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Expect More Dead Unicorns

There are 1,170 unicorns — companies with private valuation above $1 billion. More than half of them probably won’t make it.

Why?

More than 700 of those unicorns, 2/3rds of the total, have been minted since 2021.

It’s no secret that 2021 was a boom time for all forms of capital, but late-stage venture was particularly strong.

In 2021, Late-stage VC ($100 million+ rounds) totaled $194 billion in deal value, up 157% y/y. Late-stage VC grew at 23% annually the five years prior. The $194 billion figure was 19x the amount of money invested in the category just a decade earlier and 8x the amount in 2017.

A total of 842 companies raised more than $100 million in a single financing round in 2021, up 153% y/y.

Meanwhile, large scale exits also grew. The number of $500 million+ exits was 99 in 2021, up 106% y/y.

However, the pace of big exits doesn’t seem to be following the pace of big financings. One way to consider this is to divide the number of $100 million+ financings per year by the number of $500 million+ exits. (A $500m exit would be the minimum hurdle for a $100 million+ financing to return capital with preferences, etc.)

That ratio was 8.5:1 in 2021, the highest of the past 15 years.

Mega financings/mega exits averaged about 3:1 between 2006 and 2017.

If 2021 had adhered to a ratio inline with the average of the past 15 years, we would have seen 55% fewer $100 million+ financings in 2021.

There’s half of your unicorns disappearing.

Of course, number of mega exits is a trailing metric, dependent on financings from prior years. I do think it’s telling though. Allocators — VCs and LPs — need to see a path to monetize the vast amount of capital earmarked for large private financings. Perhaps the pace will increase, or perhaps we’ll see a decline in supply of money to mega financings in a return to sanity like we’ve seen in public markets.

Yes, some of the large increase in late-stage capital shifts what had previously been returns captured by public markets (small and mid cap tech) to private markets. But more of it seems to be inefficient capital allocation to companies that will never generate fundamental performance to generate great returns given high private valuations. In a way, private investors are capturing returns that used to go to public investors, but they’re also destroying alpha in the process by overfinancing losers as well.  

As we evidenced by Klarna’s 85% down round of several weeks ago, investors are now demanding prices that reflect the sanity that first returned to public markets.

The new world order in late-stage capital creates three kinds of companies: The Good, the Bad, and the Ugly. It’s the Eastwood Framework.

The Good

A handful of late-stage companies will raise new money at modestly lower to modestly higher valuations. These are the Good. They are true unicorns — companies with outstanding progress, outstanding founders, and outstanding addressable markets.

Of the 1,000+ unicorns, only a few dozen fit this class. Maybe less.

Companies like Stripe (despite their internal markdown), Anduril, Epic Games, SpaceX. There are few surprising names on this list. These are the FAANG companies of the private markets.

The Bad

Hundreds of private companies will raise money at meaningfully lower valuations (40%+) or through structured financings that delay a firm value assessment.

The Bad are not foregone winners like the Good. These companies don’t have dominating command of their markets (yet), markets may be more limited, management likely has less of a golden track record, and progress may be impaired by the prospect of a recession. Picking on Klarna again — sorry Klarna — revenue growth already slowed to 20% y/y in Q122 and would get worse if the economy weakens.

The thing about the Bad is that it’s not all bad. In a world where capital is tighter, the Bad can still access it, and that matters.

The Bad are being chosen as potential survivors and even winners in the longer run, despite exceedingly elevated valuations that never reflected reality. Many of the companies that suffer massive markdowns will still disappoint investors. Some will prove to be great and generate great returns.

The Ugly

Klarna’s raise wasn’t ugly. Ugly is not being able to raise at all. Ugly is being left for dead.

Probably half of the unicorns created last year deserve this bucket.

I don’t take joy in predicting the failure of so many companies. I do take joy in the efficiency of capital markets. Many of the Ugly companies never deserved to raise so much capital at such lofty valuations. In many cases, the excess capital will end up killing the companies.

When young, fast growing companies have too much capital, they can become permanently bloated and inefficient. They rely on broken and unprofitable pricing structures to allure consumers. They over staff with the wrong kinds of players. Sometimes founders even cash out early and lose the drive to lead a great organization.

All these phenomena are direct and dangerous outcomes of generous venture subsidies. Those subsidies are now dead. Many companies will follow.

Notes and Quotes

The Anger Phase

“No one makes money in the anger phase. Shorts go up, longs go down.”

— via Jawad Mian’s Stray Reflections

The Anger Phase almost describes the mid-summer rally of 2022.

Shorts seem to be going up. Longs too, but it doesn’t seem convincing. Maybe that’s just our portfolio.

Maybe it’s not an anger phase so much as a frustration phase. Most investors are long oriented. Sitting in cash is boring. It’s also painful when the market rallies.

We talked about patience last week. Patience matters both when markets are in turmoil or when they’re rallying, which is a natural part of turmoil.

You’ll hear many predictions about whether this is a bear market rally or a substantive bottom. Who knows is the correct answer. Ignore the noise and look for value is even better.

Whether bear market rally or not, this chart nicely frames the length and magnitude of bear market rallies back to the 1970s:

Anger and frustration are typical of bear markets. What we really want is a capitulation phase where people give up on stocks entirely. They swear them off like alcohol after a bad hangover. We haven’t seen that yet, and there’s no guarantee we get it, but that’s what the end of bear markets usually look like.

Complexity and Contagion and Cascades

Maybe it’s just perception of the moment, but it feels like markets adapt faster than ever before.

Speed of market adaptation was top of mind when I read Niall Ferguson’s piece about complexity and adaptation in Bloomberg:

The key point is that social networks today are much larger and faster than at any time in history. That is why the complex system we know as humanity is more vulnerable than ever to various forms of contagion.

Markets are a complex system built on a vast network of human decisions. Markets are also larger than ever, and probably faster per our perception.

Ferguson continued:

…a disaster such as a pandemic is not a single, discrete event. It invariably leads to other forms of disaster — economic, social, political — as well as to other forms of contagion (such as viral conspiracy theories). There can be, and often are, cascades or chain reactions of disaster. The more networked the world becomes, the more we see this.

Consider the last five years. We’ve gone from the despair of Fed tightening and recession fears in 2018, to easing via repo markets in 2019, to catastrophic pandemic in 2020, to epic rally spurred by massive easing in 2021, to vicious bear market in 2022.

You could go back even to 2009 and consider the beginning of quantitative easing and how that led to the easing in 2019 and 2021. You could even go back to the late 90s and early 2000s and consider the lax lending and government policies on housing that created the problems in 2009.

And we could even go back prior to that.

The point is this: Whatever we do now — or perhaps may do in the event of a recession — will have a cascading effect a year from now, several years from now, and maybe decades from now. Those effects will probably only be recognizable in retrospect, and they will happen fast. That's why we need to stay patient.