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Aon Retirement and Investment Blog

Buying a Unicorn on the Cheap

2015 was supposed to be the Year of the Goat. Instead, hot private technology start-ups have stolen the limelight, and unicorns are galloping around Silicon Valley and other technology markets. “Unicorns” are no longer a myth – they are private companies that have soared to at least one billion dollars of value. There are currently over 130 of them.
A confluence of new technology and supporting mega trends compounded by a six-year bull market has elevated private technology company valuations. Venture capitalists have been debating if we have reached another Internet Bubble. 2015 may be truly different from 1999, but can this fervor last? Both sides make compelling arguments. Regardless of one’s position, institutional investors that want to access this technology innovation should consider the risks associated with investing today in these unconventional later-stage managers as well as later-stage venture capital funds.
A brief primer on the life cycle of a venture capital-backed company may be useful. Early-stage venture capital funds the initial development of a new product or service. Once the product or service becomes commercial, the company often requires more capital to assist with growth. Later-stage financing rounds are directed to companies with significant revenue growth, may be at or nearing profitability, and are seeking a larger amount of expansion capital. Early-stage venture funds seek greater returns than later-stage venture funds given their higher tolerance for risk, often targeting 10x versus 3x per investment, respectively.
Today’s start-ups are remaining private longer and are significantly more mature. In the late 1990’s companies four years of age could go public with $20 million in revenue compared to companies today that on average are 11 years old with $100 million in revenue.* Companies seeking growth capital are now looking to the private markets to raise later-stage venture rounds instead of the public markets. Passed in 2012 in the US, the JOBS Act allows small private businesses to raise capital from a greater number of investors before the SEC requires these companies become public. This has opened the doors for public investors to get involved. Public equity managers such as Fidelity and T. Rowe and hedge funds such as Tiger Global have eagerly been investing in private equity technology companies with the goal of capturing some value appreciation if and when the companies do go public. According to PitchBook (a research firm that focuses on private equity), about $59 billion was invested into startups in 2014, and approximately half of this capital was provided by these public managers. The result is that excess returns have shifted from public investors, who previously enjoyed the post IPO (Initial Public Offering) “pop”, to private investors.
These public equity investors are also partially blamed for turning unicorns from mythical creatures to reality. This flood of unconventional private money with lower performance targets is boosting company values. These high values leave little room for error if companies stumble. They also severely limit the opportunity set for potential acquirers – and therefore may thwart financial outcomes. How many buyers can afford companies valued at $1 billion or greater?
Institutional investors seeking access to the venture market should not focus on pre-IPO public funds and hedge funds, but rather focus their investment dollars on early-stage venture capital funds. Early-stage valuations have generally been sheltered from the later-stage market frenzy. Median early-stage valuations prior to a company’s initial funding round has remained steady at around $18 million compared to over $300 million once the company has reached later stage.** Although investing in early-stage venture funds is risky since the technology is not yet proven, early-stage venture capitalists are able to mitigate the risks by investing less capital up-front until the company has hit certain milestones. Early-stage venture capital funds generally lose less in technologies and products that fail compared to the high capital requirements to scale these companies at later stages once the product is widely adopted and growth takes off.
Institutional investors may mitigate their risks by committing to those early-stage venture capital funds that have launched opportunity funds. Opportunity funds allow venture funds to back their early stage companies in later rounds once they have achieved significant growth (and higher valuation). This provides institutional investors an opportunity to have enhanced ownership of the best companies in their early stage portfolio. These funds offer shorter return time horizons (which can lead to higher internal rate of return (IRR)) and lower risk/return than early-stage funds. These funds can also be risky, so it is important to evaluate the team’s skill set in funding later-stage rounds.
Unicorns have become prevalent and are enticing institutional investors to invest in start-ups. Those institutional investors who seek access to this technology innovation should focus their attention on the early-stage venture capital funds who may have access to companies with greater valuation growth potential and avoid the risks associated with investing today in unconventional later-stage funds.
* Andreesen Horowitz, June 2015, U.S. Technology Funding- What’s Going On?
** Cooley Venture Financing Report, Q2 2015.

Shari Young Lewis is a Senior Consultant in our Private Equity research team working out of the Chicago office.   

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.

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