From Myth to Market: Understanding Unicorn Companies

By Markets Fool.com

To many, the word "unicorn" refers to a mythical creature: a stately animal, mostly equine in appearance save for the signature horn protruding from its head. But in the world of finance, the term means something else entirely: a privately held company valued at $1 billion or more.

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Like the legendary beast, unicorn companies are unusual ... but they're not quite as rare as they used to be.

In the tech sector, there are now estimated to be more than 200 private companies with $1 billion-plus valuations, according to a recent report by Spoke Intelligence and VB Partners. Three-quarters of the unicorn companies counted were founded in the last decade, and many were founded in the last year alone, with 81 companies joining the unicorn club in 2015.

The trend has garnered its fair share of headlines, so below we'll break down some of the basics behind unicorns to help you make sense of all the news.

What is driving the unicorn trend?
More unicorns exist today because more companies are staying private longer. In 2000, companies that ultimately went public spent a median of six years in business before their IPOs. By 2013, that number had doubled to 12 years, according toresearchby University of Florida Warrington College of Business Administration Professor Jay Ritter.

There are a number of reasons why company leaders today are deciding to wait before going public. Here are just a few:

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  • They might wish to put off launching an IPO because of the perceived challenges of complying with federal rules for publicly traded companies, especially the requirements of 2002's Sarbanes-Oxley Act, which was passed by Congress to improve financial disclosures.
  • Executives may determine that they have a better chance at a successful IPO if they grow their companies ahead of time. The longer a company waits before launching an initial public offering, the more time it has to amass value. Shares of companies with smaller market capitalizations tend to perform worse on the day of their IPO than those of larger companies, Barron's reported last year.
  • Certain start-ups, particularly those in the tech industry, don't need to rely on the public market for capital. In recent years, large, private investors have been eager to provide funding to promising companies before they go public in order to secure sizable stakes and specific benefits, such as preferred stock instead of common stock. An analysis of 37 unicorns by the law firm Fenwick and West LLP found that all provided pre-IPO investors some kind of preferred stock -- which, in the case of a bankruptcy, would give them preference over common stock holders with respect to compensation -- while more than 37% provided supervoting rights to all pre-IPO investors.

Who invests in unicorns?
While venture capitalists are known for fueling the growth of start-ups, in the past few years, hedge funds, mutual funds and sovereign wealth funds have increasingly taken the lead in the highest-value financings, said Barry Kramer, a partner with Fenwick and West. Because of rules regarding accredited investors, most retail investors are effectively shut out of unicorn financing rounds unless they invest with participating mutual or other investment funds.

Part of what has motivated large investors to venture into unicorn funding, Kramer said, is the hope that they can gain more attractive investment returns than those offered in fixed-income securities at a time of historically low interest rates.

"Until recently, interest rates were near zero and that made people more interested [in unicorns] because you couldn't make any money in the credit markets," he said.

How do unicorn valuations work?
Just because a company is valued at $1 billion doesn't mean it has actually raised $1 billion in funding. Rather, that's just how much their investors have judged the company to be worth.

"An example of unicorn is a company that raises $100 million and gives somebody 10% of the company for that $100 million," Kramer explained. If the investor receives a 10% stake in that company for those $100 million, he said, that means that investor has valued the company at a billion dollars.

But it's important to remember that a valuation is just an estimation of a company's worth, and thus it can fluctuate. Investors during a company's second round of funding may determine that the company's value is higher than what it was during its first round of fundinf ... or second-round investors may decide the opposite -- that the company is worth less than it was during the first round.

Company valuations can fluctuate based on company performance or external factors, such as slumping stock prices for publicly traded companies that are in the same sector as the privately held firm. Unicorn valuations may also change when mutual funds with stakes in unicorn companies issue interim reports assessing the companies as having lower or higher valuations than those announced during financing rounds.

How certain are unicorn valuations?
The answer, in short, is not very. Nowhere is this more obvious than in the world of mutual funds, which have become increasingly important players in start-up funding in recent years. While investors that aren't mutual funds might only make their valuations of a privately held known during a financing round, mutual funds file reports at least quarterly that estimate the value of their holdings, including the value of their start-up investments.

When two or more mutual funds invested in the same private company issue new valuations, those estimates may differ from one another by a surprising margin. In one case cited by The Wall Street Journal one mutual fund valued a software company at about $28 a share when another valued it at half that amount on the same day. That was just one of a dozen cases found by the Wall Street Journal where at least two mutual funds issued different valuations for the same unicorn company on the same date.

In the tech space, in particular, there has been growing concern lately that many unicorns may be overvalued.

"You're at the stage of the technology cycle where people see a return and are willing to drive a valuation up to get that return," said Spoke Intelligence CEO Philippe Cases. "The question is whether the space is overheating or not -- are we in a bubble or not? That's very difficult to say."

In at least a few cases, investor enthusiasm has, in fact, abated. Last year, at least three high-profile tech start-ups -- all with valuations expected to exceed $1 billion -- experiencing funding rounds in which investors determined significantly lower valuations than what company founders had expected, according to the Journal. While two retained valuations above the billion-dollar mark, a third reportedly dropped to half a billion.

What's the relationship between unicorns and the tech sector?
Unicorns are largely a tech industry phenomenon. The term "unicorn" was coined in 2013 by venture capitalist Aileen Lee, who had conducted a study of start-ups and sought a name to describe the most-prized Silicon Valley start-ups, according to The New York Times.

"Today, there is no shorthand that better encapsulates both the justified and overheated optimism in the Valley," New York Times reporter Farhad Manjoo wrote. The term, he said, "suggests both the ambition and the absurdity inherent in the tech industry today -- the idea that connecting the right bits and bytes might result in magical, mythical beasts."

What are the risks and benefits of investing in a unicorn company once it finally does go public?
Investing in a unicorn IPO may in some cases be less risky than investing in a small company's IPO because unicorns are typically larger and more established than other new companies. But retail investors should remember that they won't receive the same perks as those offered to pre-IPO investors. There's the risk that a unicorn company's valuation will drop once its shares are on the public market, or that they will drop later, after so-called lockup periods, when different groups of pre-IPO investors are allowed to sell more shares.

"Every situation is different, but one of the important rules that venture capitalists and all these late-stage investors follow is to be diversified," Kramer said. Those with limited dollars to invest, he added, shouldn't spend all their money on a single IPO.

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This article originally appeared at The Alert Investor.

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