Over the past decade, the hunt for unicorns has become an obsession of investors, the media, founders and policy makers. And in the name of the unicorn, one investment strategy has ruled: a growth-at-all-costs mentality that invests heavily in losses with almost no focus on profitability.
However, the backlash of the public markets against this style of investing, which resulted in the high-profile collapse of the WeWork initial public offering, has left venture funds from San Francisco to Shanghai questioning the credibility of this unicorn-hunting, growth-at-all-costs investing. Alien concepts like ‘positive unit economics’ and ‘gross margins’ are now topping the agenda in venture capital boardrooms. But it is worth understanding how we got to this point and what it could mean for both investors and founders.
There are three substantial structural pressures driving venture capitalists to search relentlessly for billion-dollar businesses.
VCs need startups to grow fast to help them raise their next fund
Firstly, most venture funds have a 10-year lifespan, which means venture capital funds need to invest for the first three to five years and then exit or fundraise further for these investments in the next three to five years.
However, to keep the wheels turning, they may also be launching their next fund at the same time as exiting their first cohort of investments. Unless they can show substantial exits or further rounds of external funding for portfolio companies, they will struggle to raise this new fund.
Therefore, they will be looking to invest in businesses from the outset with a rapid growth trajectory, burning through cash to hopefully secure a quick exit or a sizeable growth round.
There’s too much cash splashing around
Secondly, there is simply too much money in the market. Driven by low interest rates and the hunt for yield, institutional investors view venture as an increasingly attractive asset class.
Likewise, family offices and corporates are more willing than ever to commit to venture funds. This has meant that venture capital funds can raise exceptionally large amounts of investment.
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Between 2009 and 2019, dry powder — the amount of money committed to funds that has yet to be spent — in the global venture industry has more than doubled from $108bn to $245bn, according to Preqin. For context, dry powder in private equity grew only by 50% over the same period.
In order to deploy these record levels of capital in a competitive market, venture capital funds are investing in larger rounds, at earlier stages and at higher valuations; each of these factors creates pressure to deliver growth fast.
The winner takes all
Lastly, a ‘winner takes all’ mentality born in the Valley has dominated the tech sector. Scaling as quickly as possible to blow the competition out the water may work in certain cases — economies of network make a vast difference for marketplaces like Uber and Airbnb.
Ultimately, though, when scale only generates brand recognition, the effect is less defensible. For example, many of today’s tech titans came second: Facebook followed MySpace, Google came after Yahoo! and Amazon came after Book Stacks. Coming second created an advantage, as they learnt from the past and built a better product.
Nevertheless, ‘grow faster than the competition’ is a mantra that persists.
You can’t make a unicorn out of a horse
These three structural pressures will not change any time soon. Even if there is a recession, most funds have enough cash to weather the storm and a few years later everyone will forget the WeWork-fuelled anxieties about profit. And even without a supportive market for initial public offerings, there is a growing number of secondary funds and corporates flash with cash offering alternative exit routes.
“Endless funding and billion-dollar hype will not make a unicorn out of a horse.”
The fact remains, however, that some business models do not lend themselves to this ‘unicorn’ style of investing. Endless funding and billion-dollar hype will not make a unicorn out of a horse.
Instead, these businesses simply perpetuate the illusion of a unicorn until eventually someone — usually during an exit process — realises and reveals that the Emperor, or in this case the unicorn, has no clothes.
It is one thing to fund losses while a unique, revolutionary product is being built on the expectation that it will turn a profit once you can monetise. It is another thing entirely to be funding losses due to poor unit economics, where operational expenditure grew too quickly and was never optimised.
For companies that do not scale in the same way as unicorns nor at the same pace, a different approach is required: capital-efficient growth. At Beringea, we manage evergreen funds that do not have the same structural pressures of traditional venture capital funds. We do not need to force our portfolio companies to scale to deadlines dictated either by our limited partners (LPs) or our need to raise new funds.
Instead of chasing unicorns, we can therefore focus on growing businesses with capital efficiency and creating sustainable business models that do not rely on endless rounds of funding.
Both capital-efficiency and the hunt for genuine unicorns can co-exist. However, investors and founders must be honest and recognise early which bucket a business falls into. If a business is not revolutionary, it must abide by the standards of mere mortals: have a capital-efficient business model that can feasibly turn a profit.
The hunt for the elusive unicorn will never end. And that’s fine. But let’s not dress up horses up as unicorns and then get disappointed when they don’t grow horns.
Maria Wagner is investment director at transatlantic venture capital fund Beringea.