You’ve likely come across the term “unicorn” when digging into new investment opportunities. Likened to the legendary creature often depicted as a rainbow-colored horse with a golden horn, unicorn companies sound like rare, mythical beasts.
These companies are indeed rare and can be difficult to find, yet many have massive followings behind them. The allure of finding a unicorn often drives investors to dive in as soon as they see one for fear of missing out on a rare opportunity. But is that really a good idea?
What are unicorn companies? Are they worth your hard-earned investment dollars?
What Are Unicorn Companies?
The term unicorn company is used to describe a privately held or startup company with a valuation of more than $1 billion. Seems simple enough right? So, why is it that unicorn companies are so hard to find?
Because it is incredibly rare for a company to reach a valuation of more than $1 billion without the help of the public markets. For this to happen, one of two things has to be true:
- A privately held company has generated such strong sales that a valuation of $1 billion or more is justified by this incredible performance.
- A startup company has an idea that’s so innovative that even the experts are willing to throw caution to the wind for a chance to get involved in what may become revolutionary technology.
That doesn’t happen often.
Venture capitalist Aileen Lee, who coined the term, described four main categories of unicorn companies, which include consumer audience, e-commerce, software-as-a-service, and enterprise software. Her research showed that the vast majority of unicorn companies were split relatively evenly across these four key business models.
Where Did the Term Unicorn Company Come From?
In her now-famous 2013 TechCrunch article that popularized the term unicorn company, Lee explained that on average since 2003, only four unicorn companies are born each year in the United States. Only 0.07% of U.S. venture-backed software startups reach a $1 billion valuation.
That’s a huge statement that goes to show just how difficult finding these companies can be. The means just seven of every 100,000 tech startups will ever find their way to a billion-dollar valuation. Most of the few that ever make it to that point will do so over time, not in the startup phase.
So, unicorn companies are incredibly rare exceptions, reaching that prized billion-dollar valuation while still in the startup or privately held stage. They are so rare that an elusive, mythical creature seemed like an appropriate way to name the group.
Examples of Unicorn Companies
Keep in mind that unicorn companies are startup companies that have grown to be worth more than $1 billion. That’s exceptionally rare, but it does happen. According to CBInsights, there are currently more than 400 unicorn companies in existence today around the world, including many in the U.S. and China and several in India, Germany, South Korea, and the United Kingdom. Some unicorn companies that you may have heard of include:
- Airbnb. Founded in 2008, Airbnb quickly grew to become the online vacation rentals hotspot. The application gives homeowners a way to earn money from investment properties or their own homes when they are traveling, and gives travelers a wide array of lower cost, higher value options for rentals during their vacations or work trips. The company is currently planning an initial public offering (IPO) and has been privately valued at $31 billion according to The New York Times.
- Epic Games. Epic Games is the creator of the smash hit video game Fortnite. The company has also seen success with its titles Infinity Blade and Unreal Tournament. Epic Games reached a valuation of more than $17 billion long before any plans of an IPO.
- DoorDash. Finally, DoorDash is a food delivery service that adds a delivery component to restaurants that didn’t previously offer the service. The move proved to be a great idea, resulting in a startup company with a value of more than $13 billion and that has reached as high as $16 billion.
One similarity you’ll notice among all of these companies — other than the fact that they have tremendously high valuations — is the fact that they are all in technology. Looking at the full list of unicorn companies on CBInsights, you’ll find that nine of the top 10 unicorn companies by valuation are centered around innovative technology in one way or another.
Pro tip: If you’re thinking about adding a unicorn company to your portfolio after they go public, make sure you do your due diligence. Stock screeners like Trade Ideas can help you narrow down the choices to companies that meet your requirements. Learn more about our favorite stock screeners.
Traditional Risk Evaluations Are Thrown to the Wind With Unicorn Investments
Before you consider investing in unicorn companies, it’s important that you understand the risks. When it comes to unicorn companies, the fear of missing out — often abbreviated FOMO in investing circles — leads to uncalculated investments in which risk evaluations tend to be placed on the back burner.
Unicorn companies have often created something so innovative that even institutional investors struggle to agree on a valuation, and may be willing to value them far above what the average company would get at a general fund-raise.
There’s incredible risk in that fact.
By the time a unicorn company makes it to the public stage, venture capitalists and other institutional players have taken their positions at relatively low rates compared to the high current value of the investments. Because unicorn companies are worth more than $1 billion by nature, their IPOs tend to be quite expensive to the investing public, and may take a very long time to provide any return on investment.
For example, take a look at Uber. The unicorn company launched its IPO at $45 per share. In the first year following the IPO, there was only one day in which the stock traded above the $45 IPO price. One year after the IPO, the stock closed at just above $30 per share.
The fact of the matter is that when unicorn company IPOs take place, they tend to be expensive already, and many fall in value. As such, an investment in a unicorn stock is a big bet on the hope that the stock you’re following will be one of the unicorns that flies rather than trots or stumbles out of the gate.
Investing in Unicorn Companies Pros & Cons
As with an investment in any other type of company, making an investment in a unicorn company comes with pros and cons.
