What's Feeding the Growth of the Billion-Dollar "Unicorn" Startups?

March 18, 2015 | By Neil Howe

This editorial originally appeared in Forbes.

When venture funder Aileen Lee coined the term “unicorn” in late 2013 to describe the $1 billion startup, it was a fitting description—there were only 39 in existence. Now we may need a new term to describe the phenomenon. In little over a year, the number of unicorns has jumped to 80. Valuations have soared at an unprecedented pace: Snapchat—a company that refused Facebook’s $3 billion buyout in 2013—is now seeking a $19 billion valuation, for example. Driving this rapid acceleration is everything from big corporate buys to technological advances to the growing cost and bother of going public. At the end of the day, will today’s Gen-X business leaders avoid the pitfalls that derailed their Boomer counterparts and led to the dot-com collapse?

Unicorns have grown at an astounding clip. Defined as U.S.-based tech companies started since 2003 and valued at $1 billion or more, these startups are surging in worth and in number: The total value of these companies increased $28 billion in Q4 2014 alone. At this pace, unicorns have become almost commonplace. In fact, the new measure of exclusivity is the “decacorn” (a startup worth $10 billion or more): In late 2013 there was only one (Facebook), but now there are at least eight—including Uber ($41 billion), Palantir ($15 billion), and Airbnb ($13 billion).

Behind this growth, on the supply end, is massive investor spending: Venture capitalists (VCs) and investment firms alike are doubling down on private startups. With paper-thin interest rates and meager yields on the S&P 500, investors see risky startups as their only opportunity for appetizing returns. As a result, VCs spent $19.6 billion on tech startups in 2014, up 67% from 2013.This investment balloon has prompted mutual fund giants like BlackRock and Fidelity, known for buying shares in startups once they go public, to join the private game—opening up enormous financial channels.

Meanwhile, on the demand end, big tech companies simply have more money than ever before—which gives investors hope that there’s a big buyout waiting for startups. Considering Facebook’s $19 billion acquisition of WhatsApp andGoogle’s $3 billion acquisition of Nest, high returns are out there to be had. Even non-tech companies like Home Depot, Wal-Mart, and Red Robin are buying up startups, either to scale up someone else’s innovation or (cynics would say) to shelve the competition.

The reason these companies now possess such huge cash reserves goes back to macroeconomics: In a slow-growth, low-interest rate environment, companies like Facebook and Apple don’t have much appetite for traditional capex investing. And when they do spend their money, they prefer buybacks and buyouts.

Some say that these high valuations are being pushed upward by a uniquely profitable flood of technological innovations—such as mobile advertising, cloud computing, and P2P platforms. Today’s startups have it easier than those of the dot-com bubble: From social media galleries like Pinterest to whiz-bang inventions like WhatsApp, tech startups can utilize their massive economies of scale to reach millions while only paying a handful of salaries and avoiding costly overhead.

Still another reason for unicorn growth is an increasing desire to stay private. In the 1990s, companies like Microsoft and IBM rushed to go public and grew up primarily in the public market. Now, because of tough regulations for newly-public companies, many private startups only hold IPOs as a last resort. The Sarbanes-Oxley Act mandates stringent compliance and reporting procedures for public companies, making it simpler and more cost-effective to stay private. Even more recently, the 2012 JOBS Act expanded the maximum investor base of private companies from 500 to a full 2,000.

So are unicorns destined to become the new normal—or will they soon vanish? Optimists believe that most of today’s startups are primed for success. These companies have tech advantages and customer bases that didn’t exist two decades ago. Though the dollar signs worry others, this group says you can’t put a price on growth potential. Plus, investors don’t want to miss the next Facebook, which—despite a disastrous IPO—took only two years to rebound far above its original stock price. These stories encourage investors betting on unicorns’ longevity.

Then there are the pessimists, who believe we’re due for another dot-com crash. After all, investor capital has an expiration date: Once the Fed raises interest rates (which will likely happen in 2015), much of the money now going to startups will flow elsewhere. And official estimates of startup performance are generous. They imply that only a quarter of startups fail, but it’s more accurate to say that only a quarter succeed. The VC community hypes victories and suppresses setbacks. In the words of Harvard Business School lecturer Shikhar Gosh, VCs “bury their dead very quietly”—suggesting that the unicorn frenzy reflects “boom psychology” rather than true earning power.

One thing is clear: The term “unicorn” is better suited to describe our current macroeconomic landscape, in which we have a zero-interest rate economy without the imminent threat of recession. This rare environment has given rise to perplexing trends: While unicorns balloon in value, entrepreneurship in the rest of our economy is in decline. And though unicorns add tens of billions overnight to the market value of America’s corporate equity, they add virtually nothing to America’s workforce.

Xers, now leading most of these highly-valued companies, may be unprepared for the fall. Two decades ago, young Xers working for dot-com startups watched their Boomer bosses act carelessly only to be caught off-guard when the market cooled. Now these same Xers are making similar mistakes running their own companies: From massive office renovations to excessive salaries to personal indulgences, many startups are burning through cash. One VC remarks, “In an inflated market, everyone feels like a steroid-adjusted baseball player, but once the steroids are gone…there are only 5 to 10 people who can hit 30 home runs.” These Xers should remember that only the most efficient, agile, and revolutionary companies will be able to survive when the market cools.

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