The rise was like a tech startup fairytale. Within three years of founding, this unicorn company had raised more than $1 billion in venture capital — closing an astonishing $950 million in its final private round at a nearly $5 billion valuation. Revenue growth was skyrocketing from $30 million in year two to $713 million in year three and a run-rate of $2.6 billion in year four. On the strength of these meteoric numbers, the IPO was over-subscribed, pricing well above their $16-$18 range and raising another $700 million. Shares popped 30 percent on the first day of trading. It was the largest Internet IPO since Google.
Just as quickly, the fairytale ended. Amazon, Facebook and Google itself aggressively entered the market. Investors grew skeptical the company could live up to the lofty expectations around users and revenue. Expenses ballooned in pursuit of growth, exacerbating concerns the company could generate long-term profit. Within a year of IPO, the stock price plunged 90 percent, wiping out nearly $15 billion of shareholder value. The unicorn in this fairytale-turned-nightmare? Groupon, in 2011.
Not only did Groupon’s valuation implode, but the entire daily deal category virtually disappeared. The No. 2 vendor, LivingSocial, after raising nearly $650 million in its own right, never made it to its rumored $10-15 billion IPO. The window was closed. Amazon, who invested $175 million in the company, would later write down that investment to essentially $0.
Another daily deal site, Gilt Groupe, sold itself for $250 million after once being a unicorn with a $1 billion valuation. Today, five years later, the category and the companies are all but gone. But the impact on other unicorns or the broader financial markets? Effectively nothing.
There has been a lot of doomsaying lately about the “unicorn problem.” Fortune’s recent cover decried, “Silicon Valley’s $585 Billion Problem.” Self-described “bubble spotter” Vikram Mansharamani wrote about “Unicorns and delusions in Silicon Valley’s tech bubble” on PBS.org. The Guardian predicted “the beginning of the end of the unicorn-driven tech bubble.” CEO of Kauffman Fellows, Phil Wickham, asked on CNBC, “Will Silicon Valley’s ‘unicorns’ gallop off a cliff in 2016?” And on, and on.
An impending financial crisis is an increasingly foregone conclusion in the mainstream media.
Whether it’s a “unicorn apocalypse” or unicorns “losing their horns,” an impending financial crisis is an increasingly foregone conclusion in the mainstream media. The implicit assumption behind every citation of various unicorn lists (currently at 155 companies with a collective valuation of $550 billion according to CB Insights) is that the unicorn phenomenon is a ticking time bomb waiting to explode and a troubling harbinger of a broader economic downturn. From their viewpoint, the number of unicorns and their valuations seem to be only going up — a sure sign of a bubble.
But, for those in the trenches of building technology companies, the signs of a bubble are less apparent. In fact, in many sectors (such as daily deal sites), dramatic crashes have already happened or are well underway. Just as the San Francisco Bay Area has micro-climates in its weather, there are micro-segments within technology.
While Wall Street may lump all unicorn companies together as “tech,” each of these micro-segments can experience dramatically different market dynamics. In other words, it’s not one bubble, but many micro-bubbles — and many of those micro-bubbles are experiencing significant corrections.
For example, our company, Hightail, is in the software-as-a-service (SaaS) category and was originally cast in the cloud file storage sub-category. Starting in about 2010, this micro-segment enjoyed rapid growth, drawing in massive venture capital investment and spawning dozens of startups and at least two unicorns (Dropbox and Box). That growth drew the interest of Google, Microsoft, Amazon and other big tech companies, whose rapid entrance into the market drove down prices.
The repercussions were immediate. Dropbox and Box both lost more than half their market value. Smaller companies, like Syncplicity and SugarSync, ran for the exits — getting sold to larger firms — while companies in the middle, like Hightail, have evolved to serve specific markets and gotten profitable in anticipation of receding venture capital. The entire micro-segment went from inception to exuberance to consolidation in the span of about five years.
What was the macro-economic impact of this correction within the micro-segment of cloud file storage on the larger tech market? Pretty minimal. Box’s stock price has dropped, but that doesn’t mean they haven’t built a healthy business at a rational valuation. Sure, there’s speculation about whether Dropbox can live up to even it’s reduced valuation. But suppose, worst case, they crater completely (which they won’t). Apart from about 1,500 employees finding new jobs, some pissed off investors and some prime office space for rent South of Market, what global economic reverberations would that have? Probably not much.
