Only a small percentage of unicorns are profitable, and their loss-making business models have been called into question by many observers. But the VC industry is well funded. According to PitchBook data, the industry’s cumulative, or undeployed, cash was about $222 billion at the end of 2021, a record high. Tech startups also raised a lot of money—according to Preqin, $476 billion, and CB Insights, $612 billion—in 2021 alone. The Economist reckons that the 70 largest unicorns can cover their burn rates until 2025. This ties in with the fact that secondary pricing for unicorns declined less than the broader stock market. With a shift in investor focus, there was already a slowdown in startups joining the unicorn club in 2022 compared with the previous years, as 308 private startups crossed the threshold in 2022 through November, compared with 596 overall in 2021, according to PitchBook data.
We can expect an increase in acquisitions as investor-backed startups seek consolidation. The reluctance of investors to provide more funding at high valuations will impact unicorns, leading to significant down rounds or failure.
But this process will take time and will only start to gain momentum in a few years. By 2023, the lack of large exits, combined with falling tech valuations and slower startup investment, had made the case for funding a Series D round or later much harder. These factors contributed to pushing US investment at this stage to its lowest point in years. In the first quarter of 2023, total Series D investment was down 92 percent from the peak.
Nontraditional investors, who played a significant role in late-stage funding rounds until 2021 but have experienced significant valuation losses in their portfolios since then, may no longer play the role they once did as providers of capital. Their reduced involvement could impact the availability of capital for unicorns.
In the pursuit of achieving unicorn status and driven by intense competition, startups secured large funding rounds by increasingly granting liquidity preferences to late-stage investors, giving investors in those rounds a choice between a pro rata share in exit proceeds or a preferential repayment of their invested capital. As a result, when unicorns face a cash crunch or consolidation, certain stakeholders may bear the consequences. Earlier-round investors, lacking the protective measures to oppose such concessions, often went along to ensure their portfolio company’s viability in a competitive market. If subsequent funding rounds do not materialize, or the company fails to achieve a favorable exit, late-round investors may recover their investments even if the exit valuation is below the valuation their entry price implied.
Contrary to conventional wisdom, VC investors may thus not be protected by their lower entry valuations and may bear the brunt of such losses. This dynamic challenges the notion that lower entry valuations provide a substantial cushion for early-round VC investors. While a unicorn bubble burst may not pose systemic risk, it could lead to significant write-offs for VC funds and prompt institutional investors to reevaluate their allocations to venture capitalists. Relying on a few investments for outsize returns over a long horizon may not be viable if many holdings are lost and holding periods lengthened. It is uncertain if current stakeholders in unicorns are willing to hold their surviving positions for many years if the risk increases that a significant number of their investments will fail.
Stefan Hepp is adjunct assistant professor of entrepreneurship at Chicago Booth. This is an edited excerpt from his book Private Capital: The Complete Guide to Private Markets Investing. Excerpted with permission from the publisher, Wiley. Copyright 2024 by John Wiley & Sons Ltd. All rights reserved. This book is available wherever books and e-books are sold.