Are unicorns real? That’s a question a lot of investors have to be asking themselves these days. To investors a “unicorn” refers to privately held companies with valuations of $1 billion or more. At last count, there are 145 of them, according to CB Insights, a number that robs them of any uniqueness. About the only resemblance these sought-after startups bear to their ancestors from medieval bestiaries is their mythical status.
For many reasons, we've chosen not to join the chase. Now in our fourth fund since 1999, we have slightly less than $1 billion under management. That, plus the 2,700-mile distance from our headquarters in Charlotte, N.C. to Palo Alto, probably puts our growth equity firm out of the running for unicorns. Even so, we would never put these beasts in our sights. Here’s why:
Real unicorns are truly uncommon. For every Uber, Pinterest or Palantir, there’s a Gilt Groupe or a Groupon, companies that launched with amazing trajectories but have since faded. Even successful high fliers like Spotify and 23andMe have had trouble proving the durability of their business models. Fact is, the true payday titan (10x plus) is a rarity. We would much rather stalk small, but lucrative prey: B2B software and tech-enabled services companies with valuations between $50 million and $100 million.
To join the unicorn hunt, you have to be an Andreessen-Horowitz or a Sequoia Capital at the start of the chase or a DST Global at the end of it. Since competition to get in the game is fierce for the most hyped opportunities a well-established Silicon Valley franchise and large investments are required. It also means sharing the spoils with Series C, D, E and even F investors. We tend to go our own way on deals, seeking direct alignment with management teams of potential growth companies that are typically outside of the major tech markets where potential unicorns reside.
When pursuing unicorns, you commit to high expectations and a narrow set of outcomes: It’s generally IPO or die; swing for the fences or strike out. Even an IPO may not meet some investor expectations. You have only to look at a company like Square, which just went public at a valuation of about half what it was worth a year or so ago, to see the fate of many rare beasts. Our preferred profile is to invest in B2B companies already executing in smaller but well-established markets. We find it more fruitful to focus on the risks of execution and teamwork, rather than the perils of technology development and consumer adoption — the more common birthing grounds for unicorns.
Most unicorns require significant feeding to grow. If they’re pioneers, they need to spend mightily to introduce themselves and create awareness. Big data companies must pour on the resources to develop their systems. Consumer-based unicorns are generally not capital-efficient models, either, having to spend mightily to gather the necessary market share. We’re happy to write $10 million to $40 million equity checks, then we help the management team deploy the resources to fund responsible growth in an established market catering to enterprise customers versus consumers.
There’s no rule that says an entrepreneur’s swollen head is directly proportional to the size of the latest funding round or to the celebrity of their investor. But investing in unicorns is a game unto itself. Most of our entrepreneurs are more focused on down-to-earth advice and lining up with objectives and culture of an investor. Launching and expanding any company can be humbling. We like to establish close, long-term relationships with our portfolio companies, adding value pre- and post investment. We’re all after the same goal: successful growth with an attractive risk/return profile.
Big IPOs tend to get all the buzz. So do multi-billion-dollar acquisitions. Fact is, most of M&A in technology involves less sexy companies in the middle market. These much more modest exits still provide great returns for investors and management teams as long as the companies are not over-capitalized and focus on reasonable valuations that don’t require a big public offering. We target much smaller loss ratios and a 3X-5X return on our typical investment. These exits tend to be found in the private markets, with strategic acquisitions or sales to larger private equity groups. Those deals don’t always create headlines or huge offerings but the strategy rarely disappoints and it makes for happy investors who keep coming back.
Truth is, you don’t have to be a unicorn to be great technology investment.
Seth Harward, a principal at Frontier, contributed to the post.