November 10, 2015

Three Stages of a Unicorn Reality Check

SMITH BRAIN TRUST — A new creature has joined the entrepreneurial menagerie of gazelles (fast-growing firms), elephants (like Wal-Mart) and mice (corner barbershops). These are the unicorns — privately held startups such as Uber, Airbnb and Snapchat worth more than $1 billion each. With only 141 in existence, unicorns are the rarest creature of all. And Hewlett-Packard CEO Meg Whitman is worried about their health. She recently told CNN Money that many young companies have been able to garner "extraordinary valuations" without actually proving themselves.

"People inside the industry and in the know have been talking about this for at least a year or longer," says Jonathan Aberman, a 25-year veteran of the venture capital industry and adjunct professor at the University of Maryland’s Robert H. Smith School of Business.

He says a market correction is inevitable, but don’t expect a repeat of the dot-com collapse of the 1990s or the subprime mortgage crisis of the past decade. Instead, he describes a process that will unfold in three stages without causing widespread panic. "This will be a slow-motion adjustment," Aberman says. "This will not be a crash."

The first two stages already have occurred. What happens next will hit founders and early-round investors the hardest.

Stage One: Unicorns Get Fat

Entrepreneurs launch hundreds of thousands of companies each year, but only about 70,000 attract angel investors. From this elite group, only 2,000 to 3,000 receive institutional or venture capital. And only a small percentage of startups at this level achieve unicorn status. "You have a better chance of hitting the Lotto than being the founder of a startup that becomes a billion-dollar valuation company," Aberman says.

Still, unicorn sightings have increased in recent years as venture capitalists, brokerage houses and private wealth managers pour their money into a small group of companies ready to scale up. "They have money to invest, and they all want the same thing," Aberman says. "They are trying to make quick-turn investments, and that’s why they’re all investing in the later stages. They want their money back quickly."

That’s because money diminishes over time. "A dollar today is worth more than a dollar in 10 years," Aberman says. "Investors today are looking for a two-to-three-year return."

As the unicorns grow fat, their valuations drive up the private market to exceptionally high levels. "It’s an inevitable outcome of too much money going to a small number of companies," Aberman says. 

Stage Two: Exits Get Blocked

Many investors shrug off concerns about inflated valuations, telling themselves that unicorns today are real businesses generating real revenue. They aren’t like the dot-coms of the 1990s that didn’t do anything.

The problem is, when you look at stock markets, most public companies aren’t performing at the same levels as unicorns. "There is actually a disconnect between the public company and private company valuations," Aberman says. "Public companies trade at a discount compared to similar private companies."

This kills opportunities for initial public offerings, a basic exit strategy for institutional investors looking for a payoff. So private companies must bide their time.

As they wait, they grow larger. This shrinks their opportunities for mergers and acquisitions — the main alternative to an IPO — because fewer and fewer companies can afford the price tag. "As these companies get larger and larger in valuation, the pool of likely buyers for those companies coming to the public markets becomes smaller and smaller," Aberman says.

In the end, many unicorns find themselves penned it. "If there’s no exit, there’s no place to go," Aberman says. "There’s simply not enough appetite for those companies on public markets and M&A markets to justify their current valuations."

Stage Three: Gaps Get Corrected

Aberman says market forces will gradually take care of the disparities. Either private valuations will decline or public valuations will rise. "Markets are perfect," he says. "And that’s what happens when you have a difference. They trend toward each other. They don’t trend away."

He suspects the reality check will mostly affect unicorns. "When these companies cannot achieve exits, what will happen is they will slow their expansion, they will cut costs, and many of them will survive for extended periods of time, and eventually will be acquired by large companies at heavily discounted prices."

Aberman says founders and early-round investors have the most to lose. "A lot of these companies, in their most recent financing rounds, have taken money with terms that make sure the last money in gets out first and gets out whole," he says. "So that means that as the market starts to decline, people that will be most harmed are the founders and the people who invested in the earlier rounds. And that will ultimately be an extremely bad thing for entrepreneurship."

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About the University of Maryland's Robert H. Smith School of Business

The Robert H. Smith School of Business is an internationally recognized leader in management education and research. One of 12 colleges and schools at the University of Maryland, College Park, the Smith School offers undergraduate, full-time and flex MBA, executive MBA, online MBA, business master’s, PhD and executive education programs, as well as outreach services to the corporate community. The school offers its degree, custom and certification programs in learning locations in North America and Asia.

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