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How Much Air Is In The Unicorn Bubble?

Mushrooming unicorns and their investments may have created a problem

10Nov

The increasing valuations of unicorns has inflated the bubble even further in the past 12 months. The atmosphere in the VC world is heating up, with investors acting more cautiously than previously, but still investing generously in the hope that they won’t miss something big. It's a tricky path because high valuations do not necessarily match high earnings, so behind the valuations of these companies the actual revenue is less attractive. There are many elements for investors to consider when dealing with unicorns in the current market, but should they be preparing for the bubble to burst?

Once tech innovations start penetrating across multiple industries or even create their own, investors become interested and cash begins to flow. This wasn’t a problem a few years ago when a handful of startups attracted investment in products that have changed our lives. However, growth in the number of these companies and their capability to offer further innovations has been so fast, that VCs are becoming skeptical. Those who invested 7-10 years ago, saw the long-term potential in those 'mind-blowing tech projects', and recognized the strong potential ROI. However, as time went on, unicorns mushroomed and the 170 current unicorn status companies have a combined valuation of $742.9 billion, and so the atmosphere has become worrying.

The danger lies in the worsening imbalance between growth and profitability. If the former continues dominating, there will be less liquidity and more risk for investors as it would be harder to estimate the real state of businesses. Secondly, if unicorns fail to prove their long-term portfolio, cash injections would consequently slow down, valuations will drop, and the investments will lose a considerable amount of value.

One of the biggest unicorns, Uber, has just hit $68 billion in its most recent private valuation. There may not be any visible signs of stagnation, but the company's aggressive strategy and constant lawsuits mean that one badly planned strategic move could be enough to put the company under pressure. Take Theranos, what was a hugely successful healthcare startup turned into a scandal and destroyed $9 billion in value in a matter of days. What was believed to become a breakthrough in diagnostics, in fact was only hype which had no value for the society. Theranos’s finger stick and microfluidics technology simply failed to work, putting the CEO Elizabeth Holmes under multiple investigations following fraud allegations. The reason was self-inflicted and had nothing to do with the dynamic market nature, but the case serves as an example that with startups, the future is always unpredictable.

The age of a company is no longer a measurement of success either. Before launching their IPO in 2014, GoPro, had been enjoying its dominance as the world's leading action camera maker. Recently, though, shares of the company nosedived 20%, after a weak Q3 performance and a poor forecast for Q4. At the same time, DJI released the Mavic Pro which the Wall Street Journal referred to as the 'nemesis' to GoPro's Karma, their newly launched drone. This is not an indicator that GoPro is doomed, but this intensifying competition indicates that a company being at the top for a few years has only a limited impact on their future performance.

The current mixture of high volatility and poor liquidity signals that the bubble exists, but as with all bubbles, it's unclear how inflated it is. The drought in IPO activity is likely to continue until volatility lowers, but considering some of the failures at Twitter, GoPro, and FitBit, the trends are discouraging.

An issue that some investors currently have with private companies is that they may find it challenging to execute exit strategies, due to the skyrocketing valuations. Lower-valued startups are in a better position on this as it takes less time to scale and less investor's money to fuel. Also, if there is an exit in the form of M&A action, founders are likely to own higher percentages of their companies when they sell than founders of unicorns.

This means that unicorns have fewer options, they can take a risk and launch IPO or let someone buy the company. The latter is less likely to happen as finding a buyer is difficult and the founder takes a minority stake after the exit. Lyft, for example, has recently failed to sell to a handful of tech giants, where the $ 5.5 billion unicorn couldn’t agree on a price equal or higher than its most recent valuation.

From the investors' perspective, it's hard to stay calm when some of the investment rounds have reached billions of dollars. However, the good news is, the bubble hasn't burst yet and is not dangerously close to reaching its peak, according to Forbes. However, investors need to be prepared to call for an exit at the right time - too soon means missing out on opportunities - too late means the risk to lose money. As for now, it's likely that the unicorn economy will continue delivering a mix of success and failure stories, the question for investors is how long that will last.

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