Are Unicorns Friend or Foe?

There’s a troublesome trend right now in the startup space.

We all know what happened when they built too many condos in Florida.

It’s the same thing that occurred in China when too many steel mills were built.

And in the U.S. when too many wireless towers were erected in the ’90s.

Prices plunged… every time.

So startup investors are naturally asking, will it also happen with Unicorns?

The number of Unicorns has exploded. That’s Act 1.

And Act 2 is always the same: Prices will fall.

All that remains is filling in the details. How bad will it be? And what will be the impact on the startup market?

Here’s what we know.

Unicorn Club Doubles in Size

In November 2013, Aileen Lee created the term “Unicorn” in her breakthrough report to describe companies with valuations of a billion dollars or more.

Since then, their numbers have more than doubled. A new Unicorn has popped up about once a week.

We now have 121 Unicorns, with a total valuation of $460 billion.

You can see in this chart how the pace of Unicorn creation has picked up recently…

121615EI_unicorn-club

Click to view larger image

Now remember, becoming a Unicorn is not the destination. It’s merely a stop along the way.

The end game still awaits. Investors want to make money.

For that to happen, one of two liquidity events must happen…

They will be bought out. Or they will IPO.

If neither of these things occurs, they will continue as private companies.

But the end game doesn’t change. They still need to exit at some point. It’s how venture capital works.

Most liquidity events are buyouts. But size matters. The bigger a startup gets, the harder it is to find buyers.

So what are the chances of these Unicorns getting bought out?

The next chart sheds some light…

121615EI_table

So you see what happens once a startup reaches Unicorn status? Its pool of acquirers gets pared down to a mere half-dozen.

The ones left standing: Google, Facebook, Microsoft, Yahoo, Amazon and Apple.

IPOs: More Byway Than Highway

That leaves the IPO route.

About $5 billion to $10 billion worth of IPOs are done each year. This excludes outliers Facebook and Alibaba.

Bear with me, we have to get into some basic math now.

Unicorns usually sell between 10% and 15% of their shares (by value).

Taking 12.5% as the mid-point, the Unicorn pipeline amounts to a massive $57.5 billion (as the blue bar in the bottom chart below shows)…

121615EI_tech-ipo

At this year’s pace of $8.1 billion worth of IPOs, it would take just over seven years to clear the decks. At 2013’s pace of $9.7 billion, it would take just under six years.

In reality, it would take much longer. Why?

Only a small percentage of that $5 billion to $10 billion involves Unicorns.

Over the past 10 years, less than a third of tech IPOs – only 10 a year on average – have involved companies valuated north of a billion dollars.

Taking this into account, it would take around 18 years – not six – to empty the pipeline.

But the pipeline would be getting bigger in the meantime.

Even if the rate of new Unicorn creation halves from one a week to a half a week, that’s still 26 new ones a year.

And that means at least $26 billion added to the Unicorn pipeline every year, meaning…

Another nearly eight years of IPOs to convert them to public companies.

Something Has to Give

The situation in a nutshell…

A pool of Unicorns expanding at faster and faster rates. Coupled with a much smaller stream of IPOs.

And the IPO stream showing no signs of expanding.

Something has to give. Investors certainly won’t put up with waiting 25 years for an IPO.

But instead of a dispassionate analysis, all we get are warnings of an onslaught of “unicorpses.”

As a worst-case scenario, it could happen. But I seriously doubt it.

Much more likely, some variation of the 80/20 rule kicks in.

Think about what would happen if 80% of startups experience a correction of 15% to 20%.

It immediately removes about 50 startups from the Unicorn Club, giving them four times the number of possible acquirers (see the middle chart above).

That would alleviate downward price pressure. And allow IPOs to take a bigger bite out of the Unicorn pie.

The Unicorn Club is made up of well-deserving members and those that are not so well-deserving. So I think the remaining 20% would be split. Half subject to big discounts. The other half initiating IPOs at 15% to 20% premiums.

After a couple of years of this, order and more reasonable prices would be restored to the startup sector.

The big winners?

  • Early investors. More liquidity events. And a 15% to 20% discount off 20X to 50X winners can be shrugged off. Absorbing failing startups is part of their game anyway.
  • Late-stage investors. Only because many of these pre-IPO investors were given special terms that protect them from losses. (For more details, see my articles criticizing these “insider” arrangements here and here.)

The losers?

  • Mid-to-late-stage investors. Most weren’t given these protections, so they’re vulnerable. They paid more for shares. And they chase a higher win rate. A correction would definitely hurt on all counts.

As for founders?

A less hospitable market, for sure.

But for founders truly heading disruptive startups that can scale? They’ll be more in demand than ever as investors become more choosy.

For an early investor, execution takes on a bigger role. Big ideas and markets are nice. But a lack of execution will be punished more readily.

So make sure leadership is committed and has as much business as technical experience.

Invest early and well,

Andrew Gordon
Founder, Early Investing