Winter is Coming
And Unicorns Are Not Cold Weather Animals
If you believe Jim Breyer, the famed VC who was an early backer of companies like Facebook and Spotify, today’s investors in billion-dollar startups should be very worried. In the exclusive confines of the Davos confab, he claimed that 90% of Unicorns were in trouble and that a “blood bath” awaits investors in these over-valued businesses. On the other hand, he made that prediction nearly three and a half years ago, back in January of 2016, a year when a Unicorn was born every 9 days or so. How does that prediction look today? Well, in 2018, a Unicorn was born every 4 days so we can safely say that the bubble, if that is indeed what it is, continues to grow bigger. The predicted winter doesn’t appear to have come after all.
But Breyer is hardly an uninformed observer complaining about the mega-deals and mega-price tags of Unicorns. Instead, he is a Silicon Valley legend who was probably looking at the hundreds of start-ups securing very large rounds of financing at huge valuations and comparing this to the “old” days when venture capitalists tried to find a great entrepreneur with an amazing idea and support them early on with a few million dollars of capital along with some hard-won wisdom via a board seat. In this tried and true way of practicing venture capital, the entrepreneur might only be at the stage of having a great idea or they might have a company and some tech built. They might even have a few customers. And in this model, the VC writes a relatively small check (perhaps a few million dollars) and receives a relatively large ownership stake in the start-up in return (perhaps 20–30%).
But this kind of world, the one that storied investors like Breyer grew up in, all changed when investors like Yuri Milner of DST Global came along and pioneered a new Silicon Valley venture capital model. DST Capital’s $200M Facebook investment is representative of this shift. When they, atypically, took no board seat and paid a $10B valuation in 2009 for less than 2% of the company, it was at the time suggested as perhaps being too high a price and the sign of an unsophisticated outsider trying to make a name in Silicon Valley by throwing money around.
It may be hard to remember that back then Facebook’s revenue was a mere $270M and they were losing over $50M on that revenue, so this wasn’t an unmerited viewpoint. After all, in 2009 the model people had in their heads were companies like Amazon that had IPO’d at a market cap of less than $500M. Even Microsoft was valued at less than $1B at their IPO. So, many sophisticated investors believed that investing that much money for so small a stake, not taking a board seat and expecting a venture-like return from an investment in a private company valued at $10B was naive.
But then something surprising happened. In the intervening years, Facebook grew their revenue more than 200-fold to $56B and generated $22B in profit off of that revenue. The business is now worth ~$530B, meaning that original $200M stake if it were all still held today would be worth 53x that or nearly $11B — a venture return and then some. This kind of success was replicated by a number of other later stage VC investors and this kind of growth has been achieved in a number of other companies.
DST’s performance on their Facebook investment, alongside similar ones from companies like Twitter, Slack, AirBnB, Uber, Spotify and the like unleashed a torrent of capital into Unicorn businesses.
As the “Top Unicorn Hunters” table shows, DST is hardly the only investor playing in this space. Some of the traditionally early stage firms have raised large funds, such as Sequoia with their $8B global fund, Index Ventures at $1.65B, and Lightspeed at $1B— not to mention the super mega funds like SoftBank’s $100B Vision Fund and Tiger’s $3.8B global private company fund. In order to put those larger funds to work these investors have to allocate to later and later stage deals at higher and higher valuations.
Not surprisingly, there are now 350 Unicorns globally, with 96 born in 2018 alone. But back when Milner invested in Facebook, there were perhaps a dozen Unicorns that had been born into the world up to that point with just five created in 2009. So far in 2019, 40 Unicorns have been born — meaning that 2019 is minting Unicorns at roughly 20x the pace of 2009.
Though Breyer’s prediction of a Unicorn “blood bath” has yet to play out as being true, the number of new Unicorns being funded and the multiples at which they are being funded would suggest that he will be proven right after all, and winter may still be approaching for these later stage VC-backed companies. The signs of a bubble fueled by these bigger and bigger funds can be seen in the tectonic shifts the industry has experienced over the last decade.
The accompanying charts tell the story: Ten years ago, the smaller deals represented the lion’s share of deal dollars. Recent data released by PitchBook and the NVCA show that smaller deals (i.e. those raising <$50M) dominated the venture landscape in the late 2000s, representing roughly 80% of deal volume (see the dark blue color bars in the PitchBook chart). But, as investors began to see the performance of investment’s like Milner’s Facebook stake, a profound shift unfolded. As the PitchBook chart shows, an almost complete inversion of these numbers has occurred, with close to 70% of deal dollars now going to companies raising $50M and greater (the purple color bars).
That larger funds are chasing later stage deals is showing up in deal valuations as well. Back in 2010, the average Series D and later round was at a $66M valuation. Today, this has shot up 4x to $325M (and the trend continues, with the Q1 2019 data showing the average Series D+ valuation coming in at $345M)! (See blue lines in the chart, below.)
Even as the round prices are shooting up, the chart below shows that the overall deal count across all stages combined has been steadily declining in recent years, including a continuation of this trend with another drop in Q1 2019 according to the PitchBook Q1 report (not pictured). Notably, the shrinkage is coming from the smaller deals (the blue bars). So even as total VC deals closed has fallen nearly 20% in the three years from 2015 to 2018, the overall amount invested surged nearly 40%, in line with the growth of late-stage Unicorn-type financings (highlighted by the yellow dotted line in the VenturePulse chart below).
The Seed through Series C playing field is still filled with smart investors and a lot of capital. Nevertheless, as the chart shows, the number of pre-Series D+ rounds funded dropped by ~30% from the peak in 2015, suggesting that earlier stage (i.e. pre-Series D+) companies will probably have to work harder to compete for the relatively scarce early and mid-stage deal-dollars.
Given the run up in prices for and large increase in the number of Unicorns, huge home runs from late-stage investments may not be as numerous in today’s environment as many expect. Making matters more treacherous, a correction is sure to come and when it does, investors need to ask themselves who will better be able to withstand the coming winter. Unicorns as a species are not inherently a cold weather animal.
Certainly there will be exceptions, but many of these late-stage start-ups burn a lot more cash than earlier stage companies (spend that is harder to switch off), are less able to pivot their business models than smaller companies should that become necessary, and in a bear market will not be able sell at the high multiples required to deliver venture like returns to their investors who have paid top dollar for the privilege of having a Unicorn in their portfolio stable.
It would be an irony worthy of an episode of the TV show Silicon Valley if Sequoia Capital, a peer of Jim Breyer’s Accel Ventures and the very firm that so dramatically and effectively advised start-ups how to weather the last cyclical downturn, became victims of overreaching and not heeding their own advice, and Breyer’s, in the next one.
Disclaimer: The opinions and analysis put forward in this article are those of Zebediah Rice personally and are not the views of King River Capital or its respective affiliates.