PlayBook 2Q 2019

Beyond the unicorn summer

June 13, 2019
This story is featured in the 2Q issue of the PitchBook Private Market PlayBook.

On the morning of May 10, Uber CEO Dara Khosrowshahi took a proffered gavel and, surrounded by a bevy of longtime employees, drivers and more, officially rang in the most anticipated initial public offering of 2019. Uber, the poster child of unicorns, was finally trading publicly.

As the epitome of a new era in venture capital, the IPO represents a significant milestone in a saga that blended narratives in finance, technology, entrepreneurship, corporate misbehavior and best practices, and all their intertwined effects upon Silicon Valley, for most of the past decade. For weeks to come, we'll see dozens of takes from the glib to the ponderous regarding what Uber's IPO means for unicorns, venture capital and more. But there's a bigger picture, beyond Uber alone. There are potentially dozens of unicorns going public in 2019. What could that slew of debuts entail for the venture landscape? What could 2020 look like, after a year of unicorn IPOs?

Background

Unicorn exit value has ramped steadily over the past several years. As of early May—and even excluding Uber—2019 had already yielded $57 billion in total exit value. Last year saw a decade-high of 21 unicorn exits valued at a cumulative $49 billion. Even if some of the unicorns debut inauspiciously or trade down post-IPO, there are two things that often go unnoticed. First, any company can have a bad quarter or dip upon public debut; it takes longer to truly judge the efficacy of underlying business models. Second, venture economics are still playing out precisely as they are intended to.

By and large, most backers—especially traditional venture capital firms that invested at earlier stages—are still netting large returns. Many venture-backed unicorns are yielding more-than-sufficient value to justify their remarkable run-ups in private valuations. As paper gains finally translate to sellable securities over the coming months, long-awaited liquidity for thousands may result in a well-known phenomenon that has characterized Silicon Valley cycles for decades: the recycling of capital back into the startup and venture ecosystem.

Dealmaking

A bigger pool

While multiple new millionaires are minted throughout this year with each successive unicorn debut, even more employees with substantial compensation may look to cash out once lock-up periods are over. The impact of new angel investors, as well as new entrepreneurs, upon the ecosystem has been observed before, with the "PayPal mafia"—including Reid Hoffman, Elon Musk and Peter Thiel—especially well-known, in addition to the newly emergent counterparts from the likes of Facebook and LinkedIn. With both pools of participants in the founder-investor dynamic thus enlarged, the earlier stages in the capital stack are set for increases in competition among new and repeat entrepreneurs, as well as capital availability.

Across the capital stack

As Redpoint Ventures partner Tomasz Tunguz observed recently, the fundraising environment has never been more sophisticated than it is now, with even the seed stage diversifying into pre-seed, seed and post-seed. Such diversification in search of differentiation should only intensify. This process is contingent upon post-unicorn exit employees obtaining liquidity, again, so it shall unfold over the next few years, with the early stage impacted first. In a recent interview, Iris Choi, partner at Floodgate Fund, said increasing the supply of prospective founders and investors at the earliest stage in the capital stack only broadens the entire pipeline eventually. So even the midstages of Series A and B will eventually experience the impact.

At the late stage, dealmaking has been remarkably hot for some time. No matter how overheated the market has appeared, VC invested and late-stage valuations continue to reach and hover around record marks. After the slew of unicorn debuts throughout 2019, late-stage dealmaking should remain elevated, at least maintaining current levels.

Multiple traditional venture firms are banking rich returns from the spate of unicorn IPOs this year. VC fund managers still have massive hoards of capital to dispense, either having already raised large funds off the strength of their performance—no fewer than 11 venture funds closed upon $1 billion or more in the US last year—or embarking on the fundraising trail relatively soon. A considerable number of late-stage valuations are being validated and will be validated in public markets regardless of initial performance due to investor entry prices and protections, encouraging repetition of the investment and company growth strategies that have positioned the current class of unicorns for success.

