In the world of investing, a growing number of starup companies have reached billion-dollar valuations; they’re called unicorns. But what does it take to be part of this club, and should investors put funds behind them? Let’s start with the basics.
What is a unicorn?
A unicorn is a privately held startup company with a valuation of $1 billion or more. The term surfaced in the last decade when Aileen Lee, the founder of a Palo Alto–based venture capital fund, wrote an article about 2000s tech startups and found that less than 1% of them had reached billion-dollar valuations.
What kinds of industries do unicorns typically fall into?
Unicorn companies are typically innovative or disruptive companies that are expected to grow quickly. There are an estimated 1,101 unicorns around the world, according to CB Insights, with a cumulative valuation of $3.67 billion (or an average of $3.3 billion per unicorn).
“Unicorns tend to appear where there is a lot of fast growth in the tech space and large markets,” says Julien L. Pham, founder and managing partner of Third Culture Capital (3CC), a venture capital firm whose mission is to advance equity and diversity in health tech innovation. “[That includes] e-commerce, deep tech, SaaS (software as a service), mobile, fintechs, and of course, but not as often, health care. On rare occasions, new markets are ‘established’ by unicorns.”
Currently, the top 10 unicorn companies are:
- Didi Kuaidi
- China Internet Plus
How are unicorn valuations determined?
It involves some guesswork. Because unicorns are startups without a long track record, their valuations are typically based on how investors and venture capitalists think a certain company will perform over time. Sometimes this involves using a competitor’s performance as a foundation to determine how a startup might perform. The catch: A lot of these companies are the first of their kind, so it can be tricky to determine how they might grow, if at all.
As time has passed, more and more companies are reaching that $1 billion valuation and far exceeding it, with companies like TikTok and its parent company valued at $50 billion and $300 billion, respectively. This has left some investors wary about whether these valuations are fair or if they could be contributing to a potential unicorn bubble.
“The exercise of valuing a private company in recent years has always been a bit of an art form,” says Pham. “Given the bullish market environments, companies with $1B valuations ‘on paper’ were based on many investors trying to get into a deal and artificially raising said valuation. It is important to know who the co-investors are and what their ongoing roles in helping build and scale the companies are, versus investors who are there for the ride.”
Should you invest in a unicorn company?
Investing in a unicorn company can be challenging for average investors, as most are funded by private investors or founders.
Of the more than 35 public software companies that reached valuations upward of $10 billion from 2004 to 2015, only six achieved that level before going public, according to McKinsey. The rest reached it an average of more than eight years after their IPOs, so it can be a bit of a waiting game. For privately held companies, going public could mean greater access to capital and growth opportunities, but it could also invite public scrutiny.
It’s also unclear how a company will perform after going public. Airbnb and Uber are both unicorn companies that went public with vastly different results. Airbnb opened at $146 per share on its first day of trading; the following day it more than doubled the $68 per share price set for its IPO the day before. Uber, on the other hand, disappointed with its IPO debut, dropping 7.6% on its first day of trading on the New York Stock Exchange.
If you’re an investor with a higher risk tolerance than most, investing in a unicorn company could be the right move for you. While there’s great risk involved, there may also be a great reward if you can get in on the ground floor of an investment that will shake a certain sector or industry. Still, putting money into speculative investments should always be done cautiously, and it can be hard to time when you should go all in and whether or not a unicorn company will give you a greater return on your investment.
“Typically, the idea is to invest early in those companies and maintain a large equity stake through multiple growth rounds,” says Pham. “[But] not every investor is capable of following on and [they] could rapidly get diluted.”