"Investors overvalued these [unicorn] companies" begins the video interview about recent IPOs of unicorns in the Fortune magazine issue of February 1, 2016.
Startup veterans see the picture differently: they see unicorns following the Gartner Hype Cycle. When you understand that, it's simple to explain (1) what has happened to unicorns and (2) what will happen to them.
- Startups creating a new market category follow the “Gartner Hype Cycle”. For each new market a new name is created: e.g. Begin with early days for "ride sharing" and watch the first bunch of startups race up the Hype curve.
- Each new market starts with the Oklahoma Land Rush. Many startups jump into the race and aggressively attempt to overtake the early starters, to seize and retain the initiative.
- Vast struggles ensue among an ever growing number in the startup pack, each trying to figure out how to become the leader. The race is on for “First To Get It Right”.
- Gradually a few new enterprises figure out how to consistently attract large numbers of eager customers. They become favorites of bloggers who spread the word quickly.
- Typically three leaders emerge from the pack. Each is vying for Number 1. Each is lusting to become The Gorilla of the new space as Google, Netflix, et alia did.
- All the rest have already begun to fall back, getting farther and farther behind. They have begun dropping into the dreaded “Trough of Disillusionment”.
- A final battle for Number 1 is fought and one startup emerges victor, dubbed The Gorilla. It focuses on getting larger and picks its IPO date.
- The two losers settle in, reluctantly conceding the war is over. They become the Chimpanzees. They focus on getting profitable and cash flow positive. IPO thoughts become secondary.
- The dozen remaining companies slowly drop out of memory. They become the Starving Monkeys. The focus on how to survive with the remaining cash on hand.
- A few naive engineers try to get new startups financed by claiming “But we can do better.” ("ER" words are death). Few get financed, ones that do inevitably join the starving monkeys.
- Quietly Monkeys get sold for less than the cash investors put in.
The Fortune 500 analysts and others in the venture community make the typical error at this stage by declaring: “They were overvalued.” That’s the equivalent of saying in hindsight “I knew it all along, the others didn’t.” It exposes their lack of insight to how private rounds of venture capital are priced (lots of "down-rounds" year by year).
Primarily what they miss is first checking in on the Hype Cycle, asking “Where are we in the life cycle of this new market (category)?” If they had started there, they’d say something like “Several of the unicorn battles have progressed past the “Peak of Inflated Expectations” and the fallouts are beginning to slide down the “Trough of Disillusionment” as is typical of life with startups."
In other words, unicorn startups are behaving like startups, so nothing is new there. Each new category is settling down, with Gorillas emerging, Chimpanzees conceding, and the Starving Monkeys looking to sell to some buyer for some (low) price.
Is it the end of the new (unicorn) startup wave? No. There are many waves among the generalization of “unicorn” (such as fintech, virtual reality, ride sharing and so on). Each follows its own Hype Curve. It’s a mistake to put all into one basket and generalize on them at the same time.
VALUATION IS TOMORROW
As for “overvalued”, it depends on your view of tomorrow, years into the unknown and your level of willingness to take risks investing today.
Each startup is valued on the future financial results expected of it, years into the future, at least half a decade forward, and farther.
The New Game In Town began at the turn of this century by bold venture capitalists eager to put tons more money into a half dozen incredibly large startups. Their goal is to invest in startups that are “global game changers” (formerly, domestic “game changers” was the new new thing for VCs to invest in).
They are expected to start The Fourth Industrial Revolution.
The required metrics are simple.
The number of potential customers is global in size, vast, humongous, “lots of extra zeros."
The main characteristic is the unicorns are expected to be 10 to 100 times the potential size of domestic startups.
The larger the capital invested, the higher the risk and thus the larger the financial future must be.
The longer the time to get to IPO and profitability, the higher the risk and thus the greater the reward must be.
Going IPO before profitability is needed because the venture capital pool is too small to continue fueling unicorn startups burning cash for the foreseeable future.
The “Post-VC” stage than takes on the shape of a fresh source of venture capital investing, using the "public money pool" (mostly institutional) that trades on stock markets.
That subjects the unicorn to extra (“hyper”) scrutiny about its future, with each quarterly release of financial statements analyzed in minute detail.
Unicorn management now is absorbed with managing expectations of thousands of public people, instead of a five man board of private directors. Any failure to exceed expectations sends the recently IPO stock crashing ten, twenty, thirty percent.
Such valuation volatility actually commonly goes on in pre-IPO startups, but is carefully guarded, with “down rounds” strictly shielded from public knowledge (as much as possible).
Everyone has an opinion about the far distant date when the unicorn will attain profitability.
And for some battles (e.g. Ride Sharing in India or China), the struggle to become The Gorilla is still in play.
Risk has risen recently due to global economic slowdowns in China, commodities, and oil and gas. And geopolitical risk has risen with wars in the Middle East. Thus the future is worth less today. Ergo, down go valuations of all startups. Nothing new. Just more piling on to drop the value of new enterprises.
BOTTOM LINE: Thus I suggest sweeping generalizations about unicorns are off the mark, missing understanding of what is going on in each fresh market. It is confusing, especially when the timing of the arrival of the Trough of Disillusionment coincides with a general reduction in public stock market valuations due to rises in global risks. So expect more "overvaluation" articles to arrive daily. Meanwhile, watch the Hype Curve and place your bets.
I wish you The Best on your Adventure!