Why Are There So Many Unicorns with Sky-High Valuations?
‘Unicorn’ is a term used to describe start-up companies with valuations of $1 billion or more.
There are many reasons for the mounting number of unicorns and their sky-high valuations.
Jeff Bussgang wrote a piece recently where he asserts that these high valuations are due to simple economics 101: “Capital is chasing yield in a low interest rate environment, more capital drives up prices (simple supply and demand) and at the same time, when later stage and public investors do their future value math for growth companies, low-interest rates result in higher future value calculations -- thereby valuing growth even more.”
That’s a good, basic explanation but there’s a lot more to consider.
According to a group of VCs, economists, CEOs, investment bankers and others consulted for this article, the following are additional factors driving this phenomenon.
Macro-Economic Drivers
The term unicorn and their very high valuations reflect these companies’ success, and how much that performance is prized by angel and institutional investors (read: VCs who price the round). That positivity carries over to Wall Street analysts, the mainstream business media, technology trade press, Twitter and the blogosphere.
Money is still cheap because interest rates are relatively low and there is still a great deal of cash on the sidelines chasing the best deals. Those deals are more competitive today than ever before. For innovative and disruptive unicorns, elevating valuations and making headlines makes sense for their breed.
The number of unicorns and their enormous valuations have been created in part by the influx of both start-ups and investors. Today there are more VC firms than before the recession of 2008 – 2011). After the recession, start-up activity greatly expanded due in part to the fact that many companies went under during the recession. That not only created a vacuum, it also freed up talent.
COVID contributed to the creation of unicorns by accelerating digital transformation in the enterprise and, in turn, accelerating the era of ecommerce/digital solutions for masses. One example among many is Amazon’s marketplace/aggregator growth and valuation.
Other examples of COVID-related expansion of unicorns include Internet- based services such as Zoom, Peleton, Klarma, and Tide. In addition, many companies in the AI, cybersecurity, and FinTech sectors benefited from the new reality of workers spending more time at home and less time in their offices.
International (B2C and B2B) markets are more accessible today. Today, start-ups becoming unicorns conquer global markets early in life. This results in an increase in the total addressable market (TAM) and hence valuation.
The tight labor market will impact the growth of unicorns in numbers because it’s difficult to sustain regular growth without hiring more people.
A Unicorn Is Simply a Giant Start-up
Founders and executives who joined one of these companies early-on generally prefer that their companies remain a unicorn longer rather than going through the daunting IPO process. That process, which these executives need to handle along with their ‘day jobs’, means that they have to deal with the SEC, Wall Street analysts and quarterly reporting, elaborate boards of directors, the threat and constancy of law suits, and the other negatives. Founders and early employees, in particular, have benefited from unicorn valuations because their stock is so valuable in the secondary market. Often there’s a willingness to let them cash-out “early” a portion of their holdings.
There’s hype around these unicorn businesses and we are in a speculative tech bubble. However, most observers concur that today's valuations are more justifiable and less risky than similarly positioned companies during the Internet Bubble.
We are going through a period in which many enterprises embrace start-ups as a source of innovation -- as opposed to building the technology themselves or using consulting firms. This has expanded prospects for an M+A exit. (For example, banks and financial services companies’ strong interest in FinTech start-ups/unicorns.)
For unicorns that elevate their valuations and make headlines, it’s easier to raise money, accumulate customer logos, hire hard-to-get talent, expand into new markets and accomplish more. Those factors, like self-fulfilling prophecies, are reason enough to drive up unicorn valuations.
Many of today’s unicorns have business models that are new and disruptive, but also tested and stable. Essentially, they are in the same place as companies who go public but they prefer to remain private.
Unicorn executive compensation packages are highly lucrative. Obviously, very senior executives overseeing a growing unicorn with large teams of well-compensated workers are the type of talent that unicorns want to retain through the IPO. This contributes to high OpEx and the need for additional rounds of capital while certain pre-IPO milestones are reached. Therefore, additional funding with higher valuations is often required prior to an exit.
