Time to Re-Assess the Unicorn Club Idea

November 11, 2015

“Please accept my resignation. I don’t care to belong to any club that will have me as a member”.

– Telegram from Groucho Marx to the Friar’s Club of Beverly Hills to which he belonged, circa 1959.

Hearing the successive recent announcements about the different travails impacting some high-profile members of this illustrious club, I couldn’t help but recall Groucho Marx’s famous quip as he resigned from the Friars’ Club. You have to ask if the Unicorn Club is still as exclusive and appealing for every young startup to aspire to join as it was until, say, three weeks ago? Or has it become a little tarnished by the recent misfortunes of a few of its members? Furthermore, will it survive or fade, as one more Silicon Valley fad to hit the wall? I’d prefer to assume for now that it could still survive provided that the rules of membership are modified, and I’ll expand on this notion further below.

First, let’s consider the short but growing list of recently devalued assets in the Unicorn Club:

  1. Dropbox: Valuation of the company recently cut by 24% by Blackrock on its books, followed by advice from bankers to Drew Houston, the co-founder and CEO, that the company cannot afford to go public at its current valuation without risking an embarrassing lowering of its stock price in short order.

  2. Snapchat: Valuation decreased by 25% by Fidelity Investments, for similar reasons. Observers speculate that Fidelity noted Twitter’s 26% stock price devaluation in 2015 and considered this as a comparison for the purposes of updating the valuation of Snapchat. Other negative developments at Snapchat this year have included the departure of the head of communications, COO, and other top people, in two cases after very short stints at the company.

  3. Square: Pre-IPO valuation estimated to be 35% or so below its valuation of $6bn. after the last funding round. Speculation surrounding the causes of this lowered value ranges from concern about competition from Apple Pay and other fairly recent competitive product announcements to whether the company can fulfill lofty expectations with a part-time CEO (Jack Dorsey, recently announced as Twitter’s CEO in a second coming for him in that role).

  4. Theranos: Valued at $9bn at one point, now in increasingly hot-to-boiling water because of issues related to exaggerated claims about its product offering and the controversial hyping of the growth potential despite the fact that the company’s blood-testing equipment has still not completely passed muster with the FDA. Founder and CEO Elizabeth Holmes has fallen from a high perch, having at one point been featured on magazine covers and feted as a new wunderkind, to now being considered somewhat of a fraud. Being at high risk of crashing and burning, Theranos is an outlier in this list, but one that nonetheless contributes to tarnishing the cachet of the Unicorn Club.

Note that the “devaluers” of Dropbox and Snapchat are not VC firms but mutual funds. This is significant because mutual funds have not traditionally been investors in early-stage tech companies though they could not resist jumping into later funding rounds in acclaimed startups. More importantly, we should be thankful that these mutual funds decided to dabble in tech because they have in essence become the canary in the coal mine, sounding the alarm over the bubbly valuations of two of the most highly visible unicorns. Since they are obliged to formally revalue their investments on a regular basis as a means of governance to prevent sudden meltdowns in the value of their investment portfolios, they have taken note of the reduced post-IPO valuations of companies like Box (a fairly direct comp for Dropbox), Twitter, (an approximate proxy for Snapchat), MobileIron, Violin Memory, and others, and responded accordingly.

In contrast, the Unicorn Club has undoubtedly acted as a red rag to a bull as far as angel investors and VCs are concerned. Getting into the club, and funding new rounds at ever more spectacular valuations has seemed to be a game everyone on the inside wanted to play. The current tendency now should be for angel, VC, and PE investors in each Unicorn company to review its valuation and adjust their investment strategies accordingly. Already we’ve heard that some savvy insiders in companies like Square demanded investment protection against possible downgrades at IPO time. These protections, called ratchets, are designed to compensate some late-round investors in the event that the shares go public below a certain threshold. In Square’s case the threshold is $18.56 a share, and the current price range announced by Square is $11 to $13 per share, a discount of 30%-40% in round numbers.

The tech industry needs to act smarter than this. By promoting a number of startups to stratospheric valuations through a what rapidly can become a vicious cycle of self-reinforcing up-rounds, angels, VCs and PE firms are conspiring, knowingly or not, to generate another disastrous bubble. Added to which, tech needs friends more than enemies in the larger economy; people who don’t work in tech must be getting sick and tired of hearing every couple of months about the latest instant paper billionaire.

How the Unicorn Club Started Life

Just to recall how this all started, the Unicorn Club first appeared in late 2013, coined by venture investor Aileen Lee, founder of Cowboy Ventures. The catchy concept quickly caught on, and thereafter took on a life if its own. No one is to be blamed for this phenomenon, it’s just something that happens when a new idea causes a virtual “epidemic”, in this case around an aspirational goal. It’s just human nature to want to join an exclusive club, and it also has practical aspects. For one, joining the club immediately elevates your company’s profile, and draws the attention of investors, including (hopefully) top-tier VC and PE firms. But the Club that originally housed 39 privately-funded companies that had been founded since 2003 and valued at $1bn or more quickly grew to 140 companies by mid-2015. Thus it seemed that there was less and less uniqueness (or “unicorn-ness”) about being member of an “exclusive” club that now has no less than 140 members. Indeed, we did have the so-called Super-Unicorns like Facebook, Uber, and Airbnb, with valuations above $20bn. Snapchat was a member of this select group till now. Today it is valued at a mere $16bn. even though (like Whatsapp, the messaging service snapped up by Facebook a year or so ago for $22bn in cash and stock) it still has no meaningful monetization model.