In turn, more companies will follow the paths the current and exiting herd of unicorns have blazed, supported by the capital infusions of the investors that successfully backed their predecessors. The number of companies that could become the next wave of unicorns is significant—80 within the US alone raised financings since April 2018 at post-money valuations of $750 million or less. That's just one slice of a much larger pool of companies that are either ramping up to achieve significant growth velocity or are already in the early stages of doing so. In short, the supply of companies for late-stage VCs to back is ample and growing. With the supply of companies and demand for exposure to said companies both expanding, the equilibrium for late-stage levels of investment will at minimum stay strong, as investors seek to replace exiting unicorns in their portfolios.

Nontraditionals are here to stay

Finally, nontraditional VCs will continue to play a critical role in the formation of unicorns, as well as general late-stage dealmaking. Even if some hedge and mutual funds have pulled back from past rates of participation, many are staying active within the late-stage market, particularly as the boundaries between certain arenas of public markets and private markets blur increasingly.

Formerly, pockets of the public markets contained smaller, faster-growing companies that were worth their levels of risk in exchange for prospective growth. Now, as much of that growth occurs privately, investment managers are looking to obtain exposure in that market—hence the advent of nontraditionals into the late-stage venture market in the first place—or a ramp up of their existing VC participation. Some investors in the later-stage fundings of unicorns may end up under water relative to prior private valuations, but given typical late-stage protections of capital invested, the incentive to continue gaining priority access to potential blockbuster companies by staying active at the late stage will trump some underwhelming results. There's a big difference between not seeing hoped-for upside and losing your capital.

Exits

An exit crunch?

Even as 2018 waned, there was much chatter about how 2019 could end up finally recording the long-anticipated slew of mega-IPOs by unicorns. The list of unicorns rumored to be preparing to go public ballooned. From Slack to Postmates, unicorn after unicorn made it official. The potential payoff from a summer of unicorn debuts is obvious yet hard to predict, contingent as it is upon the vagaries of markets. However, there is a consideration that has remained less discussed. Could there be a unicorn exit crunch?

There are well over 100 unicorns in existence, with seven officially announced to go public or be acquired as of early May. And whether or not they ultimately follow through, there will be plenty of unicorns ready or preparing to exit come 2020; herein lies the crunch, as it is uncertain all will be able to do so next year, much less in 2019. Based on initial results from unicorn debuts, realistic investor demand, and increased market choppiness due to macro concerns around trade wars and ever-present political uncertainty, concerns are well-founded.

The question of whether there is enough demand on the part of investors to be quenched by dozens of unicorn debuts remains unresolved. It's not a matter of just overall market demand, although the vastness of public markets engulfing one unicorn per week from here on through the end of 2020 is hard to fathom. Matt Levine, noted Bloomberg "Money Stuff" columnist, made a cogent point recently. He observed that given the blurring of lines between private and public markets, some of the investors that would have bought into Uber's IPO already had gained their desired exposure via participation in late-stage private rounds, which might have removed some potential demand that could have propped up Uber's IPO.

So not only could some demand that used to be historically built in now cease to exist, even the most prominent unicorns that are going public are being affected. As these more notable and well-established unicorns go public throughout 2019, with investors' thirst slaked between their mega-rounds and IPOs, there may not be much of a market for the remainder.

Multiple unicorns may need to look at their array of options and consider that perhaps public markets in 2019 may not be as balmy as first supposed. The waiting line for exits via public market will extend, as some push out their expected listing date into 2020, or even beyond. Especially if markets remain more subdued and significantly choppy after recent highs, will many still elect to list next year after pushing beyond 2019? For the companies that can't bill themselves as the next Zoom or PagerDuty–enterprise-focused businesses with robust metrics—establishing a strong IPO in a volatile market will be difficult. Consumer-predicated platforms are often buzzier, it's true, but bear more risk, as is seen in the Lyft-Uber dichotomy. Primarily outliers succeed, and, even among unicorns, few are such outliers.

