When unicorns don’t fly, who pays the price?

In the wake of the Theranos scandal, some managers fret that if their own unicorns fail to meet expectations, investors may resort to litigation. It’s unlikely, but possible.

There’s an impulse to assume that Theranos, the failed billion-dollar blood-testing start-up, is an outlier: a rare undeniable fraud perpetrated by a telegenic, unscrupulous founder, enabled by a roster of star investors and public figures.

But that discounts the chance that other companies may be generously calculating sky-high valuations, or basing expectations on less than credible clinical trials. And when people lose a sufficient amount of money, there will be temptation to use the courts to recover some.

For the private funds industry, investors might not be so quick to sue if a unicorn underperforms. Current fund documentation does plenty to limit liabilities, and LPs are sophisticated investors well aware of the subjectivity of any valuation. Furthermore, they also have relationships with managers that go beyond a single company.

But that isn’t to say GPs have nothing to worry about. The scale of monetary loss or valuation inflation can make these structural safeguards irrelevant. Egregious bad behavior can still bring real consequences to managers.

“As a practical matter, I’d say the risk of a manager getting sued over an underperforming unicorn is relatively low,” says Tim Mungovan of the law firm Proskauer. “But after Theranos, the risk isn’t merely theoretical.”

The odds of litigation rise sharply post-IPO, lawyers say. “It’s safe to say investors don’t appreciate being defrauded,” says Joshua Korff of Kirkland & Ellis. “But a distinction needs to be drawn between pre-IPO unicorns and those companies that recently went public. A company is much less likely to face a lawsuit as a private company.”

Korff cites numerous factors, including the fact that plaintiff lawyers find more opportunities with the higher number of securities laws governing public companies. “Private company investors tend to be more sophisticated by definition, and less prone to litigation.”

Trigger shy

Lawyers stress that private fund LPs understand the subjectivity of any valuation. “Fund documentation has elaborate risk disclosures around valuations, and in general courts will uphold those disclosures,” says Jim Windels of law firm Davis Polk & Wardwel. But even if an LP was tempted to sue over a blown investment, there are other considerations. “The relationship between GPs and LPs often transcends a single investment.”

As the portfolio company goes public, it’s subject to a new set of securities laws; Korff says lawsuits might still be rare against private fund managers, though. “People are so careful around IPOs, it’s not easy to find a material misstatement,” he says. “There are so many lawyers and bankers kicking the tires that disclosure for IPOs is as good as it gets.”

This doesn’t mean GPs should feel that litigation is out of the question for companies with generous valuations and lousy results. “The magnitude of loss will play a factor, but lawsuits won’t be filed simply because a manager valued a company at x rather than y in the absence of fraud,” says Mungovan. “Instead, a lawsuit related to valuation will more likely be tied to a methodology or policy the manager promised to use, and didn’t.”

Perhaps the most likely situation for litigation is where that unicorn proves to be just a horse with a phony horn. “There will always be litigation in the event of fraud, or even in the event of an accusation of fraud,” says Korff.