November 25, 2015

Putting the Cart Before the Unicorn: Finding the Next Billion Dollar Startup is an Art, Not Science

With news of Square’s recent IPO, it’s clear that tech “unicorns,” or startups that have reached a valuation of $1 billion or more, continue to lead new categories and disrupt existing industries. Investors are constantly looking for the next unicorn, but discovering one is almost as difficult as founding one.  

Attempting to crack the unicorn code is a hot topic, and many research firms have published data/reports trying to identify trends to do so.  One of the more recent is a PitchBook blog post containing funding data illustrating a pattern in which unicorns raise series B and C rounds at significantly higher valuations than the average. While interesting, I found this quantitative approach a bit too backwards looking, as it is in many ways a lagging indicator of success and a forgone conclusion. With that said, here are some of my thoughts on the matter:

Mediocre managers cannot make a good idea successful, but good managers can make a mediocre idea successful.

The origin of that statement is uncertain, though many recall Jamie Dimon making a similar statement in 2002 during the aftermath of the dot-com bubble. I believe early-stage investors are better served searching for a management team that has a disciplined and focused plan of execution. It is no secret that majority of startups fail, with most researchers placing the number close to 90%. The reason for the high failure rate also shouldn’t be a surprise. Statistic Brain Research Institute recently published data that indicated that close to 90% of startup failures are related to poor planning and experience, lending credence to the adage.

Further supporting this notion are the investors most often associated with unicorns (presented in Figure 1).  They just happened to be VCs that know how to bring value beyond dollars. A trait that frequently causes those VCs to be viewed as extensions of the management team, often grounded in their own experiences and success as entrepreneurs. As an aside, at Verizon Ventures we too come armed with our own unique arsenal of artillery aimed at bringing value beyond dollars - be it our Developer Community, Innovation Program & Centers, dedicated venture business development team, and of course the potential to leverage our reach (i.e. subscriber base, retail stores, enterprise businesses, etc.). Nevertheless, the valuation differential cited by PitchBook is more likely to be a result of management hitting their milestones and executing between funding rounds, rather than being a leading indicator for unicorn picking (i.e. putting the cart before the horse). 

Unicorn image 1The use case for the “PitchBook method” can still be made…though barely.

While I don’t believe it is prudent for early stage investors to screen for potential unicorns by looking for startups that have raised rounds at valuations meaningfully above average, late stage investors could find it somewhat appealing. Growth equity and/or private equity investors, those seeking 2-3x returns over 1-3 years, may view PitchBook’s method as a way to get into startups before they hit unicorn status, even if it is at a valuation in the hundreds of millions. That said, even there management/execution risk is important, as luck, market conditions/bubbles, and other factors could have been at play up until that point. Case in point, Hortonworks raised two rounds of funding, both at over $1B valuations ($1.1B and $1.4B), only to IPO 5 months later at $666M (PitchBook). In another example, Fab who was thought to have raised capital at over a $1B valuation (CEO recently indicated a high of ~$875M), was recently purchased for a rumored $15M. In both cases, according to PitchBook data, Hortonworks and Fab not only raised Series B and C rounds at valuations that far exceeded the average, but also the average for unicorns. Thus, while $1B private funding valuations are certainly something to celebrate, the real milestones to cheer for are realized billion dollar exits.


Make no mistake, finding a unicorn is tough business.

Regardless of whether you use a more quantitative based approach for finding unicorns as PitchBook suggests, or a more subjective management approach, unicorns are rare.  In fact, data shows that only 1% of startups funded five or more years ago obtain unicorn status. For startups funded more recently that figure drops to 0.5% (see Figure 3, below). That said, PitchBook data does indicate that it typically takes about 6.3 years for startups to reach unicorn status. Nevertheless, reality can sometimes be lost when we hear all the reports about the rapidly increasing number of unicorns without also mentioning the equally (if not more rapidly) growing number of startups seeking funding.

VZV-Blog -Unicorn -Figure 3_112315v2Source: CB Insights


Related posts from Verizon Ventures: 

Next-Generation Farming: Silicon Valley Meets the Central Valley and Beyond 

VR Will Change the Game for Sports Fans

Startups Adopt Blockchain to Disrupt Big Industry 

Tags: investing , Funding , Startups , VC , unicorn , valuation