Pros of Investing in Unicorns
There are several benefits to investing in unicorn companies. Some of the most impressive of these benefits include:
- You Likely Know the Company. Unicorn companies don’t grow to billion dollar valuations before their IPO without a reason for that valuation. These companies have created something highly innovative. If the product they’ve created is on the market, it is likely a very popular one. If it hasn’t hit the market yet, a large audience likely already knows it’s coming. Think about it, Airbnb hasn’t yet gone public, but if you haven’t heard the name, chances are that you live under a rock. There’s a strategic benefit to investing in companies that you have heard of and know well. Remember, educated investing gives the investor a better chance of seeing growth.
- Some Unicorns Really Do Fly. As their namesake mythical creatures do, some unicorn companies fly following their IPO. A great example of a successful unicorn company is Zoom. The stock debuted at just $32 per share. One year later, the stock was trading at well above $100 per share.
- Innovation Has Long-Term Value. Unicorn companies are the kings of innovation, and there’s tremendous value in that. Those that do hit tend to hit hard, generating tremendous long-term profits. Take a look at Tesla. After launching a unicorn IPO at $17 per share in 2010, the stock has never fallen below its IPO price. Just 10 years later, the stock has multiplied more than 100 times.
Cons of Investing in Unicorns
While there are plenty of clear benefits to investing in unicorn stocks, even the most beautiful rose will have thorns. There are a few drawbacks to consider when investing in these stocks.
- Billion-Dollar Valuations Don’t Necessarily Mean Profits. Although all unicorn companies have valuations at $1 billion or higher, many lack something important: profits. Consider Uber — the ridesharing company is valued at more than $50 billion. However, it has yet to turn a single penny in profits. In fact, the company loses millions of dollars every quarter. Many other unicorn companies follow along these lines, making them risky plays. After all, a company that operates on losses will eventually run out of money.
- Ridiculous Overvaluations. Unicorn companies are generally valued on different metrics compared to others in their sector. Therefore, when looking at fundamental valuation metrics like price-to-sales or price-to-book value, these companies generally come with ridiculous overvaluations. That means that when you invest in a unicorn company, you are banking on the company being overwhelmingly successful and growing at a much faster rate than the average company within its sector. That can prove to be a risky bet to make.
- Lack of History. A unicorn company gets its billion-plus-dollar valuation from venture capitalists and institutions that fund it early on. However, these companies are pre-IPO, meaning that the market hasn’t had the opportunity to price the company. Oftentimes, the market doesn’t believe that the company is as valuable as institutions do, leading to declines once a stock hits the public stock exchange. However, without any trading history, there’s no way to determine how the overall market will value the company.
Tech Unicorns: Dot-Com Bubble 2.0?
At the center of the unicorn company’s anatomy — its heart, so to speak — seems to be technology. Innovative technologies are valuable, and unicorns all seem to center around an innovative technology that will disrupt traditional markets.
However, we’ve seen what overvaluations of innovative technology have done in the past. Just think back to the dot-com bubble. During this time, investors were throwing as much money as they could at any stock with a dot-com in its title. The value on Internet-based innovation was ridiculously high, and it had to come back to earth.
To some degree, the same thing is happening with today’s unicorn companies. Investors are throwing caution to the wind, ignoring valuation metrics that would generally be screaming red flags, and diving into investments that simple due diligence would tell them to avoid.
It’s far from clear that the risk of investing in disruptive but high-priced — and often initially unprofitable — companies is worth the reward. Surprisingly, in some cases, like that of Tesla, the move pays off greatly. Some argue, however, that as technology unicorn companies continue to see increasingly high valuations, we’re seeing what will become the dot-com bubble 2.0.
Should You Invest in Unicorn Companies?
Unicorn companies are exciting for investors because of the significant gains that they can create. However, any time there is an opportunity for significant gains, there’s also the opportunity for significant losses.
Investments in unicorn companies are highly speculative. This means that these investments are made under the speculation that an innovative technology will be a game-changer in a specific sector. Unfortunately, unless you’re a fortune teller, there’s no way to say that for certain.
Just like any other company, unicorn companies can do belly flops, and due to their overwhelmingly high early valuations, their belly flops have a tendency to be incredibly painful. So, it takes a special kind of investor to invest in these types of stocks.
In particular, if you’re an investor with a heavy risk appetite, a strong understanding for technology and the implications of new and innovative technology, and the ability to take on losses and absorb them without losing your livelihood, unicorn stocks may be for you. On the other hand, if you’re not comfortable with risk and don’t have money to lose in the stock market, this is a category of stock that you should stay away from.
Unicorn stocks are intriguing. These companies do the seemingly impossible; they create technologies that are so ahead of their time that they have the potential to change the shape of the entire sector in which they work. In doing so, they fly to billion-dollar valuations well ahead of their peers.
However, there’s a catch. Unlike the mythical creatures for which they’re named, unicorn companies aren’t all perfect and beautiful. While some have the potential to generate significant gains, they also have the potential to generate significant losses.
So, if you’re considering investing in these stocks, instead of making a FOMO-based trade, take the time to do your research and seriously consider whether the technology that keeps the unicorn’s ticker ticking is something that you believe to be revolutionary. Dive into the company’s books, and make an educated decision for yourself as to whether the company’s billion-dollar valuation is justified.