Investing In Unicorns: The Perils And The Promise

2013 was a simpler time to invest in unicorns. There were only 39 private startups valued at $1 billion or more; 37 of them were based in the U.S., and their collective value was around $150 billion (excluding Facebook, which accounted for nearly half the total).

How things have changed. In Q4 2019, there were over 500 unicorns spanning 24 countries and collectively valued at over $2 trillion. Dozens of unicorns join the list each month.

But a unicorn boom is not necessarily a unicorn bubble. Given low interest rates, continued growth in technology and recent regulatory perks, investing in unicorns makes sense. Late-stage startups can still obtain capital despite billion-dollar valuations, so why go public? And investors can achieve ROI from unicorns that they won’t find anywhere else.

However, investing in unicorns comes with a paradox: The availability of private equity makes them less likely to go public, but their reticence toward public markets makes their stock hard to find.

Today’s unicorns are no longer as rare as their mythical counterparts, but they can be just as hard to approach. So I want to help late- and growth-stage investors enter the unicorn market, and do it wisely.

Beware: Here Be Dragons

A 14th-century globe had hic sunt dracones (“here be dragons”) over unexplored country. Ignorance is just as dangerous now as it was then. Not all unicorns are created equally. The market contains fake unicorns, inflated ponies and unpredictable dragons. Here are the categories I recommend avoiding.

1. Fake Unicorns: Everybody wants to profit from the buzz around unicorns, whether they’ve earned it or not. It’s not unusual for companies approaching the $1 billion threshold to massage their pre-money valuation and then to hustle just enough capital to push them over the top. Instead of trading equity for capital to grow the business, they’re hocking shares for a quick marketing coup. Others might misrepresent their industry, selling a plain-vanilla advertising venture as a mobile data analytics business to bask in the glow of that industry’s higher value-to-revenue multiple. The result is the same: The unicorn is fake.

2. Inflated Ponies: When a unicorn is a runaway success, many other startups in the same sector benefit as investors hope that lightning will strike twice in the same spot. The inflated ponies benefiting from their competition’s success might indeed earn their valuation, but it will take time for their real value to catch up with the perception, or they may never justify it before going public.

3. Unpredictable Dragons: China has been producing unicorns at a gallop. But 72% of Chinese unicorns are sensitive to changing policy priorities, and 83% are sensitive to regulatory uncertainty. Further, 60% change their internal organizational structures at least every 12 months. Chinese unicorns depend on personal relationships and current policy priorities. Predictably, though, relationships are opaque, and policy priorities can change quickly and dramatically. Government regulation often restricts Chinese unicorns’ reach, making them dependent on the domestic market, and there is even a quasi-official scam to capture value from foreign investors.

4. Healthcare: Nothing says healthcare startups can’t or won’t grow. Some experts, like Scott Lenet, have even identified healthcare as a growth sector for the next decade. But regulation does mean they won’t grow fast. Lenet also concedes that “meaningful progress is more than a decade away.” Investors seeking quick growth should look elsewhere.

Where To Find The Winners

Any investment class contains better and worse candidates. The first trick is to find the best; the second is to gain access.

Unsurprisingly, the U.S. produces more unicorns and more value than any other market. China aside, U.S. unicorns are more than twice as numerous and more than three times as valuable as all others combined.

The most fertile ground for U.S. unicorns is exactly where you’d expect it: Silicon Valley. Just 4 million people in the Bay Area produce as many unicorns as all of Europe combined. For all their efforts, no other market or region has managed to replicate Silicon Valley’s vibrant combination of brilliant brains, innovative tech and bold capital.

Maximizing Returns

Unicorn valuations roughly follow a power law. In other words, as the valuation rises with each billion, the number of unicorns worth that much or more drops by about half.

Our research suggests that the $2 billion to $5 billion range offers the optimal balance between the potential for high growth and a realistic chance of actually achieving that growth. That’s the winner zone.

Secondary Market Access

The good news is that the secondary market for unicorn equity is booming. In Q1-Q2 2019, transaction volume hit $55.4 billion. It’s like Wall Street in the 1980s.

However, the same tight community of VCs and innovators that invigorate Silicon Valley make it hard for outsiders to participate. The VC community is a caste system with rules shrouded in mystery. Just as investors compete for the most promising unicorns, the unicorns compete for the most prestigious investors. Brand matters both ways.

Outsiders need the inside knowledge and relationships only obtained through experience in that community. Brokers can be risky because they profit from transaction fees, not as a function of their clients’ profit. Fortunately, some funds are managed by reputable private equity firms that provide such insight along with some built-in diversification.

Unicorns are beautiful, but they’re elusive. To find the winners and gain access, new investors should look to well-managed funds and experienced VCs based in Silicon Valley. That’s where to find the guides with the right location, the right team, the right connections and the necessary experience.

Originally published by me at https://www.forbes.com.