Some 144 companies are so-called unicorns, with valuations of $1 billion or more in private markets. But experience shows the good times may not last for some, according to David Erickson in this opinion piece. He is a senior fellow in finance at Wharton and co-teaches “Strategic Equity Finance” with professor David Musto, chair of Wharton’s finance department. Prior to teaching at Wharton, Erickson worked on Wall Street for over 20 years, helping private and public companies raise equity strategically.

When Square went public in November 2015 at around $3 billion — a significant discount to the $6 billion it raised in 2014 — some media outlets spoke openly of the extinction of the “unicorn,” as tech companies that achieve a billion-dollar-plus valuation in the private markets have come to be called.

High profile Silicon Valley tech investors such as Mark Andreessen and Bill Gurley have indicated for a while that parts of the tech market are significantly overvalued. As a matter of fact, in a Knowledge at Wharton article back in June, it was suggested that a tech bubble for unicorns was starting to form.

Other investors have gone to great lengths to contrast this market with the tech bubble of 2000. Roelof Botha, a Sequoia Capital partner who has invested in several high profile unicorns, said to Bloomberg in September, “If you look at the valuations of public tech companies, it’s nowhere near the frothy levels that you saw in 1999 and early 2000. Often people point to anecdotal examples of private companies that they think are overvalued and I’m sure in the fullness of time, it’ll prove to be that some of them were overvalued and won’t be successful. But I’m not sure you can point to something systemic that cuts across all of those companies.”

And yet, while the tech pool may not be as “frothy” as 1999 and 2000 on a public-valuation metric, what is a parallel to that time is that many of today’s unicorns are nowhere near being cash-flow break-even.

Where Did the Unicorns Come From?

As explained above, the name “unicorn” has, in recent years, been bestowed on tech companies that achieve a valuation in the private markets that exceeds a billion dollars. (The name “decacorns” was coined for private companies that achieved a ten-billion-dollar valuation in the private markets). In December 2015, the database CB Insights had 144 companies on their “Unicorn” list of private companies that have a total cumulative value of $508 billion.

“With today’s unicorns, and even with Facebook and Alibaba, the founder is now often the CEO.”

A likely catalyst for companies staying private longer was the US JOBS (Jumpstart Our Business Startups) Act, which was signed into law by President Obama in 2012. A feature of the bill was an increase in the number of shareholders a company could have before being required to register its common stock with the S.E.C. and becoming a publicly reporting company. Before the bill, companies like Google and Facebook had to start the S.E.C. process when they reached 500 shareholders. Now, under the JOBS Act, the number has grown to 2,000. This new number may not seem like a lot, but when you consider that one institutional investor who participates in multiple financing rounds and may contribute tens of millions in each counts only as one investor, it could have a significant impact on how long a company can stay private.

Another catalyst has been the increase of investment dollars migrating to the private venture market. As companies are staying private longer, those investors that have typically first invested at IPO have been forced to invest privately to continue to participate in the “growth curve” of these companies. With the strong public equity market performance for high-growth companies in recent years, prominent public investors such as Blackrock, Fidelity, T. Rowe Price, and Tiger Global have been emboldened and more prevalent in private rounds for these unicorns, contributing significant amounts of investment. As an example in November, reported that Fidelity had led a $500 million round for, an e-commerce startup that launched last July.

One of the things we discuss in our “Strategic Equity Finance” course at Wharton is the contrast between Google’s going public in 2004, on the one hand, and, on the other, the public offerings of Facebook in 2012, and Alibaba in 2014.

Google raised $1.9 billion, with a market cap of a little less than $25 billion — unprecedented amounts at the time for a high-growth venture-backed private company (dwarfing the more typical $100 million of IPO proceeds raised by other high-growth venture-backed companies). In their more recent IPOs, Facebook raised $16 billion and Alibaba more than $25 billion. While Google could be characterized as one of the earliest tech “unicorns” (though the term didn’t exist back then), there are still significant differences with today’s group of unicorns, and even Facebook and Alibaba:

  • It was common practice back then to bring in a “professional” CEO, though the founders would stay involved. In the case of Google, Eric Schmidt, the former CEO of Novell, was brought in, with the founders, Sergey Brin and Larry Page, continuing to play prominent roles. With today’s unicorns, and even with Facebook and Alibaba, the founder is now often the CEO.
  • Google, Facebook and Alibaba were each already making a significant amount of money when they went public. In 2003, the last full year before it went public, Google made more than $100 million in net income. Both Facebook and Alibaba made even more before they went public. In contrast, Square reported in its recent IPO prospectus that it had lost more than $150 million in 2014, its last full year before going public.
  • When Google went public in 2004, it was at the tail-end of a very difficult period for several tech start-ups, with many going bust. Many of today’s younger founders/CEOs of unicorns weren’t in the tech industry back in the early 2000s to experience this frustration. As a result — and given the plentiful supply of private capital available over the last few years — the question from some of these young founders/CEO is not “When should we go public?” but “Why should we go public?”

