In mythology, unicorns are rare and impressive, but can also be destructive and even dangerous.
They have a lot in common with their namesake in the investment world.
The term “unicorn companies” generally refers to startups valued at $1 billion or more by their investors. This situation used to be vanishingly rare, but today it is more common, with about 140 companies that have hit the mark. Some of these companies are well-known, like Uber, Airbnb and Pinterest. Others, like ticketing marketplace Eventbrite or eyeglasses vendor Warby Parker, are on track to becoming equally common names.
Finding a unicorn is exciting, and venture capitalists are eager to try to spot them early. Startups that haven’t yet reached the $1 billion mark may still catch investors’ eye as unicorns-in-waiting: Will online razor sales be the next to join the list? An online pharmacy? Website marketing companies? No one knows for sure, and a lot of investors are paying very close attention.
But investors should keep an equally attentive eye on the risks involved. Some recent signs have pointed to trouble for more than one of these enterprises.
For example, Fidelity recently marked down the value of its investments in several privately held startups, including Snapchat and the human resources automation platform Zenefits – both of which are unicorns. As Fortune observed in covering this change, “marking values of private companies is more art than science,” but “Fidelity is clearly feeling some frost.”
Does this mean all unicorn companies are terrible investments? No. But it does suggest that investors are in greater danger than usual of letting enthusiasm for such enterprises carry them away.
Another sign of trouble is the fate of highly valued tech startups preparing to go public. The Wall Street Journal recently reported that online storage provider Dropbox Inc. more than doubled its valuation early last year, ultimately reaching $10 billion, but now may be unable to go public at that level. BlackRock Inc., a major investor in Dropbox, last month cut its estimate of the company’s per-share value by 24 percent, reflecting both caution about Dropbox in particular and a chilly climate for initial public offerings in general.
According to Dealogic, 2015’s IPOs have included the smallest percentage of tech companies since at least the mid-1990s, and high valuations may be partly to blame. The problem is compounded by favorable terms called “ratchets,” in which companies promise early investors that IPO shares will be worth more than investors originally paid. If the IPO falls short, the company must make up the difference. Textbook rental company Chegg Inc. and travel planning company Kayak Software Corp. both had to pay hefty penalties for lower-than-expected IPO prices.
While venture capital investors are used to taking big risks in pursuit of the occasional big reward, individual investors should look at companies with a more guarded perspective. The fact is, some startups will succeed, a few will become enormous and many will fail. That is the nature of the industry, and it remains true even for companies valued at $1 billion or more.
Consider Theranos, a medical company founded in 2004 with an estimated value of more than $9 billion. The company promised a new technology allowing up to 30 lab tests from only a few drops of blood, making lab work substantially cheaper and less painful. Venture capitalists and journalists alike responded enthusiastically at first. However, a Wall Street Journal article published in October reported that the company had exaggerated claims of its proprietary technology’s potential. A few days later, the Food and Drug Administration asked the company to stop using its “Nanotainer” on all but one of the blood tests it offers because of concerns about its reliability. While Theranos has said it will release its data to put doubts to rest, its bright future has substantially dimmed.
For individual investors, it can be seductive to see institutional investors like Fidelity and BlackRock backing a private tech company. The danger is in letting such signals lure you into thinking a venture capital investment is a sure thing. The few unicorn companies that have gone public recently have struggled; according to Fact-Set, among the nine venture-backed technology companies that were valued at $1 billion and have gone public since 2014, only three have met or exceeded analysts’ profit forecasts.
It does not seem to me as if unicorn companies are a bubble in the traditional sense, because they are not available to the general public. Yet investors with exposure to these companies would still be wise to temper their expectations. For investors in startups, big or small, the basics still apply. Perform proper due diligence. Diversify: Investing in several startups can take the sting out of a particular underperformer. And for investors receiving unicorn exposure through a mutual fund, recognize that your exposure to any one startup is likely to be heavily diluted by public equity holdings. Ask yourself whether the additional management fees involved are appropriate given the limited exposure to private companies. If not, it may make more sense to focus on a low-cost, diversified index fund.
A tech startup that has achieved a valuation of $1 billion or more in this environment has proved it can do one thing: attract capital. That is not meaningless, but it is not magic either. Investors should decide whether or not to steer clear accordingly.