After a record pace achieved in 2015, there’s no doubt the rate of billion-dollar valuations for startups has cooled down in 2016. But it is too soon to tell if the pause is temporary or reflects a return to the past when billion-dollar valuations for startups were as rare as unicorns.
Success in general brings greater scrutiny and builds even higher expectations for the future. Unicorn tech startups are no different. After pouring in large amounts of money at rich valuations the investors have huge expectations from Unicorns both in terms of the level of success they need to achieve and the time period within which that success should be achieved.
A Unicorn is a private company with a valuation from private investors of US$1 billion or more. The term entered the Silicon Valley vernacular around 2013. By then there were 39 such companies with a combined valuation of $100 billion. Previously, Unicorns had been relatively rare.
By the end of Q1 2015, there were 95 Unicorn tech startups globally, growing to 167 by the end of Q2 2016 with a combined value of more than US$600 billion. Although the number of Unicorns grew each quarter during the last six, the pace decreased from double-digit growth to single digits recently; 10 companies joined the Unicorn club in Q2 2016 with an aggregate valuation of US$15.4 billion.
Private financings in recent quarters have produced lower valuations due to the overall tight IPO market, as reported in our Q2 2016 Tech IPO report, and to what is becoming a buyer’s M&A market.
Enabled by widespread adoption of mobile computing and cloud computing, the growth in “technology as a service” (such as SaaS, PaaS and IaaS) has allowed start-ups to overcome the previous barriers of large capital investments in technology, resulting in smaller capital investments and more operational flexibility. This has created low barriers to entry. Compared with even five years ago, young firms no longer need a large or complex infrastructure to achieve global reach and penetration. And these operating models are not only agile, they are highly efficient, allowing start-ups to undercut prices.
The original unicorn was a mythical horse-like creature with a single horn on its head. One legend has it that unicorns really did exist, but disappeared because none made it onto Noah’s ark. Although reports of the Unicorn startup’s demise are premature, it appears at least some Unicorns could miss the boat when they go public, by posting IPOs worth much less than their billion-dollar valuations. Some could sink entirely (fail) while others will go on to become buoyant publicly held companies.
This much seems clear: Current Unicorns are not likely to receive new funding rounds at existing or higher valuations unless they can demonstrate a clear path to profitability in the not too distant future, not just the possibility of future revenue growth. If they are unable to pave a clear path to above average revenue growth with profitability, they will have a difficult time convincing the investors that they are worthy of Unicorn valuations. With the pace of change and technological disruption moving fast, some of the existing Unicorns also run the risk of being disrupted by newer startups before they finish executing on their plans.
Despite the above cautions, there are three mitigating factors that seem to favor Unicorns: their liquidity needs differ; market conditions, and investor patience.
Different liquidity needs
Because they have already raised large amounts of money at higher valuations, most Unicorns should have options that many other startups may not have. Many Unicorns are highly liquid and may not need to access capital markets just for the liquidity.
If they need more capital because their business models call for higher levels of investment for global expansion or for developing new markets, Unicorns should in general be able to raise new money, though in many cases at relatively lower valuations. The lower valuations may not excite existing investors, but they could attract opportunistic new investors who may have previously deliberately stayed on the sidelines during the earlier rounds.
Although budgets vary from company to company, Unicorns should in general have more options for managing cash than most startups. For example, they could choose to stretch their budgets by slowing global expansion or entry into new markets that require greater investment or initial losses. One side benefit: wrestling with these decisions and executing them will teach the management team lessons it needs to learn for the long haul.
Successful startups often choose business models that call for limited investment in infrastructure until they have a proven path to growth and profitability with a respectable customer base. When access to capital at high valuations is difficult, this forces the companies to be more thoughtful in choosing where to spend their resources. Fortunately, emergence of cloud and associated new business models using “everything as-a-service” offer multiple options to all companies to stretch their budgets without sacrificing access to needed services.
Market conditions and investor patience
Because a Unicorn has achieved high valuations prior to its IPO, any IPO valuation must be significantly higher than the private valuation to be considered successful, and that requires stronger IPO markets than we’ve seen in recent quarters. This is especially true for Unicorns that raised money in 2014 and 2015 when valuations were often very rich.
In fact, from 2014 through June 2016, more than two-thirds of Unicorns have seen their values plummet after going public (trading today below their IPO closing price), according to a recent report by SVB Analytics. Of the 17 Unicorns that went public during this period, nine were trading below their final private valuation. Of those nine, 80% are US-based, while only half of those trading abovetheir final private valuation are US companies. This suggests that US investors are clearly willing to take greater risks, but as a result may bid up valuations to unrealistic levels.
A weaker IPO market means reduced risk tolerance by investors, which causes greater focus on demonstrated profitability. By its nature, that focus would extend the IPO time line for many companies. Once again, this is good training for management teams, and for testing and adapting the business model –perhaps a blessing in disguise.
When it comes to achieving liquidity, the investor’s patience is impacted by several factors. The most important may be time elapsed from when they made the investment. Many startups achieved Unicorn status during the past 12 to 18 months; most investors understand the era of the quick flip is over, and that now they must wait three to four years from the time they invested. Investors understand that their impatience could lead to an IPO at a valuation that may be lower than the private market Unicorn valuation, or to the outright sale of the company at a lower amount.
It is too soon to predict whether the recently minted Unicorns will achieve success at a much higher rate and in a shorter time period than the historical success rates and gestation periods for startups.
There is an inflection point wherein the passage of time reduces the likelihood of success. While the inflection point would vary from company to company and by sector, most Unicorns have not reached the inflection point yet.
The dotcom bust of 2000 proved that if access to capital becomes too easy and cheap, it is not valued and often contributes to reckless spending and wishful business models that lead to failures.
If the capital markets of 2016 had proven to be much stronger than 2015, then the Unicorns of 2015 would have had the fortune of achieving IPOs at even higher valuations. But, they may also have fallen into the same trap from the dotcom boom, which led entrepreneurs to believe success was possible on the strength of ideas (that appear great) without demonstrated revenue growth and profits.
In many respects, it is better for Unicorns born in strong markets to experience challenges of a normal or weaker market as a test of the resilience of their product, business model, and management team.
Raman Chitkara leads the global technology practice at PwC.He has more than 30 years of experience working in the technology industry in the Silicon Valley. His clients have included technology companies with global operations ranging from start-ups to multibillion-dollar multinationals in semiconductor, software, internet, computing and networking sectors.Read his full biography here.