This pattern of self-correction is one we’ve seen in many other tech micro-segments — for example, social gaming. Zynga was a prototypical unicorn, raising a total of $867 million and closing its last private round at an $8.6 billion pre-money valuation. After Zynga’s IPO in late 2011, the valuation increased further, peaking at a $14.69 share price and a $14 billion market cap.
Within 6 months, the stock price was trading in the $2 range, where it has remained ever since — eradicating $12 billion in shareholder value in the process. The rest of the social gaming segment quickly shook out. Playdom sold to Disney. Playfish sold to EA. Both acquirers shut down the titles and laid off the staff within a few years. Other social gaming vendors, like Kabam, have largely pivoted out of social games. What was once a frothy unicorn micro-bubble in 2012 is now a distant memory, and the broader market barely noticed.
Although valuations might contract, many other pressures on a startup actually relax in a down economy.
Or consider the flash storage micro-segment, pioneered by companies like Pure Storage, Violin Memory and Nimble Storage. Violin Memory is down 89 percent from its 2013 IPO price, and currently trades as a penny stock at $0.79 as activist investors try to force the company to sell. Nimble Storage has plunged from a high share price of more than $50 in early 2014 to its current $7 range, a decline in market cap of nearly $4 billion. And Pure Storage is down 26 percent from its October 2015 IPO price, dropping on its opening day and currently trading $600 million below its $3 billion valuation in its last private round. All these vendors were punished by the market’s rapid shift away from dedicated storage systems and toward hosted solutions (such as Amazon S3).
From streaming music to online real estate, the list of tech segments that have experienced similar valuation declines is long. Each of these categories was once white-hot with multiple unicorn startups; each has just as dramatically corrected. Yet none of these micro-implosions has had far-reaching economic implications. Even within a category, market contagion seems contained. Nobody is speculating that Google is in trouble based on Yahoo’s recent struggles. Twitter’s valuation plummet isn’t driving Facebook’s stock price lower. This is how technology markets behave. They emerge rapidly, grow exponentially, consolidate suddenly and normalize ruthlessly. And through that process, great companies emerge.
At a macro-economic level, this self-correcting property is a wonderful thing. As the hype collapses around certain companies and categories, it helps prevent the entire market from boiling over. The companies that survive become more efficient and profitable. Investors re-focus their capital on more promising segments.
Furthermore, and importantly, the investors in existing unicorn companies have largely been private equity firms, who will sustain losses themselves — rather than those losses being borne by the public markets. Their investments haven’t been hedged or re-packaged as derivative securities that proliferate risk to unsuspecting investors in unknown ways. If the “unicorn problem” is going to cause a macro-economic Armageddon, wouldn’t these micro-corrections have triggered it by now?
That isn’t to say that a contraction in venture financing won’t be painful at a micro-economic level. Certainly, for a number of companies and their investors, this retrenchment will be a huge problem. As Steven Davidoff Solomon insightfully outlined in this New York Times article, liquidation preferences, anti-dilution rights, ratchets and other provisions will divide investors, founders and employees.
There are companies that are burning cash, surviving from financing to financing based on hype and yet, to prove out a scalable business model, will face brutal down rounds, if not outright existential danger. If you’re one of 352 un-profitable food delivery companies, you should be nervous.
But for well-run, profitable companies with proven business models and healthy balance sheets, the market correction we’re already in the midst of feels like a long-awaited rain storm after a California drought (to invert the analogy).
Although valuations might contract, many other pressures on a startup actually relax in a down economy — fewer venture-backed competitive entrants, an easing of the unbelievably tight tech labor market, a willingness by customers to re-evaluate past purchasing decisions. It’s a process akin to burning out the underbrush so the healthiest trees can grow. It’s a necessary transformation that facilitates sustainability of the ecosystem.
In the long term, after whatever economic reckoning occurs, the technology companies that survive along with a new generation of yet-to-be-founded companies will continue to methodically transform every sector of the global economy. This truth is as immutable as the advent of electricity or the internal combustion engine, yet at a magnitude that dwarfs these previous revolutions. It is the defining economic trend of our era and the underlying reason capital will eventually return. And it is why, even in the near term, what pundits call a problem feels more like an opportunity.