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Unicorns are finding it harder to run with the pack as valuations tumble

May 9, 2022, 12:00 PM UTC

Kevin Kelleher here filling in for Jessica who will be back Tuesday with a new earlier Term Sheet send time. Start looking for this newsletter in your inbox at 8:15 ET. 

Maybe we should start calling them thoroughbreds instead. Unicorns—private startups valued above $1 billion, so called because they seemed once a rare and magical beast—have become a ho-hum, run-of-the-mill breed. Agile and quick enough to win races, perhaps. But unique? Not so much in 2022.

CB Insights counts 1,101 unicorns around the world, with a cumulative valuation of $3.67 billion (or an average of $3.3 billion per unicorn). Some 522 of them joined the growing herd of unicorns in 2021 alone. Another 142 have emerged so far in 2022, led by visual collaboration company Miro and Elon Musk’s The Boring Company, valued at $17.5 billion and $5.7 billion, respectively. The data shows that 53% of global unicorns are based in the U.S., with another 16% in China and 6% in India.

But if the number of unicorns is growing ever higher, the outlook for their funding ahead is getting more uncertain. The Federal Reserve raised interest rates a half percentage point Wednesday, the largest increase since 2000, with Fed Chair Jerome Powell saying that similar boosts “should be on the table for the next couple of meetings.” Powell further warned that in June the Fed would start reversing its generous quantitative easing policy, which could dampen investor demand for highly valued companies.

Already, market anticipation of the Fed’s move to head off inflation have taken a toll on public tech stocks. The Nasdaq Composite is down 22% this year—with 77% of the index’s stocks in a bear market—and the S&P’s tech sector has dropped 19%. Former unicorns that graduated to the public stock market have been hit hard: Uber, Meta, Block, and Shopify are all down between 36% and 70% this year. 

But what about the unicorns still private? VCs tend to take the long view with their portfolio investments, and the relatively illiquid nature of private markets can act as a sort of sea barrier to protect against the storms that roil public markets. History suggests they may also be in for some lean times as the IPO market grows less friendly.

Consider that the first quarter of 2022 saw 37% fewer IPOs raising about half the haul seen a year ago, according to Ernst & Young. In total, last year saw 400 U.S. companies stage IPOs, led by names like Rivian and Didi. Other companies like Sofi and Talkspace merged with SPACs to secure a public listing. Many of those recent debuts have seen valuations tumble back to earth: Rivian is down 72% in 2022, while Didi has fallen 65%. Sofi and Talkspace are down 59% and 34%, respectively. 

“Up until a few months ago, it seemed those valuations would stay high,” says Will Gornall, a finance professor at University of British Columbia’s Sauder School of Business. “But now things don’t seem so great. Talking with VCs, my impression is they aren’t making deals partly because no one wants to offer a term sheet that’s half the valuation that the founders are expecting. They’re waiting for that reality to percolate out.”

One hard new reality startups can expect: more demanding terms to shield late-stage investors. Gornall co-authored a paper with Ilya Strebulaev of Stanford’s Graduate School of Business that outlined a new model for valuing unicorns. The paper looked at post-market valuations for 135 U.S. unicorns and found that they exceeded fair value by an average of 48%, thanks in part to complex protections offered to late-stage investors such as IPO return guarantees and seniority over other investors.

Gornall and Strebulaev haven’t updated their paper since December 2019, but the valuation model they developed offers that some takeaways may apply to private unicorns in 2022. If investor protections are a key reason that post-market valuations enjoy a premium to fair value, they may become more common in a down market. Startups forced to raise money in a down round may be further hampered by anti-dilution provisions aimed at protecting existing investors, Strebulaev tells Fortune

Gornall notes that during last year’s robust market, founder-friendly terms were generally favored over investor protections, but that could change if companies become hard pressed to raise money. “If we see a downturn, I would expect companies will issue more terms that promise investors all sorts of rights and features,” he says. “That could mask valuation declines, but that doesn’t mean these companies are not struggling.” 

In other words, unicorns are transitioning from a private market friendly to founders to one that favors investors who can endure lean times with ample dry powder. Tighter monetary policy may make it harder to earn the high valuations that were the rule last year. And that may mean many recent unicorns that can’t guarantee a strong exit for investors could end up looking not so special after all.

“History suggests that it may be more difficult for these unicorns to exit via IPO or access public markets in other ways,” says Stanford’s Strebulaev. “As a result, either they will continue raising private rounds of funding, get acquired, or scale down their ambitions to concentrate on profitability.”

Kevin Kelleher
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