Oh, the siren song of the unicorn! Investors today look at companies like Facebook or stories about Yahoo! passing on a $1 million Google acquisition to justify aggressive pursuit of promising brands.
But research shows that – even with venture capital (VC) backing – aspiring unicorn startups are far more likely to fall than soar. Harvard Business School lecturer Shikhar Ghosh points to the most reliable available data, which indicates that three in four VC backed startups will fail.
So why keep hunting for that mythical financial score?
What is a Unicorn, Anyway?
You probably saw images of unicorns in storybooks growing up. White, sparkly, and sporting a pointed horn on its forehead, they were as sparkly and compelling as they were fictional.
In finance, the term “unicorn” means more than it does in fairytales. Technically speaking, a unicorn company is a startup with a valuation exceeding $1 billion. For venture capitalists, unicorn hunting means investing in companies that they think can quickly scale to that point.
These companies are called “unicorns” because they are just as rare as their fairytale counterparts. Hundreds of millions of companies launch each year. A mere couple of thousands (if that) qualify as unicorns.
The Allure of Anecdotes
The discouraging rates of failure are nothing new, but VC firms are nothing if not optimistic. That’s the entire point of their business model: taking a “flyer” on companies with promise. That line of work requires magical thinking sometimes.
These bets (when they’re made by reputable pros) are backed by data. Due diligence in venture capital is no joke. But the only reason that data gets looked at in the first place is that there’s a historical track record of these bets paying off.
We’re talking about companies like Uber – players who upended sectors and changed the way we live. VC firms who got in early made billions.
What those stories don’t always acknowledge is what happens after an IPO. Uber’s stock launched at $42/share. At the time of this writing, their stock is just over $39/share.
Even so, flashy headlines tend to overshadow retrospective missives about VC gambles on these purported unicorns. Despite stumbles in 2022, VC investments surged 10% in the first quarter of 2023. Part of this might be attributable to investors seeking alternative investments in pursuit of diversification, but part of it is way more basic.
Fear of missing out, or FOMO. Those headlines are like catnip for the financially ambitious.
Unicorn Spotting Requires Serious Skill
Though the comparisons abound, investing isn’t quite the same as gambling. Such metaphors, however, offer a way to understand specific types of investment strategies. VC firms offer a great example.
Technically, VC firms bet on the potential profitability of a company – just like purchasing a single share in a company on a stock exchange works like a bet on that company’s financial future. VC bets, however, tend to be much, much larger than a trade on Robinhood. They also come with additional risks tied to things like liquidity and time horizons.
Like its cousin private equity, the stakes in VC investing mandate rigorous due diligence prior to investment. But VC due diligence can be even more challenging. In many cases, the companies in question are considered “disruptors” – meaning directly correlated data might not be available or reliable.
To this end, unicorn hunting requires a certain amount of excellence not quantifiable in a spreadsheet. You need some imagination to extrapolate data from generally related spaces to future revenue potential.
Beyond the Numbers in Unicorn Appeal
Everyone wants to make money. Unicorns make a lot of money for savvy investors. But there are reasons for pursuing unicorns in VC that extend beyond dollar signs.
For most outside of investing circles, name recognition in VC holds little value. To the principal at a VC firm, though, name recognition holds the key to attracting substantial and durable inflows from accredited investors.
When a VC sticks the landing on a unicorn bet, the resulting headlines supercharge their credibility. To this end, small failures feel justifiable. After all, failure is always a risk in VC. But when a VC firm gets it right, the returns to their current investors will attract more investors with deeper pockets, empowering them to make bigger bets in the future and generate even higher returns.
Are Unicorn Bets Worth It?
There is not an investor alive who doesn’t wish they’d gotten in early on companies like Amazon or Microsoft. But in their early days, betting on their viability felt sketchy. We didn’t yet understand how technology would transform the way we live.
VC offers a bridge between where we are and where we could be. Unicorns operate as promising vehicles. Finding them, though, can be challenging – to say the least. That doesn’t mean we shouldn’t seek them out. It just means that we should rely less on fairytale plotlines than we do data. Numbers tell an interesting enough story all on their own.
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This is an updated version of an article from 2019. © 2023. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
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