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The dangers of chasing unicorns

European countries are promoting programmes to increase the number of unicorns born within their borders. But focusing on $1 billion valuations could foster bad habits and be a recipe for disaster.

Saying the word “unicorn” to a tech/VC audience can induce a number of emotions. These can range from excitement and wonderment at one end, to annoyance and the overwhelming urge to roll one’s eyes at the other.

For many European investors and governments, however, the main emotion now is desire; the desire to grow and nurture their current stable and create even more entities that boast $1 billion-plus valuations. And while venture capitalists and other stakeholders have a clear reason for this—bigger exits mean bigger paydays—policymakers are also increasingly putting money where their mouths are in a bid to fund startups towards 10-figure valuations.

But is this not entirely missing the point?

Home-grown unicorns

Several countries and institutions in Europe are actively trying to recruit the brightest minds to build the biggest companies in their domains. Last year, for example, France launched a ‘Talent Passport’ visa programme which allows foreign entrepreneurs and their immediate families to stay in the country for four years. The nation has also made a swathe of technology investments in support of the ‘La French Tech’ initiative. Speaking at the Viva Tech Conference last year, President Emmanuel Macron famously declared he wanted to make France ‘a country of unicorns’.

The UK, meanwhile, has taken this fetishisation a step further. Following a government review, the British Business Bank launched its £2.5 billion patient capital programme, which it will seed with £400 million of commitments. Investing in funds and startups alongside the private sector, the initiative has the express purpose of helping cutting-edge UK companies reach $1 billion valuations. This is similar to the EU’s VentureEU initiative, a €2.1 billion programme to increase the size of the continent’s VC funds in order to allow them to make larger follow-on investments.

Clearly, legislators want to widen the pool of firms that can invest in high-growth European startups (as do investors themselves) and topple the current US/Asian investor monopoly that dominates the biggest rounds in VC. This is admirable.

So, what’s the problem?

Scaling for the sake of it

Firstly, should the goal of setting up a business be scaling it to an ultimately arbitrary valuation? In general, founders create companies because they believe they have a solution to a problem that people will hopefully be willing to pay for. Growing that business is also important, as Frog Capital partner Shirin Dehghan noted during a discussion on scaling earlier this year.

However, if VC funds are incentivised by government policy to inflate these companies further, then they will end up, more often than not, funding a lot of rubbish that isn’t ready or able to scale to the desired level. This can even happen to the largest privately backed startups. One only needs to look at bikesharing startup Ofo‘s rapid launch in and hasty retreat from the US this year, including the loss of 70% of its staff.

When it works, it works phenomenally. According to DN Capital‘s Steven Schlenker, Germany’s Auto1 has gone from selling 200 cars per month in 2013 to selling 200 times that amount today, with massive rounds from the likes of DN Capital, DST Global and Piton Capital helping that expansion. The company is now worth around €2.9 billion.

However, stories like Auto1’s are the exception, not the rule, and increased attempts at creating more $1 billion companies will, by extension, lead to more failures at doing so. Yet now, instead of less costly, earlier-stage write-offs which can be expected in VC, these failures will cost some firms and LPs tens or even hundreds of millions. US wearables startup Jawbone, for example, went bankrupt last year, having once held a $3.2 billion valuation and raised nearly $1 billion in VC funding from investors including Sequoia and Andreessen Horowitz.

Too much, too soon

As the amount of capital at the disposal of VCs increases, so does their need to generate larger returns in a shorter timeframe, as dictated by the traditional venture fund lifecycle. The length of time it takes for a startup to become a unicorn from their first bit of VC funding has fallen from nearly seven years in 2013 to less than 4.5 years so far in 2018, according to PitchBook data. This leaves less time for startups to test, try out, refine and develop their products, and instead shifts focus to their perceived worth, masking potential underlying problems. It is akin to building an ornate, grand mansion in double-quick time, but potentially forgetting to lay the foundations.

And this is happening as the average age of unicorns rises, meaning that companies are hitting the 10-figure mark earlier and staying private that way for longer.

This is a problem.

The $1 billion question

To succeed, unicorns need to disappear; they need to be sold by VCs at a lofty premium. It brings to mind Bing Bong, Riley’s imaginary friend from the Pixar movie ‘Inside Out’, who had to be forgotten in order for Riley to mature mentally. Billion-dollar private companies eventually need to move on from institutional backing, as painful as it may be, in order to grow up.

Yet with longer hold times, this is no longer happening as much; instead, we’ve seen the rise of private secondary transactions in late-stage startups, with VCs and institutional investors passing around the hot potato among themselves instead of sending it into the public markets.

Which means when companies do eventually go public, it can lead to some spectacular public market failures; ask initial buyers of Blue Apron and Snap stock how they feel right now. This in turn can lead to a vicious circle, where public market buyers become increasingly skeptical of late stage VC-backed stock, and VCs are increasingly stuck with companies they need to sell to meet their LP fiduciary duties. Encouraging larger VC funds would only act as a catalyst for this.

Right priorities

VC has changed enormously in the last few years, and it is understandable why European policymakers would want to keep up with the rest of the world when they see investors from record-breaking VC funds such as NEA $3.3 billion vehicle and SoftBank‘s Vision Fund have so much cash they can invest in whatever their teenage daughters are talking about on Instagram that evening.

However, making unicorn hunting a part of government policy could incentivize VC behavior that leads to rushed investment decisions, starves and agitates public markets, badly burns limited partners and leads to a fundamental misunderstanding of the VC and startup community among the public. A private company being valued at $1 billion in Europe is cause for celebration to be sure. However, reaching that number is the means, not the end—and in the vast majority of cases, shouldn’t be the means in the first place.

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    Written by Sean Lightbown
    Sean was a financial writer in PitchBook’s London office, working on the daily European newsletter. Previously, he worked in both London and New York for Mergermarket, writing and editing white-label reports for accounting firms, law firms and other service providers, covering topics including M&A, private equity and high-yield debt.

    Sean holds a BSc in Politics with Economics from the University of Bath, and is a long-suffering Bolton Wanderers supporter.
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