This question originally appeared on Quora: Why do venture capitalists hate the term ‘unicorn’?
Answer by Crystal Huang, VC @ GGV Capital, on Quora
I’ve been feeling unicorn fatigue for the better part of this year, and so I’m glad to see this question. Many of my points will refer to a Fenwick & West study of unicorn #valuations, and I think everyone interested in the explosion of unicorn companies should read it: https://www.fenwick.com/FenwickDocuments/The-Terms-Behind-The-Unicorn-Valuations.pdf
Main reasons some VCs (I certainly won’t claim to speak for the entire community) would find the term “unicorn” frustrating:
- Valuations are orchestrated, negotiated and don’t necessarily imply the level of traction they used to. According to the Fenwick survey, 35% of the unicorn deals they evaluated had post-money valuations of $1-$1.1B, implying that the deals were negotiated specifically to attain this valuation. In many cases, these valuations would not be justified by fundamentals or rational valuation multiples, but the addition of liquidation preferences and other #investor-friendly terms provides significant downside protection, enabling the companies to attain high sticker prices. PR typically tends to only focus on “X company just attained unicorn status!” which reinforces high valuation expectations in the market.
- Related to the terms point – average employees are not necessarily aware of the liquidation (or senior liquidation preferences) that significantly reduce their potential upside in the case of an acquisition. The >$1B valuation stamp of validation no doubt helps companies recruit top talent, which is always going to be drawn to the perceived “hot” companies. However, employees celebrating this symbol of success may not realize that their own options may not be worth much even in the case of a sizable acquisition, if the investors’ preference stack is large enough.
- The rise of unicorns has coincided with an extremely frothy, competitive market for VCs where investment decision making is uncomfortably momentum-driven. Post-recession, VC fundraising levels have rebounded sharply and then some. Although the Series A Crunch is real for many companies given the glut of seed investors (this deserves a separate post entirely), the most sought after companies from Series A and onward have a slew of VCs angling to get into their rounds, and rounds are getting ever larger. A Series B round even five years ago could have been <$10M, and nowadays more commonly I see rounds of $30-$50M for companies that are not larger in revenue or traction than the ones who raised $10M a few years ago. More concerning still, ex post facto rationalization for the deals, in the absence of many unicorn exits, has been along the lines of, “Look, they raised more money at a higher valuation!” I imagine that at least the old investor FOMO involved regretting the loss of real exits or shots at under-the-radar companies that were actually doing extremely well. The new FOMO is alarmingly focused on missing out on valuation mark-ups. Is unicorn hunting driving this behavior or just a symptom of it? That I can’t say for sure, but I can say that in this environment, there’s a suspension of intellectual and analytic honesty that I find deeply unsettling. When valuation multiples (and even valuations overall) in private companies exceed public market companies with significantly more revenue, and when investments seem predicated on the likelihood of someone else putting money in later, it feels as if I’m doing a job that I didn’t really sign up for.
- The pursuit of unicorns masks the reality that there are many ways to generate great VC returns. One of my partners prefers to say, “There’s more than one way to skin a cat,” but I really like cats so I won’t go there. Anyway, cultivating unicorn logos does not mean that the investor got into those deals at valuations that are likely to appreciate >3x in the future. It is entirely possible to invest solely in unsexy B2B businesses that have <$500M exits and still generate great returns if you have high ownership stakes, invested early at attractive prices and keep your fund size relatively small. Now, you could make the argument that unicorn outcomes generate more absolute amounts of cash for LPs than smaller exits, which is probably true given the power law of startups, but I would argue that the primary returners of that capital are that unicorn’s seed, Series A and Series B investors who got in well before the company attained unicorn status. Additionally, the unrelenting press around unicorns, especially around which firms have how many logos, can result in LPs questioning why you aren’t in a certain deal, why you’re not #investing behind the perceived biggest companies of the day, even if you know it would be challenging to actually make money on that deal.
- VCs are not even the primary drivers of unicorn #financings, but we bear the brunt of the “bubble” accusations. According to the same Fenwick survey, 75% of deals reaching >$1B valuations were led by non-VC investors (hedge #funds, mutual funds). These firms have different return expectations, and often bring with them a public market investor mentality, looking for a 1.5-2x return at the IPO (or, as previously mentioned, have structured liquidation preferences such that they are high unlikely to lose all their money even in a downside sale scenario). However, when my friends on Wall Street or in other industries snarkily ask me if VC investing is just throwing darts on a board, I suspect they are thinking of Sand Hill (and South Park), not these other players.
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