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The latest buzz in the Silicon Valley is the race to become the next “unicorn”—the term techies are using to describe a privately funded startup valued at over $1 billion. Fortune magazine recently counted more than 80 unicorns, led by Uber, the on-demand car service, valued at an astounding $41.2 billion.
Unicorns are sprouting up as companies postpone going public with an IPO. In 2013, only Facebook had crossed the $10 billion private valuation, while today eight companies have. Deals feeding the frenzy include Facebook’s $19 billion purchase of WhatsApp, the privately held instant messaging startup. Apple bought headphone maker Beats for $3 billion.
Other current unicorns include Snapchat, Airbnb, WeWork, Dropbox and Square. It’s interesting that neither Google nor Amazon ever reached a billion-dollar valuation as a private company.
While unicorns bestow wealth to a group of newly rich entrepreneurs, they might not be particularly profitable for investors. When you pull back the covers to see what is really going on, you find that many of the venture capital firms are pouring late-stage money into unicorns mostly for the aura of being associated with these successful companies, not primarily for the purpose of making money for their investors. VCs that can showcase these companies in their portfolios anticipate it will be easier in the future to raise more money and collect more fees from their pension-fund investors.
This phenomenon was confirmed by a study conducted by John Backus of the National Venture Capital Association that found just 27 percent of investments made by VCs into unicorns were paid back to the funds, even though the exit values were high. The reason was that their investments were made at such a late stage and at an already high valuation for the startup—just before a sale or IPO—that little money was made by the VCs.
Even some Silicon Valley insiders view this late-stage funding behavior with a jaundiced eye and believe the size of the unicorn market indicates bubbles are being blown again. Greycroft Partners veteran Alan Patricoff, who has spent 40 years as a VC, is wary, saying, “If for any reason there is a blip in the outlook, people could be left holding a lot of inventory they wish they didn’t have.”
Bill Gurley, an Uber board member, predicts a lot of failure in 2015, noting that even in the best of times startup investing is high-risk. He warns that if your valuation goes backward while you are private, all of a sudden funding sources dry up and it’s harder to get incremental investments from VCs.
For the time being, huge sums are being thrown at unicorns by VC firms flush with cash. Yet it seems as if the warning bells have begun to ring. But as we know from history, the Cinderellas will end up staying past midnight and things will end poorly for some.
So next time you hear that Uber or another high-profile unicorn got a slug of cash from VCs in a late round of funding at some obscene valuation, you should hope it is not the venture capital fund held by your taxpayer-supported state pension fund that is making the investment.•
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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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