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Is Unicorn Just Another Word for Subprime?

A number of privately held tech companies have generated valuations over $1 billion. Some experts see that as a problem.

Plenty of ink has been spilled over the mushrooming number of young, privately held technology companies valued at more than $1 billion. These companies are popularly known as unicorns.

But many venture capitalists and analysts don’t see the trend as a good thing. The reason: They are worried that companies are becoming obsessed with reaching unicorn status to the detriment of their businesses.

“The desire for these marquee valuations isn’t healthy,” says Mark Leslie, former CEO of Veritas Software Corp., which merged with Mountain View, California–based Symantec in 2005. “I think the competition for valuation is destructive. It’s kind of a fever in Silicon Valley.” Leslie invests in tech start-ups, serves on their boards and lectures in management at Stanford University’s Graduate School of Business.

The unicorn universe now consists of 129 companies, according to Dow Jones & Co.’s VentureSource. San Francisco–based ride-hailing service Uber Technologies leads the list at $51 billion, followed by Beijing electronics company Xiaomi at $46 billion; San Francisco’s hospitality company Airbnb at $25.5 billion; and Palo Alto, California, software company Palantir Technologies at $20 billion.

Experts decry the quest for unicorn status because it distracts founders from focusing on their business and distorts the capital allocation process, making it difficult for some worthy start-ups to attract capital.

Blame for the trend should be spread widely, experts say. “It’s a collective game in which people — the whole ecosystem, including VCs and founders — are willing to sacrifice,” says Aswath Damodaran, professor of finance at New York University’s Stern School of Business. “The idea is that getting to $1 billion is a path to prosperity that makes up for today. Whether that’s true is irrelevant.” In fact, it’s often not true, he says. Even journalists are complicit in the process, with their glowing stories about unicorns, Damodaran maintains.

“Individual companies are being mismanaged” amid the preoccupation with $1 billion valuations, he says. “Products are being developed that shouldn’t be.” When companies don’t develop their businesses rationally, there’s a collective damage to the entire start-up system, Damodaran says. “It will take down good companies and bad companies.”

As an example, he cites San Francisco–based payment services company Square, which created huge buzz with its $6 billion valuation last year but drew a wave of bad publicity last month when its initial public offering valued the company at just $2.9 billion. Although Square’s revenue is growing quickly, so are its net losses. If the company had been more realistic about its valuation, it wouldn’t have suffered as much criticism when the IPO came out, Damodaran says.

Other unicorns that have stumbled when going public this year include Redwood City, California–based cloud storage company Box and Brooklyn, New York’s craft web site Etsy. “Great companies have to realize that much of their value comes from the credibility of management,” Damodaran says. “If you’re spreading a number that’s not the right value, then people will think you’re cooking the books.”

The only time valuation really matters is when a company is sold, experts say. Indeed, the unicorn valuation is merely an “interim” one, says Venky Ganesan, a managing director of venture capital firm Menlo Ventures in Menlo Park, California. “Some people consider a unicorn valuation as subprime,” he says. “It’s not the right focus, unless it’s tied to an investment strategy. You should only raise money when you need it, and raise it prudently.”

Company executives who are focused on reaching the $1 billion plateau are often executives who aren’t focused enough on their business, experts say. “Every time you raise capital, you’re going to be away,” says Vassil Mladjov, research director in Santa Clara, California, for technology consulting firm Gartner. “You’re taking your eye off the ball. You can’t run your company by phone.”

There’s a certain amount of hubris at work. “The biggest distraction is that people get tied up in an ego boost instead of the fundamentals of building revenue and profit,” Ganesan says.

Venture capitalists have their own obsession with unicorns that exacerbates the problem, experts say. “I recently talked to a top-ten VC who said, ‘We’ll only invest in unicorns,’” Mladjov says. “He said unless the market is huge, they don’t care about anything else. They don’t care if a company is making $10 million in profits. VCs are putting oil on the fire.”

Those companies that don’t make the $1 billion cutoff can suffer as a result. “There are some really great companies whose interim valuations are lower than $1 billion,” Ganesan says. “But unfortunately, we live in Lake Wobegon, where everybody thinks they’re above average.”

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