In the “startup world” it is no secret that signaling matters. With opaque benchmarks, it can be difficult for a startup to determine how they stack-up relative to their peers. Success often comes in the form of hot awards, prominent investors, and coverage from mainstream news outlets. Investors are anointing hyper growth companies as “Unicorns” at a rapid rate.
Understandably so, startups have become fixated with hanging their prized unicorn status on the wall to share their success. But Unicorns are fake. Always have been and always will be. Looking at the data, unicorns may resemble a different mythical character: Icarus.
“In Greek mythology, Icarus is the son of the master craftsman Daedalus, the creator of the Labyrinth. Icarus and his father attempt to escape from Crete by means of wings that his father constructed from feathers and wax. Icarus’ father warns him first of complacency and then of hubris, asking that he fly neither too low nor too high, so the sea’s dampness would not clog his wings nor the sun’s heat melt them. Icarus ignored his father’s instructions not to fly too close to the sun; when the wax in his wings melted he tumbled out of the sky and fell into the sea where he drowned, sparking the idiom “don’t fly too close to the sun.”
More Capital Going to Fewer Companies
Recent venture capital data shows that more capital is being invested than ever before. However, it is going to fewer companies. AKA — fewer companies are being formed. These mega rounds have allowed companies to stay private longer, burn cash, and chase huge valuations.
If you look at the most recent quarter’s data, you’ll see ~680 total venture capital rounds with 80 (12%) of those single rounds being $100M(!!!) or more. But the reality is most of these companies will fail to return upside to their investors and stakeholders.
To better understand how Unicorns are born, we first need to understand the drivers behind them. In short, VC funds raise capital from LPs, invest the capital, create returns in 10-12 years, and hopefully do it again. However, not all venture capital funds have similar return profiles, they follow a power law curve. In short, a small % of firms produce a large % of returns.
Investors traditionally call the breakdown of a fund the “⅓, ⅓, ⅓” rule:
- ⅓ of investments — fail
- ⅓ of investments — return some capital
- ⅓ of investments — do well
However, this has been proven wrong. Data shows that only 4% of investments do well (10x returns — power law curve at work again) and 67% of investments fail to return any capital.
The team at Impression Ventures states that, “The industry common average target is a min. IRR of 20 percent, which means for a $100 million fund, the fund manager needs to return $300 million to its LPs, a multiple of 3x.” If the same fund owns on average 10% of each portfolio company that means the aggregate exit value of all investments would need to be $3B. And remember this is the expected minimum return.
If a VC fund really wants to make waves they’ll need to generate 5-10x returns for their LPs. Given these fund mechanics VCs finding 10x (or greater) investments are vital to their ability to attract future LP capital.
VC Fund Creation
At the same time that more capital is being invested into fewer companies, more new VC funds are being raised as well.
Great, right? Maybe not. While more VC funds means more capital this does not necessarily mean more winning companies. Startup fundraising is often a demand based process. If the market or vertical is hot, demand will increase amongst VCs, and the higher the valuation soars for the company.
And more VC funds means additional demand. This combined with fewer companies being created is driving demand to greater levels and in turn inflating valuations to Unicorn-esque levels. But remember, every company will eventually be valued at what they are truly worth. And as companies raise mega rounds to stay private longer, the jury (the public markets voting with their wallets) is out on their true worth.
Additionally, Fred Wilson argue that the “software eating the world” narrative has captured any “tech” related company. As he recently wrote,
“I believe that we have seen a narrative in the late stage private markets that as software is eating the world (real estate, music, exercise, transportation), every company should be valued as a software company at 10x revenues or more.
And that narrative is now falling apart.
If the product is software and thus can produce software gross margins (75% or greater), then it should be valued as a software company.”
Pair the simple supply and demand imbalances with irrational revenue multiples and we have to question the sustainability of current valuations. Will these high valued companies fly too high and close to the sun, like icarus, to come crashing down?
What do you think of the recent funding climate? Download our Q3 Venture Funding Report to access the data behind our post.