AI/ML, Open source software, marketing services such as Hubspot, and cloud services, such as those provided by Amazon Web Services, Microsoft Azure, and Google Cloud Services, as well as related technologies, have made it easier and less expensive to grow a start-up into unicorn status.
Another consideration for the mushrooming unicorn army occurs when returns for venture-backed companies perform less well in high markets than those that are started when stock market valuations were low. A downturn would have the biggest impact on these companies as funds for future growth might be less available and perhaps at lower valuations. WeWork is a good example of this occurrence.
Venture Economics
In late-round investments, the amount raised is typically greater than in earlier rounds, therefore resulting by definition in higher valuation. When “soonicorns”, for example, elect to raise a very large round involving 100s of millions of dollars, VCs are more than willing to give them a premium on their valuation and unicorn status.
Large private equity firms and mutual funds are investing in unicorns in their penultimate or final funding rounds, which also drives up their valuations. These investments, made before the company goes public, are seen as optionality on the IPO (i.e., these investors hold a bigger position compared to having to “buy-into the IPO” as the price goes up).
According to Bloomberg, unicorns offer VCs incentives to jack-up the valuations on late-round investments, such as guarantees that the VCs will get their money back first if the company sells (a shorter “lock-up” period) or will earn additional free shares if a subsequent round's valuation is less favorable.
Some VCs have convinced their LPs that a unicorn is just as good as a lucrative exit. In fact, some LPs don’t want too many lucrative exits in any given year because of the tax implications.
Variety is the spice of life and make unicorns spicy as well. According to Crunchbase, Fintech is the most highly represented category accounting for 19% of all unicorns, followed by internet software & services (17%), e-commerce & direct-to-consumer (11%), and artificial intelligence (9%).
Stripe, with a $95B valuation as of March 2021, is the most valuable Fintech unicorn, followed by Canva, which at $40B as of September 2021 is the most valuable internet software & services unicorn. In e-commerce and direct-to-consumer, Fanatics occupies the top spot with a $18B valuation in August 2021, followed by ByteDance (BKA, TicToc), which leads the AI category with a $140B valuation as of March 2020.
Unicorns are said to rely heavily on a social buzz to continue going from strength to strength.
Public Market Drivers
A SPAC is simply a shell company with neither a product nor a business that goes public. The money that is raised in their IPOs is then used to purchase one or more unicorns, which in turn takes the SPAC’s place in the public market. This reverse merger strategy is faster and easier – mainly due to lighter SEC compliance requirements, among other things – than a traditional IPO.
The IPO exit ramp for unicorns with higher valuations is a major draw because over time, they will get their liquidity, valuation and more. Crunchbase found 83 unicorn-valued companies that have gone public in 2021 to date. They were collectively valued at just under $1 trillion at IPO, compared to 2020 with 38 listings and a debut value of $394 billion. Crunchbase expects the pace of private unicorns going public to continue unabated into 2022.
Both unicorn valuations and public company market capitalizations are in the stratosphere because of a “Why Not?” dynamic of mutually reinforcing valuation/market cap increases. That, plus the fact that the public market is still on a bull-run.
While many unicorns do well post-IPO (e.g., Beyond Meat, PagerDuty, others), it is important to note that there is a divergence of unicorn valuations in public markets and their valuations while private. (Many articles have covered this topic. Here is one.)
There is a simple reason for this: VC consistently overvalue their portfolio companies and often “rush” these companies into IPOs resulting in poor post-IPO performance. This was obvious with respect to companies like Lyft, Uber, Deliveroo (ugh!), Door Dash and others (WeWork is an especially bad case in point).
Over the last year, we have also seen this as more companies go public via SPACs. These companies’ public valuations do not match pre-public unicorn valuations. (For examples, read this article).
In sum, these macro-economic, unicorn-start-up related, venture economics and public market factors have been the underlying drivers and reasons for the increase in the number of unicorns and their valuations. The combination of these factors explains the magnitude of the wave that has hit the technology and finance industries.
One has to ask, ultimately, “why not” and continue to hope there will be a soft landing on the other side of these crazy valuations and the burgeoning unicorn population.