A unicorn in the financial sector is defined as a start-up company valued at more than one billion USD. The 1 billion USD value here has no special meaning, it is purely arbitrary. These are typically in the software and technological fields where the actual real market value can be heavily influenced by time and expectation. Where the current value can be augmented by projections on what the future value of the technology will be, there arise various problems in determining the financial prudence of investing in technology unicorns. These are included but not limited to;
The valuation value of a unicorn is not determined by traditional metrics like a balance sheet but rather by what investors are willing to pay for the company. According to a 2017 study by two professors [one from the University of British Columbia (UBC) Sauder School of Business and another from the Stanford Graduate School of Business] examining 116 unicorns found that over half were overvalued and about 11% overvalued by over 100%. This is a shocking statistic. Over-valuations are achieved using what can be kindly called new era funding trickery. Investment is encouraged in a cyclical basis which separates shareholders, there are minimum funding caps that shut out the less able investors and initial investors are offered lower share prices and less rights than late stage investors. Late stage investors are considered more precious as they are the ones who help start-ups achieve unicorn status. Late stage investors are also offered various perks such as guaranteed minimal share returns, preferred payment on dividends or more voting right per share than early stage investors.
The end goal of the valuation is an IPO or acquisition. Messaging service Whatsapp was acquired by Facebook for a record setting 19 billion USD, despite having no way to generate revenue and no determination that the end user would be willing to pay a cent for a service they have so far been using for free. The only thing Facebook gained here was goodwill from the end user who keeps enjoying the free service and relates this to Facebook generosity.
The willingness of investors to put so much stock in a high – risk investment takes away from the funding opportunities that would have assisted more traditionally valued enterprises.
The devaluation of ordinary shares and perks associated with late stage investment thus demands the prudent investor seek to be a late stage investor in order to have more preference and to maximize return potential. Inflated valuations offer start-ups a competitive edge as they give them a greater bargaining position.
The other issue with technology unicorns is the unpredictability of trends and lack of guarantee on returns. With an inflated valuation, the risk of loss on investments is greater than with real on the ground valuations. Admittedly, the potential profit is greater too and this risk is borne onto the investor.
From an investor standpoint, start-ups also come with higher risk than already established businesses. This is made more complex as valuations are based on what the future will be rather than what actual returns might be. Technology innovations are expected to grow exponentially and this might not necessarily be the case on the ground. Take Google Glass Incorporated for example, they invented smart glasses. These are optical head-mounted displays that were expected to revolutionize computer interfacing, with a forecast of 0.83 million units sold in 2014 and 21.15 million units sold in 2018 (statistics from statistica.com). This was not the case. The smart glass technology did not catch on and many an investor in Google Glass is crying all the way from the bank!
It is impossible to accurately predict the future and as such, one must be ready to be disappointed after investing in a technology unicorn.
Faith and Discipline
Due to the unpredictability of returns on a technology unicorn, the investor must be ready to invest in the long term and have a predetermined cut off point. This raises the risk of staying in for too long and losing on investment; or cashing out early and missing out on the next Apple or Samsung. This requires a level of faith and discipline that few have, coupled with the financial intelligence to make smart moves to maximize returns on investment.
In conclusion, knowing what you are getting yourself into is key, thus all available information should be processed and used to make a decision. As with any other investment, there is inherent risk but this can be minimized by knowledge. Perhaps a good place to start would be Dropbox or Spotify for local traders as well as international share traders alike.