Understanding Startup Unicorns: How Startups Get to $1B Valuations
Whether you’re new to startup investing or a seasoned VC, you’ve likely heard the term “unicorn” used to describe some of today’s biggest companies. This term refers to startups that have earned valuations of $1B or higher as private companies. Once thought of as a rare and magical feat, a $1B+ valuation deserved a mythical association.
With an increasing number of startups entering the market, more access to early-stage funding, and digital avenues allowing for accelerated user/customer acquisition, unicorns are now being born faster than ever.
Let’s dive into what makes a unicorn and what we can learn from them.
What Does “Unicorn” Mean?
Simply put, a unicorn is a startup, still privately owned, that has earned a $1B valuation. We can thank Aileen Lee, founder of Cowboy Ventures, for creating the term back in 2013, using the word to describe the longstanding, but growing, obsession among venture capitalists (VCs) with massive valuations to sustain their portfolios.
At the time, the list only included 39 companies, all of which happened to be tech companies like Facebook, Palantir and Square. Since then, the growth of direct-to-consumer (DTC) ecommerce has given rise to a new breed of unicorns: digitally native consumer brands like Allbirds, Glossier and Away, whose business models are based on acquiring paying customers rather than just users.
There are even brands like Impossible Foods, which sells plant-based imitation meat products, breaking the $1B threshold. It would have been outlandish to think in 2013 there would ever be a fake meat unicorn. Yet here we are today.
How Many Unicorns Are There?
According to TechCrunch, there are 498 unicorns across the globe at the time of this writing, including over 100 in the US. There have already been 81 unicorn foals born so far in 2019 – more than twice as many as the number that even existed when the term was first coined only six years ago!
But, compared to the approximately 80,000 startups that are formed in the US every year by Axios’s count and the 8,948 venture capital deals totaling $130.9 billion in 2018 according to a Pitchbook report, unicorns are still quite a rare breed. According to Fundera, only 0.05% of startups raise VC money, and only 1% of startups that raise seed rounds will sprout a horn.
What Makes a Unicorn?
Unicorn status is determined by the valuation assigned by investors during a funding round. Investors put money into a startup in exchange for a percentage stake in the company. How much the company is worth can be extrapolated from how much the investors get for their money. For example, if a startup raises $100M for 10% of its total equity, that company is worth $1B (or $1.1B post-money, including the cash invested).
Successful startups – even ones that never get close to $1B valuations – go through many stages of fundraising, known as “series” (ex: Series A, Series B, etc.), receiving increasingly higher amounts of cash invested and generally commanding increasingly higher valuations as funding rounds march their way through the alphabet. Though if the company isn’t doing well, they may raise funding at a lower valuation (called a down round).
Some earn their $1B valuation as early as Series B, some as late as Series F – it all depends on the business. But, in all cases, the funding rounds that result in the mystical transformation from “just-another-really-big-company” to “unicorn” are known as mega-rounds (venture funding rounds of $100M or more).
In fact, the average unicorn round weighs in at almost $300M in 2019, with the average unicorn raising $160.4M prior to that round.
The risky nature of venture capital requires a few key successes to make up for the high percentage of a VC’s portfolio companies that will inevitably fail without delivering returns. VCs therefore funnel larger sums of money into their more promising investments as they grow in order to help them scale to the point where returns on those successful investments will make up for the portfolio’s failures (and then some).
Indeed, follow-on rounds greatly outnumber first-time VC deals, which you can see this trend illustrated below.
Correlated to this trend of follow-on investments is the increase of the number of mega-deals over time as VCs pursue the elusive home run that can generate outsized returns for the firm. These trends explain why there are more startup unicorns every year.
Common Traits of Unicorns
If predicting the next unicorn were easy, venture capital success rates would be higher. Still, there are some common traits we have identified among unicorns:
- Disruptive Business – unicorns often displace existing industry leaders through innovation, creating massive growth opportunities within saturated markets. Uber (though no longer a unicorn after going public) built a platform that allowed anyone with a car to provide rides to users, disrupting the transportation industry and changing the way people get around on a daily basis. Casper improved the way people buy mattresses with a customer-friendly, direct-to-consumer digital experience, knocking legacy retailers off their feet.
- Scalable Model – companies need to show some kind of growth in order to earn the attention of investors. Whether that’s user growth, revenue growth or some other kind of growth, a startup’s business model has to show a proven market fit that is also easily scalable for it to ever sniff a $1B valuation. Software companies are particularly scalable because their products require little capital outlay to get into more and more users’ hands once they’ve been developed. Snapchat’s initial viral user growth is a great example – once the app had been developed, word of mouth led to thousands of downloads at next to no cost per user acquired.
- Expert Founders – any idea is only as good as its execution. And when it comes to startups, execution is in the hands of founders. While some startups, like Facebook, are born from founders with a big idea and no direct experience, many are formed by a team of seasoned industry superstars and veterans of high-growth companies. Aurora, a $2.5B company which develops software for autonomous vehicles, boasts a dream-team composed of the former technical lead of Google’s self-driving division, the former leader of Tesla’s Autopilot team, and a machine learning expert from Carnegie Mellon who was a founder member of of Uber’s Advanced Technologies Group.
Interestingly, profitability isn’t always necessary for companies to land a billion-dollar valuation. Many unicorns (and even some former unicorns that have gone public, like Dropbox and DocuSign) are, and always have been, losing money.
Investors and public markets are more concerned with future opportunity than current income statements, and the desire to increase their market share and achieve market dominance drives some unicorns to slash prices (and their profitability) in order to acquire more customers at a faster rate.
This can impact how well a company performs on public markets (just look at the state of WeWork’s IPO) because public markets are wary of high prices for something that has yet to generate a profit.
Exit Scenarios for Unicorns
There are realistically two ways for founders and investors to turn their unicorn equity into cold, hard cash: taking the company public or getting acquired.
According to a Harvard report, 20 unicorns went public in 2018, including Lyft, Dropbox, and Slack. Unicorn acquisitions, while less frequent, occur as well, whether Facebook’s famous acquisition of Instagram, or the recent unicorn acquisitions in the consumer packaged goods. Dollar Shave Club, for example, now belongs to Unilever, while rival shaving unicorn, Harry’s, was recently acquired by Edgewell Personal Care.
Nevertheless, while an exit spells payday for shareholders, it doesn’t mean the company is on cruise-control – Uber, Lyft and Snap have struggled mightily to maintain market value, let alone grow, after going public, and more unprofitable companies are IPO-ing than ever.
The glaring downside of these astronomical valuations is the pressure it puts on the companies to maintain the growth trajectories and market share to justify them. Companies are often forced to resort to unsustainable business models like keeping prices artificially low to beat out the competition (as in the Uber/Lyft price wars) or offering free services to keep user growth on pace.
The irony of it all is that, in the effort to reach levels of market share and growth that would enable investors to have a profitable exit, companies fail to build a profitable business. The number of unprofitable unicorn IPOs—especially as a percentage of overall unicorn IPOs—is striking:
Though not nearly as unlikely as winning the Powerball, the odds of finding the next unicorn amidst the stampede of startup horses are slim.
But unicorns aren’t the only way for startup investors to succeed. In fact, sky-high valuations can be bad for investors and for companies, and much smaller exits can earn a smart investor excellent returns, if they know what to look for when investing in startups.
We believe that equity crowdfunding is a healthy alternative to traditional VC investing, as it doesn’t drive companies to accept sky-high valuations so that VCs can pay back their partners, which helps both the companies and the investors funding them.
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