VC Journal

Culling the unicorns? Down rounds seen increasing in 2017


By Tom Stein

The coming year could see unicorns lose their horns and morph into donkeys.

That seems to be the consensus in the venture community. Nearly a third of the 90 U.S. tech startups that have reached $1-billion-plus valuations will eventually be worth less than $1 billion, according to report by private-markets-research firm SharesPost in the fall.

“Some unicorns have been built on rickety models during a time period where growth at any cost was the flavor du jour,” says Mitchell Green, a founding partner at Lead Edge Capital, a growth-equity firm whose investments include unicorns such as Uber and Bla Bla Car.

“I could build a billion-dollar-revenue business overnight if I sold dollar bills for 90 cents. This is essentially what many of the unicorns were doing, and for those I believe and sincerely hope the end is near.”

We are still at the peak of the unicorn stampede: Some 174 unicorns globally are valued at a total $626 billion, according to research firm CB Insights. That’s more than four times the 39 billion-dollar startups in 2013, when the term “unicorn” was coined.

But after years of prosperity, unicorns may soon be on the endangered list. In third-quarter 2016, 35 unicorns raised a collective $8.38 billion in 38 funding events, according to VentureBeat. That’s less than half the cash of the year-earlier period, when unicorns raised $17 billion in 61 fundings. What’s more, only nine new unicorns joined the club in Q3, versus 23 new entrants in Q3 2015.
Alex Rosen, a managing director at IDG Ventures, expects to see the unicorn herd continue to thin out in 2017. In particular, he says the consumer space will see a number of high-profile flameouts. But he also says enterprise unicorns will be spared from slaughter.

“Many of these consumer unicorns are low-margin businesses that are required to spend significantly on customer acquisition, so it’s hard for them to cut their way to success,” he says. “By contrast, unicorns that sell to the enterprise typically have long-term contracts and high gross margins, so they can survive longer.”

Venky Ganesan, managing director at Menlo Ventures and chair of the National Venture Capital Association, agrees that 2017 will be a year of reckoning for unicorns. He says a number of shaky unicorns were able to survive in 2016 without raising new capital, but they won’t be so fortunate this year.

That’s because the non-traditional late-stage investors who helped fuel the unicorn bubble, such as hedge funds, mutual funds and sovereign-wealth funds, are likely to abandon the market.

“After the presidential election, bond yields immediately started to go up,” says Ganesan, whose firm has invested in several unicorns, including Uber and Warby Parker. “That tells us we are moving to a high-interest-rate environment, which does not bode well for unicorns.”

When bond yields are low, he explains, investors push into riskier asset classes, like venture capital. But when yields move up, their investment options start to open up again. That prompts more competition for their money across a range of assets, so they can be more selective about their VC investments.

“Unicorns were focused on growth at all cost, and it didn’t matter if that growth was profitable or not, as long as you could find late-stage investors willing to fund you,” Ganesan says. “But now, if you are not building a fundamentally sound business, you probably won’t be able to raise any more money. A rising tide lifts all boats, but as the water level goes down, we will find out who really stays afloat.”

Green of Lead Edge Capital says 2017 will see some newly minted unicorns, but the bar for investment will rise. In general, he sees valuations going down, not up.

“While these companies are still private, investors can fool themselves into thinking that everything is going well,” Green says. “But as equity capital dries up and investors realize the possibility of unicorns going out of business or being sold for pennies on the dollar, fear will set into the market and valuations will fall.”

Dreaded down rounds are likely to accelerate in 2017. In 2016, unicorns saw an average of one down round or down exit per month, according to CB Insights. The most recent: The Chinese Android app store Wandoujia, which venture investors once valued at $1 billion, in July was acquired for just $200 million by Alibaba.

But the relatively few down rounds to date could be deceiving. Some say down rounds are already happening in force but are invisible to outside observers. Many new fundings look like flat or up rounds, but in reality they are structured as down rounds.

“The dirty little secret is the underlying structure of some of these unicorn rounds,” says Bob Ackerman, managing director of Allegis Capital. “A company gets to report a high valuation, but what was not reported are the terms around that valuation.”

For instance, some companies have resets built into their unicorn rounds. If a company goes public or gets acquired, provisions can reset its valuation far below the public market or acquisition pricing.

“Just because a company has the letter B in their valuation, that doesn’t mean it’s warranted or justified,” says Ackerman, who anticipates more down rounds in the coming months.

Of course, not all unicorns are toxic. Green argues that a handful of unicorns have wide gross margins, strong repeat-customer metrics, dominant pricing power and huge markets into which they can grow. He says these are the mega-unicorns that will enjoy valuations in the tens of billions of dollars and continue to break away from the pack.

The big question is whether these companies will go public in 2017. “I believe more will go public, especially companies that have strong business models, like Twilio and Coupa,” Green says.

“Many unicorns will claim that they don’t want to go public because of the cost and burden of increased compliance and reporting requirements. While this is a reasonable consideration, many unicorns are not going public yet because their financial metrics are not strong or predictable enough.”

Overall, investors say unicorns will continue to be an important phenomenon in the venture world.

“As George Bernard Shaw once said, a good battle cry is half the battle,” says IDG’s Rosen. “Just being called a unicorn signals strength in the market. Startups will always fight to get that billion-dollar valuation, but it will become increasingly rare again because, frankly, they’re supposed to be unicorns, not multicorns.”

Tom Stein is a Palo Alto, California-based contributor. He can be reached at