capital management and also an eye on what the public equity markets demand. After all, it is the goal of many a captain of (tech) industry to bring their companies public, with all of the risk and reward that journey entails.

Looking a bit more closely at the market mechanisms most risky, White cautioned the industry on secondary markets, wherein startup employees getting in on the ground floor can, in turn, sell holdings to outside investors.  Not the most liquid of markets and valuation again comes into play here, especially with derivative contracts.

All of these cautions from White (and by extension the SEC) come ahead of the SEC crowdfunding rule, which means that investors can have an easier time of putting money into non-public companies – albeit just at a time when volatility may really be gearing up. In terms of industries, White’s remark seemed to settle on online lenders, which have the allure of higher yields … but then again, higher yields translate into higher risk.

Here, she said, disclosure remains key, with investors needing to know as much as possible about who is lending, who is being lent to, and just what is being lent, at what terms. In other words, in an opaque industry, information remains key. Perhaps this is akin to building a rocket ship while it is flying, and bundling loans into bonds has proved to be a seductive model that soared and crashed to earth (in mortgages). At the same time, a number of agencies are working together – across the Federal Reserve, the Consumer Financial Protection Bureau and others — to gain visibility into online practices.

When the Feds start bringing jaundiced eyes to bear on valuations, in a high flying milieu, the warning remains: caveat emptor.

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