The unicorns unwilling or unable to go public in 2020 then will have to resort to alternative means for liquidity or form new strategies for extending their lifecycles as private companies. Should some need to return to the deep well of private capital, they will not only invigorate late-stage dealmaking but also be able to provide liquidity to investors, much like Uber did. In the meantime, they also will have access to increasingly diverse sources of liquidity, such as secondary exchanges, to relieve the pressure from the very earliest employees and investors. Granted, they will have to make their case for another infusion of late-stage capital, but many have been successful in doing so thus far.

The road less traveled

Much of the focus upon the class of mature unicorns has spoken only of IPOs as an exit route, and for good reason. Not many companies can offhandedly buy a $1 billion-plus enterprise, after all. However, that doesn't preclude all potential buyers, and M&A as an exit route for unicorns could increase in popularity. M&A at scale is unlikely for the largest unicorns, but not necessarily all. For example, had Microsoft not invested so much time and money into its Teams product—a platform like Slack—it potentially could have acquired Slack to better integrate its tools into Microsoft Office Suite and Azure workflows. In addition, if unicorns are not able to garner the types of exits desired via public markets, strategic acquirers could sense greater opportunity in cutting more reasonable deals, avoiding sky-high premiums.

Fundraising

As investment firms see their savvy bets in unicorns pay off, their case for fundraising only grows easier to make.

But the slew of unicorn debuts in 2019 will do more than just make it easier for their backers to distribute loads of capital to limited partners and consequently re-raise with ease. It will also encourage some to evolve their fundraising strategies or take them to the next level.

Consider the case of Sequoia Capital. After backing Zoom and turning a $100 million investment into a $1 billion stake (or thereabouts), what do you do next? Raise a similarly sized fund and do it all over again? Granted, the case of Sequoia is somewhat of an extreme, but they are the paramount example of what some of the more prominent backers of unicorns are going to opt for: raise even more funds and replicate the successful strategy at greater scale, and elsewhere. Right now, Sequoia has four open funds, even after closing five of varying sizes and strategies. Some of those funds are dedicated to exploring opportunities in China; others are focused elsewhere.

Stick with what you know. A common adage that is often mistakenly used to signal a diminution of ambition, it actually exemplifies a distinct type of ambition: achieving consistent excellence. It's also the phrase that managing partners often use to explain why they are raising a similarly sized fund. Benchmark Capital, for one, even after its potentially record payout from Uber's IPO, is raising a ninth flagship fund of $425 million. Its prior flagship fund's size? $425 million. Granted, its sidecar vehicles have grown modestly, but the firm's decision to hone its investment thesis in a size category it knows well makes plenty of sense.

The economics of venture have stayed the same even as the entire capital stack has inflated gradually and continually. Although managers may have had to raise larger vehicles to keep pace with expanding Series A rounds, for example, they are able to deploy their hard-earned experience within that arena for companies facing growth challenges at that stage. It's an eminently sensible strategy, in the end, and one that will persist for multiple investment firms, even those that backed unicorns.

To 2020 and beyond

Sometime by the wintry close of this year, a different bevy of C-suite executives, prominent investors and others will gather around a podium at a vaunted stock exchange. A different CEO will take a proffered gavel, and ring in the symbolic debut of the last venture-backed unicorn to go public in 2019. But that will be far from the end of what this year's slate of unicorn IPOs could entail.

This year's surfeit of venture-backed unicorns looking for an exit will exert a considerable impact upon the entire venture cycle. Whether continuing to propel late-stage dealmaking in order to grow just that much further; innovating approaches to liquidity while establishing a new paradigm for staying private longer; or exiting and vindicating their backers' strategies tenfold, the current herd of unicorns will transform the venture ecosystem. It's too early to tell if the change will be for the better or for the worse; for now, we only know it is going to come.

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