The Puzzling Unicorn
Brian Thorpe, Dartmouth Business Journal
In the world of venture capital, there exists a special class of startups that attracts the attention of investors from nearly all backgrounds: Unicorns. These firms consist of private startups that are worth at least one billion dollars. The taxonomy goes further in order to identify the truly massive startups called “decacorns,” referring to their valuations in excess of $10 billion. Companies like Uber, Snapchat, AirBnb and SpaceX are among the best-known unicorns.
Conversations about the size of the valuations seem just as ubiquitous as the companies themselves. Headlines read of Uber’s $62 billion valuation, which easily surpasses Ford’s $50 billion market capitalization, and of AirBnb’s $25 billion valuation, which similarly trumps Hilton Group’s $22 billion market capitalization, despite having only eight percent of its revenue. In response to these astonishing sums, skeptics reverse engineered the growth expectations via traditional valuation techniques and found that, with astonishing frequency, unicorn valuation depends purely on optimism. Optimism, however, is not a new element in Silicon Valley’s expectations or in inflated valuations. The cause for this trend in inflating valuations is best explained by the changing nature of venture capital as it pertains to unicorns, and as a consequence, it is clear that valuations do not attempt to represent concrete value.
New considerations have been included into the valuation calculus. Average funding round size has increased dramatically in recent years, with some suggesting that “Series A round is the new Series B round,” referring to the notion that funding typically increases in each successive round. Over the course of 2014, average Series A funding rose 6 percent, Series B rose 20 percent, Series C rose 31 percent and Series D rose an astounding 100 percent. The increase in Series D funding picks up on a new strategy used by technology companies like Uber, in which mature companies stay private for longer and sustain operations with large, late-stage funding. Indeed, part of the inflation trend is due to the prestige of unicorn status itself, which is evidenced by the fact that Fortune Magazine lists just fewer than 100 companies that have valuations of one billion dollars, out of a total of 229 unicorns. CEOs and investors may see a startup’s unicorn valuation as a way to legitimize the company, attract new talent and over time, justify the overly ambitious valuation. Another part of the valuation inflation is due to the popularity of “downside protection provisions” as elements in funding agreements that shield investors from risk. For example, senior liquidation preferences are one common downside provision, and specify that an investor has its investment returned before other preferred stock or common investors should the company be liquidated. Another common downside protection is a provision that guarantees an investor additional shares if the company raises funds based on a lower valuation, thereby preserving the value of the investor’s stake in the company. Such stipulations have been increasingly popular as a method to shield against risk from investors, which consequently frees investors to make larger investments. As a result, it is clear that the inflation seen in valuations of unicorns represents the fact that the valuations are not pricing risk accurately.
Notable individuals from the worlds of technology and business have voiced concerns over some outlandish calculations. Jim Breyer, prominent investor and partner at Accel, a venture capital firm in California, commented early this year that he expects only 10 percent of current unicorns to survive and the remaining 90 percent either to fail or be revalued. Assuming his estimation is correct, only about 23 companies have accurate, or at least sustainable, valuations. In fact, skepticism is not uncommon. Bill Gates is wary of the future of unicorns as well, and warned of “overenthusiasm” in startups during a February interview with the Financial Times.
Regardless, some investors remain bullishly optimistic on unicorns. Scott Kupor, chief operating officer at venture capital firm Andreessen Horowitz, attempted to disabuse skeptics of the notion of a second tech bubble in a presentation this past year. He highlighted several key differences between 1999 and today, most notably the dramatic increase of Internet users (900 percent), the amount of funding (only 32 percent of the 1999 level) and the much lower median time to IPO (four years today versus 11 then), among other metrics. Evidently, he failed to convince many of his colleagues. A survey of 500 startups conducted by First Round Capital found that 73 percent of responders affirmed the existence of a technology bubble. The proportions of this bubble do not approach the frenzy of the late nineties, but there still remains an implicit understanding between startup owners and venture capital firms that valuations do not exactly equal value.
These mismatched valuations explain in part the scarcity of technology sector IPOs in 2015. Once public, markets will decide the true value of companies, so startups need to delay public offerings until fundamentals can support IPOs that reflect private valuations in order to protect investor value. Both Box, a cloud storage company, and Square, a payment service company, went public with offerings priced below their private valuations, providing a cautionary tale for executives and investors at other unicorns who have their eyes on the public market.
Like the valuations themselves, the disagreement over the existence of a second technology bubble can only be decided by the market itself in the years to come. Many of these unicorns have indeed reached incredible sizes with incredible speed. In seven years, Uber became the world’s largest taxi provider; it took AirBnB eight years to become the world’s largest hotel-provider. Perhaps it seems likely that the upper-echelon of the “decacorns” has substantial overlap with the ten percent mentioned by Jim Breyer. Yet, considering the 100 or so startups that may have wrangled for a billion-dollar valuation only for the title, many unicorns are simply overvalued, despite the “enthusiasm” attached to their future prospects. Silicon Valley and its bankrollers ought to remember that while enthusiasm is a critical asset for any startup, it is only as valuable as it is monetizable.