With VCs riding unicorns just to collect their logos, we all stand to lose

Today’s market observers are seeing a new trend: big-name VC firms that are traditionally known for early-stage investing are increasingly jumping into later-stage deals. Why? Just to get these unicorns into their portfolios.

According to CB Insights, VC investment in Internet companies expanded to $19.6 billion in 2014, driven by “mega-financings to a small but growing group.” That’s why the amount of funding was up 67 percent year-over-year, while the deal activity for 2014 was up by only seven percent.

According to Pitchbook, more than 60 percent of all VC-invested capital went to rounds of more than $25 million in 2014, the highest percentage since the dotcom boom. There were 414 rounds of $25+ million last year, 50 percent more than the 276 rounds in 2013. VC capital invested jumped $20 billion from 2013 to 2014, while the number of financings fell by 16 percent.

Historically, private company valuations have largely been tied to valuations in the public market. But there is now growing concern that VC valuations have exceeded reasonable public valuations — a dangerous sign. Facebook’s $22 billion acquisition of WhatsApp has inflated valuation expectations. Meanwhile, potential tech buyers such as Google, Yahoo, Alibaba, Apple, and Microsoft have tens of billions of dollars in cash holdings. Series D+ valuations saw a 50 percent jump from 2013 to 2014. Valuations now exceed some of the closely watched historical exit parameters. We’ve also seen a significant increase in median Series B valuations. Capital invested in late-stage rounds was up to $11.5 billion in Q2 and $10.6 billion in Q4, representing the only two $10+ billion quarters since the dotcom boom. Seed rounds declined to 221 in Q4 versus 564 in Q1 2013.

If last year was the year of the angel, this year is the year of the unicorn. Markets move fast!

CB Insights also notes that Sequoia Capital has invested in the most U.S. unicorns, with 13 portfolio companies valued above one billion dollars. It further reported that “the diversity of top unicorn investors highlights the ascent of a new class of hedge fund, mutual fund, investment bank, and private equity investors clamoring to get into high flying tech companies.”

Reading through the CB Insights data, we find that Kleiner Perkins Caufield & Byers piles up unicorn logos, with 12 currently, but it hasn’t invested in a single one at the early stage; meanwhile, Andreessen Horowitz has 10 unicorns, but only two were early-stage investments. These VCs are willing to stomach zero-percent returns on these companies because it’s probably worth the payoff they get in terms of higher visibility.

In other words, some of these venture capital funds are now, essentially, what used to be called “mezzanine-level” funds and are investing at what may someday seem to be crazy valuations — meaning this may be a very risky game. This “unicorn riding” at high private valuations is likely what is driving the comparative venture return benchmark so high. And I doubt that these private valuations are real and sustainable.

According to David Coats of Correlation Ventures, more than half of VC money invested from 2011 to 2014 has been invested in rounds greater than $100 million pre-money. If the average venture exit value (according to Pitchbook) was $140 million, how does one make money with those figures? If you invested $40 million on a pre of $100 million, yielding a post of $140 million, you would own 28.5 percent of the company. So if the company sold for the average exit ($140 million), you would just get your money back — or a zero percent return. Nice.

If a unicorn is defined at the low end by a $1 billion valuation, and if many of these unicorn riders enter late and own less than five percent of these companies, then about a $50 million net asset value is what a (low-end) unicorn ride is worth. However, if a VC fund typically owns a 15 to 30 percent position in its companies at exit, it gets “unicorn ride equivalency” at company valuations of $200 million to $300 million or even at a valuation substantially below that. Of course, the value of a true early entry into one of the massive multibillion-dollar unicorns — perhaps they should be called “thunder lizard” unicorns? — is staggering. But this is why this whole “unicorn” topic is so misleading and needs to be properly calibrated in order to be intelligently discussed.

It remains to be seen whether, or perhaps how long, the unicorn valuations will hold up. There are so many companies valued at such huge numbers on paper, and I assume those paper valuations are inflated by nontraditional mezzanine stage players who are moving down from public equity investments. The shaky performance of some private high fliers who have gone public may have scared some of today’s unicorns into staying private for as long as possible. This is so that their valuations aren’t determined by a skeptical public and punctured by quarterly earnings releases but are privately valued by a handful of mezzanine investors who may be playing a game of “valuation musical chairs.”

We’ve arrived at a point where private financing valuations are well in excess of what an arms-length acquirer would pay or where intelligent bankers would take the company public. Remarkably, the investment banks have kept a lid on irrational exuberance.

If the holders of stock in these exorbitantly priced companies can’t sell the companies and can’t go public, what happens? Some wildly priced company — that needs capital and has to break ranks and raise at a lower valuation — will crack the market. And it doesn’t take much.

When an over-inflated market runs out of steam, the collapse can be very rapid — and the results can be as messy as getting bubble gum all over your face when a bubble you’ve been slowly blowing bursts. Here is an example. In 1982, when oil was at record levels after the OPEC embargo of 1979, the price of gasoline shot up. As more oil was drilled, the market in down-hole steel pipe — which was needed to line the hole drilled into the ground — was booming, with the land rig count climbing to well over 5,000 from less than 1,000 in three years. The price of this commodity continued to rise for four years, until one day an oilfield buyer told me something fascinating. He said a pipe exporter had phoned in a bid for the buyer’s business, viz, so many dollars per foot of high-alloy pipe. My friend said it sounded a little too high, and that he would wait for other competing bidders to offer a more reasonable price — and hung up. Five minutes later, the same exporter called back my friend with a lower price. That had never happened before, said my friend. It turned out that the exporter’s willingness to bargain meant that the market for down-hole steel pipe was about to crash, and it did — within weeks. On the way out, the expansion of the bubble is slow and steady; not so on the way back in.

Kevin Kinsella is the founder of Avalon Ventures. He has specialized in the formation, financing, and development of more than 120 early-stage companies.