Unicorns Are a Sign of the Right Kind of Bubble
Let’s not talk about a bubble. It’s a loaded word, and people can’t agree on what it means. Let’s talk instead about classes of securities that cruise along at high and rising prices for years, then lose much of that value for no obvious exogenous reason. (OK, “bubble” does have the advantage of being pithy.)
Such episodes have been occurring for about as long as there have been financial markets. What they all have in common, I think, is that there’s something new and different about the securities in question. Investors haven’t experienced them before, so it’s possible to believe that this time is different.
Sometimes it’s the financial technology that’s new and different, sometimes it’s the underlying asset. Examples of the former: closed-end funds in the 1920s, portfolio insurance in the 1980s, collateralized debt obligations in the 2000s. Examples of the latter: railways in the 1840s, conglomerates in the 1960s, telcos and dot-coms in the 1990s. I’m not quite sure where to place the excitement over tulips in the 17th century and the Mississippi Co. and South Sea Co. in the 18th -- they seem to be a mix of both.
It’s new financial technologies that bring the greatest risk of sudden crashes and crises. They are often marketed with the promise of near-riskless return, and depend on borrowed money. When they inevitably disappoint, things can turn ugly. Still, some of them do eventually turn out to be useful. After the Mississippi and South Sea crashes in France and Britain respectively, a lot of people thought the publicly traded corporation had been thoroughly discredited. It made a comeback.
When it’s the thing that people are actually investing in that is new and different, prices usually follow a different trajectory. Instead of a sudden panic there’s a sickening slide. And more often than not, economic value has been created even if lots of investors lose out. The telco bubble left behind fiber-optic cables spanning the globe, tulip mania left behind a Dutch flower industry that now accounts for $5 billion in annual exports.
So … let’s think about the unicorns, the current breed of $1-billion-plus startups from Silicon Valley and elsewhere. What’s new and different about them?
The most obvious innovation is on the financial side. These companies can raise hundreds of millions of dollars to finance their growth, and reach valuations in the tens of billions, without the hassle and scrutiny of going public. I don’t know that this really counts as a new financial technology, but it definitely offers new ways for investors and company founders to delude themselves.
As venture capitalist Bill Gurley warned in February, (1) the very lack of scrutiny is risky, because investors often don’t know enough about how the companies are performing, (2) the big piles of cash may be luring companies into pursuing growth at the expense of more durable virtues, and (3) the “liquidation preferences” that private investors demand creates a tangle of different potential payouts that make it really hard to determine a company's value. In September, New York Times “deal professor” columnist Steven Davidoff Solomon went so far as to describe these liquidation preferences as a “time bomb.”
It could also just be a fizzle, though -- as with mobile-payments startup Square aiming to go public at a valuation lower than the one set in its last private funding round. Late-round unicorn investors may have had stars in their eyes, but I don’t think any of them believed that what they were doing was risk free. That’s a recipe for disappointment, not collapse. Also, as noted a couple of paragraphs ago, being a public company is a hassle these days, what with all that Sarbanes-Oxley paperwork to do and those mean activist hedge-fund managers to defend against. This keeping-companies-private-longer thing may be, once the inevitable kinks are worked out, one of those financial innovations that sticks around.
As for the dangers lurking in the actual business models of the unicorns, these companies do all sorts of different things, but the largest number are trying to bring the connectivity, ease of use and self-organizing properties of the Internet (especially the mobile Internet) to established industries. While there is overenthusiasm and a lot of “Uber, but for …” me-tooism, these are generally far more sophisticated, technology-driven endeavors than the dot-coms of the late 1990s.
And remember, even that crazy era gave us the juggernaut that is Amazon.com. This era seems to offer the potential of a more profound restructuring of the economy around the capabilities of ubiquitous digital and mobile technology. Some of that restructuring will be done by established corporations, but big companies face organizational constraints and pressure to hand their money over to shareholders. New entrants have their advantages.
Someday people will surely shake their heads about the unicorn era. The name alone merits smirking, and “decacorn” is of course much worse. Some of today’s unicorns will go down in history as poster children for hubris and excess. Others, though, will surely live on as big, successful corporations. If that’s a bubble, it’s the right kind of bubble.
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