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Unicorns are usually young companies that operate globally, or in more than one country, by offering innovative services to customers whose demands have not been met by current market players.
A Niche in the Market
Looking back to the previous decade, the dot-com bubble severely hit the global economy and markets seem to have learned from it, with technology companies now trading in line with historical valuations. However, there seems to be a mismatch between the mechanism that first fuels the growth of companies in their early years and the point at which they are ready to be exchanged in public markets.
What has been observed since 2010 is an increase in the number of pre-IPO funding rounds for private companies, with the average size of these investments having more than doubled between 2013 and 2015. A major change that must be taken into account today is that the economy has become global at almost every level. In the 2000s, the US was the leading world economy, but China is now also strongly taking its position in the top rows.
What this means is that there has been an increase in the circulation of money, an increase in competition, and an opening of new markets (mostly in China) that have proven to be as large as most of the Western markets combined, in some cases. Hence, in the last few years, it has not been uncommon to see Chinese companies reach sky-high valuations and further increases in valuations for such companies up to five times in a single year.
What comes out of this scenario is plenty of cash – cash that is searching for investment opportunities in a bullish way, flooding any potentially profitable business opportunity with capital.
The amount of uninvested but committed funds in the technology industry globally surpassed $100bn in 2012, and in 2015 surpassed $150bn, the highest level ever. What has fuelled this abundance of cash has also been the entrance into private markets of new types of investor (institutional and wealthy individuals) that have been mainly interested in the latter stages of funding of these companies – closer to the IPO or exit stage. Given the high level of funds provided by these new investors, now Unicorns are staying private more than ever before, precisely three times longer on average.
In 1999, the average age of US tech companies that went public was four years according to Jay Ritter, a professor at the University of Florida who is specialised in public markets. Between 2004 and 2015 of the 35 companies that reached and surpassed the $10bn valuation threshold, only six achieved this valuation level before going public. For the others, it took on average eight years post-IPO. What is being observed now is that high-tech companies are increasingly reaching $10bn and over of valuation without the need to go private, as also noticeable from the graph below.
Between 2001 and 2008 fewer than 10% of IPOs were made after a given company reached profitability. By 2010 almost 50% of companies had at least reached the break-even point for profits against expenses. In fact, the number of high-tech companies going public has remained stable since the 1990s, but the capitalisation size at the IPO time has more than doubled. In 2014 the average number of years taken for tech companies to go public was 11 years, with a cumulative amount of financing rounds that have been generating an increasing number of Unicorns and Decacorns (startups with valuations of $10bn).
One of the reasons for the longer period that these companies remain private is also due to new policies that have been enacted, particularly in the US with the US Jumpstart our Business Start-ups (JOBS) Act. It passed in 2012 as a new law, and it increased by four times the number of shareholders that a company can have before it has to disclose its financial statements. Furthermore, the capital invested in tech companies in the private market has increased drastically in recent years, from $26bn in 2013 to $75B in 2015.
From the graph below it is possible to observe the variation in capital invested from 2005 to 2015 for each of the series of Venture Capital funds that a firm receives. This data confirms the fact that later stage investments account for the most of the capital invested, providing an increasing interest from institutional investors as well as wealthy individuals for these types of financing rounds.
Another important consideration is the fact that it seems that public markets assign higher multiples at the point of IPO and afterwards, with better performance, too, for companies that are larger compared to those that are smaller.
There are no doubts that at a certain point, these investors will require an exit and cash in on their investments, but for what it seems now, it is still not the time. What will happen at a certain point is that these Unicorns will need either to go public or be acquired by a listed company, their valuation at that point in time will be crucial.
Two different scenarios could emerge if there still exists a mismatch between valuations in public and private markets: one scenario – and the most realistic one – is that these Unicorns will start gradually to go through down rounds of funding with lower valuation levels up to the IPO date. Another scenario is that the valuation in the private markets will continue on the same path they are now on, and at the moment of the IPO these companies will see a drastic drop in their stock price due to the excessive valuations at which they would be offered to the public. It is clear that the second scenario is the most wealth-destroying one as the losses involved could be severe.
However, the first scenario is the most probable one in reality, as some Venture Capital late-stage investors like Fidelity and T. Rowe Price have already marked down investments in some Unicorns. It is also becoming extremely common to see high-tech startup IPOs that raise less capital than the last stage of their pre-IPO funding rounds. This also means that the market is unwilling to assign excessive valuations to businesses that could potentially generate abnormal returns in the future, but that most of them will still not turn profitable.
So far, in the last three years, 61 companies have gone public with valuations of $1bn or more, and the median that they are currently trading is around 3% over their listing price. What is interesting also to notice is that between 1997 and 2000, there have been as many as 898 US tech IPOs, with valuations totalling $171bn.
However, due to the burst of the dot-com bubble among other reasons, only 303 survived to 2015. By 2010 only 128 remained. Between 2000 and 2010, those 303 companies saw average share price returns of -3.7% per year. In the following five years they received an average share price return o-0,8% per year. There are little doubts over the fact that valuations of Unicorns have been inflated due to the exuberance of private equity investors.
Due to an abundance of funding and market euphoria as well as the questionable revenue models that some of these young tech companies exhibit, there are strong signals that a bubble could be developing. Yet, it is still early to say what private equity funds will do – whether they either continue to pour money into these companies or begin more thought-through investment strategies.
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