Checking in on the herd of unicorns

Magical Unicorn Forest by Catmando,

Talk about unicorns, up until a few years ago, was usually reserved for discussions about the plot of Harry Potter novels or the latest Lisa Frank product. But due to some clever marketing, “unicorns” are now the talk of Silicon Valley.

The term refers to privately held companies worth more than $1 billion a piece—and they’re some of the U.S. economy’s most hyped companies. Think Uber, Airbnb, and Dropbox. But with the proliferating number of these private companies, investors and commentators have started to wonder whether the whole endeavor is a repeat of the tech bubble of the late 1990s and early 2000s. Whatever the case, the rise of the unicorns does point to something interesting about the state of U.S. businesses overall.

During the dotcom frenzy, the exit strategy for young tech firms was an initial public offering. After an IPO, the firm would be listed on a stock market and the company could raise funds from public investors. But unicorns and their ilk seem happy to stay private for much longer. This trend isn’t restricted to high-growth tech firms, however—the number of public firms in the United States actually peaked in 1998. Companies are far less likely to go public than they were in the past, but the exact reason for this hesitance isn’t well understood.

The Economist would have you believe that the shift to private ownership is because companies have just realized that private ownership is superior in most cases to public ownership. In the case of public companies, according to the magazine, the lines of ownership are no longer clear. On paper, shares of the company are owned by public investors, often workers through retirement accounts. But these shares are really held by asset management companies in the form of mutual funds. This opacity doesn’t happen in private companies, as owners and managers are often the very same people.

While it’s true that private companies can specifically dole out ownership shares to workers, public firms can do that as well via stock options. In fact, the increasing use of stock options for compensating executives at public firms seems to mirror The Economist’s belief in such a tight integration between owners and executives. Of course, some research has argued that increasing concentration of ownership among mutual funds has resulted in anti-competitive behavior among firms.

It’s also worth noting the incentives of one set of key investors in unicorns. Venture capital firms eventually have to show a return to their own investors, and have specific funds that need to be closed, usually over a 10-year period, so that their invested dollars are returned with, well, a return. An eventual exit of these high-growth unicorns onto public markets or their sale via acquisitions by public or private companies seems likely given the needs of their venture investors.

If these unicorns do go fully public, some may reserve a special class of shares that actually maintains the control of the founders, as Facebook did. Businesses in other sectors of the economy might continue to stay private or take another form for a variety of reasons, but the unicorns seem to be outliers in this regard.

But while these unicorns remain private, there’s fear that they are just the latest bubble to arise in the U.S. economy. Given the track record of predicting bubbles, it’s hard to say for sure what will happen. But if the valuations of these companies do crash, it seems unlikely that the fallout will be anywhere near the damage done by the bursting of the housing bubble.

For starters, the potential unicorn bubble would affect an incredibly small share of the population that has the ability to invest in these companies. A dent in the net worth of those rich individuals who have the wherewithal to invest in venture funds or directly in high-tech startups would have a small impact on consumption across the entire U.S. economy. The reason: An equity bubble is nowhere near as bad as a debt bubble—as the dotcom implosion proved—for either long-term share valuations or the severity of the ensuing recession. But who knows. Maybe the valuation of unicorns will stay high and nonbelievers in these new firms will be shunned.

While it’s tempting to believe in unicorns as the future of the U.S. firm, they are outliers in important ways. Yes, U.S. businesses are increasingly likely to be privately held, and there has been a movement toward non-corporate business types. But these companies are high-growth start-ups in an economy with a declining start-up rate. Holding them up as a new model for the U.S. economy doesn’t add up. They are, it seems, just horses of a different color.

October 28, 2015


Nick Bunker
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