Unfortunately, as we have seen before (and likely will again), when public equity investors lose enthusiasm for high-growth companies (especially those that are losing money), it not only becomes more difficult for these companies to go public, it often constricts the private capital market as well.

What Will Happen to the Unicorns?

As with many of the unicorns, Square’s private market liquidity/valuations got ahead of what is likely equivalent in the public market. “Decacorns’” like Uber, Airbnb, Snapchat, and others could face a similar issue. These companies could either wait until their numbers grow into their likely public market equivalents, or go public now (if they really need the cash and/or need to get public) and potentially come at a lower valuation than their last round.

“… The question from some of these young founders/CEO is not ‘When should we go public?’ but ‘Why should we go public?’”

Let’s use Uber as an example.

When both Facebook and Twitter went public (as two of the largest private internet companies to go public and probably two valuation benchmarks for Uber when it goes public), their valuations were approximately 10-12 times revenue for the forward year. So for Uber to get to the $60 billion in the public markets that they have been rumored to be valued privately, they would have to be talking approximately $5 billion to $6 billion in forward-year revenue.

There are two more things to say about Uber, specifically. First, my guess is that they would like to go public at a premium to their last private round; so, that could mean potentially $70 billion to $80 billion-plus, which would potentially mean that more than $5 billion to $6 billion in forward year projected revenues may be necessary. Second, Uber has already achieved the rare brand status of being used like a verb (similar to Google); so, it is possible that with superior growth (and other comparable characteristics), they may be able to go public at premium multiples to Facebook and Twitter, though that is much harder to do with a $60 billion-plus valuation.

The question is when does that value intersect for Uber, and does the company have enough cash to get there? While Uber has raised a significant amount of cash, it is also losing a significant amount, as reCode and other media outlets reported in August.

Numerous people in Silicon Valley have tried to suggest there aren’t any parallels between now and 2000. Having taken several high-growth technology companies public back then, I must disagree. While the business models are broadly much better and the companies are much more seasoned now (than in 2000), the similarity with 2000 is that many of these unicorns are nowhere near break-even and are burning lots of cash. My bet is that a company like Uber will be fine. But what about the other 143 unicorns?

“… Uber has already achieved the rare brand status of being used like a verb (similar to Google); so, it is possible that with superior growth … they may be able to go public at premium multiples to Facebook and Twitter.”

If the public equity markets continue in the near-term to be flat to down as we have seen in the last several months, I think many of these unicorns will hit the wall. As Mark Andreesen said in a widely published Tweet back in 2014, “When the market turns, and it will turn, we will find out who has been swimming without trunks on: many high burn rate [companies] will VAPORIZE.”

Better and Worse

In the near-term, I would suggest there are “better” and “worse” choices that many of these “unicorns” will face (similar to what we saw in 2000):

Better Choice

  • Go public with no/minimal adjustment (like Pure Storage, a unicorn that went public in October that priced basically on top of its last round).
  • Go public with a major valuation adjustment (like Square).
  • Raise money privately (if their existing VCs/backers are supportive or they can find new investors).

Worse Choice

  • Try to sell the company.
  • Revise the model to race to break-even (which will likely slow growth/burn cash, as well as slowing the interest/excitement in the company, which could potentially lead to losing employees, etc.); or
  • Hit the wall.

I think that Square’s (and Twitter’s) CEO Jack Dorsey, knowing there was going to be a significant valuation “haircut,” made the decision to take his lumps in the public markets and be one of the first unicorns to go public. That way, Square has more flexibility for the future, having better access to the public debt and convertible equity markets, and a public currency to make acquisitions. By being an early public “unicorn,” Square also may be the beneficiary of the potential troubles ahead. And it may be an acquirer of companies (and/or people from companies) forced to take the “worse” choice above.

Time will tell how many of the 144 unicorns today will still be around and thriving, whether private or public, in the years to come. However, past experience shows that the unicorn “herd” will probably be thinned significantly.