Trouble in Tech's Enchanted Forest
It’s a word that induces the same swooning expression from a venture capitalist as from a story-loving child. But unlike the mythical horned creature of the fairytale world, unicorns of the business world are very real, and proliferating. The term was coined to describe startups with valuations of more than $1 billion that had not yet gone public, and was meant to emphasize their scarcity. Now California’s Silicon Valley seems to teem with them, while sightings are becoming common in Asia and Europe. By early 2016 the list of unicorns had swelled to about 200 companies. Think Uber and Airbnb, Xiaomi and Snapchat. For the most part, however, don’t think profits, at least not yet. That’s one reason some investors are starting to wonder whether soaring valuations reflect a new era of innovation — or are just another bit of financial make-believe.
So long as a company is closely held, its value can be fuzzily defined. If it sells shares in an initial public offering, the market determines a price, and that math has not been as favorable to unicorns of late. While 32 unicorns went public or found a buyer in 2014, only 11 did in 2015. Several of those, such as Etsy, an online market for craft goods, and Square, a mobile-payment service, disappointed investors after their share sales or had to settle for lower prices to complete their IPOs. And headwinds that hit publicly traded technology stocks in late 2015 spilled over into the private market, prompting retrenchments and even layoffs at some startups. Big investors such as BlackRock and Fidelity, which have to estimate the worth of their holdings in quarterly filings, have been cutting unicorn valuations. As a result, many unicorns that sought fresh capital in the second half of 2015 did so on less favorable terms than they had gotten earlier. Some even saw their estimated market value fall below the magic billion-dollar mark. The fuzziness of unicorn math caught the eye of Mary Jo White, the head of the U.S. Securities and Exchange Commission, who warned that pressure to achieve high valuations meant that investors should approach startups with caution.
Once upon a time, startups that showed promise quickly tried to arrange an IPO. Money from public investors would pay for expansion — and enrich founders and venture capitalists. That was the pattern in the 1990s dot-com boom, for both successful companies such as Amazon and notorious flops like Pets.com. But the meltdown in 2000 left a withered IPO market in its wake. The adoption of tougher disclosure requirements following the Enron and WorldCom accounting scandals made it more attractive to raise capital in private markets, especially for technology companies that could tap a vast network of venture-capital funds. The trend got a further boost when investment and pension funds reacted to the low interest rates that followed the 2008 crash by putting more of their cash into tech startups. The way the valuations were calculated was simple: If an investor paid $100 million for a 10 percent stake in a startup, that meant it was worth $1 billion. But many startups rewarded early investors by protecting them against losses, meaning shares of other later investors were worth less. Doubts about that kind of math, worries about a bubble and the lack of profits at many of the companies seem to have taken some of the shine off the unicorn horns.
Almost as soon as the first unicorn sighting was reported, Silicon Valley observers began wondering whether the billion-dollar valuations signaled a bubble. Others doubt that a unicorn shakeout would inflict widespread harm. Unlike in the 1990s boom, few individual investors have direct stakes, and the shares bought by institutional investors represent a tiny slice of their holdings. The same probably can’t be said for the many unicorn employees who get much of their compensation in shares that are difficult or impossible to trade. Delayed IPOs — or no IPOs at all — mean that small investors are missing out on the chance to bet on companies at an early stage when potential profits — and risks — are greatest. Some in Silicon Valley now say the pressure of a shaky billion-dollar valuation can make a unicorn an albatross. And there's another tech species that may take their place: Cockroaches, small, nimble companies with low overhead that can survive market downs as well as ups.
The Reference Shelf
- The Techcrunch article in which the term “unicorn” was coined.
- A 2015 article in Vanity Fair magazine on the proliferation of unicorns.
- A March 2016 Bloomberg View essay on unicorns.
- A “Frontline” history of famous bubbles.
- A Bloomberg QuickTake on bubbles.
- A list of the biggest early-stage venture capital investors.
First published March 17, 2016
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