It’s worth recalling how Cowboy Ventures defined the club they invented in late 2013 out of an ongoing internal research initiative called the Learning Project, including the key learnings they identified at that time:

  1. “We found 39 companies belong to what we call the “Unicorn Club” (by our definition, U.S.-based software companies started since 2003 and valued at over $1 billion by public or private market investors). That’s about .07 percent of venture-backed consumer and enterprise software startups.

  2. On average, four unicorns were born per year in the past decade, with Facebook being the breakout “super-unicorn” (worth >$100 billion). In each recent decade, 1-3 super unicorns have been born.

  3. Consumer-oriented unicorns have been more plentiful and created more value in aggregate, even excluding Facebook.

  4. But enterprise-oriented unicorns have become worth more on average, and raised much less private capital, delivering a higher return on private investment.

  5. Companies fall somewhat evenly into four major business models: consumer e-commerce, consumer audience, software-as-a-service, and enterprise software.

  6. It has taken seven-plus years on average before a “liquidity event” for companies, not including the third of our list that is still private. It’s a long journey beyond vesting periods.

  7. Inexperienced, twenty-something founders were an outlier. Companies with well-educated, thirty-something co-founders who have history together have built the most successes.

  8. The “big pivot” after starting with a different initial product is an outlier.

  9. San Francisco (not the Valley) now reigns as the home of unicorns.

  10. There is very little diversity among founders in the Unicorn Club.

How to Preserve the Unicorn Club Going Forward

My suggestion is this: If we want to seriously categorize companies with certain valuations and assuming that it makes sense to extend, or more specifically, advance the Unicorn idea, we need to establish some key criteria and ground rules to define different types or “tiers” of membership. This will enable us to reflect critical differences between types of member, as in a golf-tennis-swim club where you have separate memberships for each sport and for general social membership. As Ms. Lee’s report showed us, consumer-focused unicorns tend to be more plentiful and have higher valuations in aggregate, whereas enterprise-oriented unicorns need less capital to achieve their growth and generate more value on average, with a higher return on invested capital. This is largely because B2C businesses often target explosive adoption in winner-take-all games, whereas B2B companies take longer to penetrate businesses but experience longer-term growth in their installed base, and moreover are not usually in winner-take-all categories.

Another distinction between the two is that B2C companies often target adoption before monetization, then try to figure out how they will monetize over time. In contrast B2B companies generally need to have – and do have – a monetization model in place on day one to accompany their journey across the chasm into the mainstream, even if they offer freemium pricing. Since these two business models are so different, at minimum the Club should have two separate chapters – let’s call them Unicorn-B for B2B members, and Unicorn-C for B2C members.

Further classifications could include redefining the valuation threshold, since $1bn. has now become so commonplace; also, they could be separated by growth stage (nascent, emerging, high-growth) or funding stage (A, B, C, D, E rounds). The purpose of establishing these club membership rules and criteria would be to (a) acknowledge important differences between different types of business model, and (b) provide a more reliable way for investors to map out potential targets. I haven’t yet commented on Ms. Lee’s hint about the four major business models that Cowboy Ventures identified: consumer e-commerce, consumer audience, software-as-a-service, and enterprise software. But this could also provide us with pointers on how to organize the Club’s membership going forward.

As of now, the Unicorn is showing signs of losing its luster and relevance. If we assume that there is something worth doing to regenerate interest in the Unicorn Club – and I’m not yet convinced that this is the case – some basic ground rules are needed.

So, to start with, here are three possible tiers of membership with a straw man detailing key qualification criteria for each:

Tier 1, Unicorn A, would consist of the few super-unicorns with valuations above, say, $20bn. These would generally but not necessarily be B2C businesses. Like Uber and Airbnb, these could be immediate members based on this valuation criterion. But even if there were a mix of consumer-focused and enterprise-focused companies, at this point in their growth other dynamics become important such as whether or not they have business models with proven moats against their competitors, sustainable levels of growth and customer engagement, and sufficient management maturity to attract new rounds of funding and/or plan for their IPOs.

Tier 2, Unicorn B, would consist of B2B companies valued at, say $1bn. and up, with functioning monetization alongside clear differentiation, strong customer adoption and revenue growth, plus a clear plan for profitability even if they don’t yet generate current profits.

Tier 3, Unicorn C, would consist of B2C companies valued at, say $3bn. and up, with explosive adoption and strong and increasing customer engagement; also, a credible plan for monetizing the business sometime within the ensuing 2-3 years.

These are my thoughts, just to get the discussion going. What do you think?