The era of the startup unicorn (a startup company valued at over $1 billion) appears to be at a tipping point—meaning, it is game-over for startups with overinflated valuation based on debt. These subprime unicorns will fail along with the Angels and Venture Capitalists who invested in them.
What is the basis of my premise? It is actually quite simple. From a micro perspective, valuations that are based on private equity investments or growth projections rather than the actual numbers on the company’s balance sheet create disequilibrium. From a macro viewpoint, exchange markets have historically self-corrected to restore balance between buyers and sellers who come together and engage in buying and selling of goods and services.
Take for example, the global financial crisis of 2008-09. Extensive real estate buying led to an overvaluation of mortgage securities. Debt became the primary economic vehicle that buyers and sellers used to engage in the buying and selling (mostly buying) of a host of goods (i.e., , , , and . But debt is a funny thing in that if you play with it for too long, it will bite you.
The market always self-corrects, which means the Unicorn bubble is about to burst!
Raising capital using debt instruments is not sustainable. Too much debt eventually leads to market divestment (decline), which is what happened during the housing market collapse. When mortgage securities (bundled with other securities) began to drop, this caused panic among investors, which led to a domino effect of selling, resulting in the crash of various asset classes—sending the economy into a tailspin of epic proportion.
Like the meteoric rise in the commercial growth of the Internet during the 1990s and the Housing market boom of the mid 2000s, we are witnessing an oversaturation of liquidity (debt) into startup companies. Just in the last few years alone, private equity investors have poured close to half a trillion dollars into startups. We are now in the era of the Unicorn Bubble—where most startups are grossly overvalued and are pricing their valuation based on debt.
By definition and historical precedent, during a bubble, many companies become grossly and insanely overvalued, which drives securities above their value. And this is exactly what we are seeing from Silicon Valley IPOs. In response to this bubble, a valuation reset is inevitable. The market always self-corrects, which means the bubble is about to burst. And when the bubble bursts, the prices of market securities will fall precipitously—this time, wiping out Angel and Venture Capital firms’ equity on a level never before seen.
While a small number of startups will be able to weather the resultant economic fallout when the bubble bursts, the majority of startups will sink—taking many small and large private equity firms down with them. And because “those firms are investing on behalf of others—pension funds, university endowments, millionaires—the economy will feel the effect.” I imagine there are those who insist that private equity investors’ diversified portfolios of highly vetted startups shield them against financial losses.
Just because Angels and VCs are presently making money (not as much as you are led to believe) investing in startup companies does not mean that they will continue to make money in the future. This belief is known as the hot-hand fallacy. It is like a gambler on a winning streak who keeps on playing. Every new win reinforces in his mind that he will keep on winning; therefore, he keeps on playing and betting until he loses.
The reality is most startups go through many cycles of hemorrhaging cash and never become profitable. Pouring funds into startups that have high burn rates is simply not sustainable. What happens when the funding rounds end and the well runs dry? If the economy tanks just a small percentage, then go bye-bye—those companies will become insolvent.
Historical data has shown what happens when valuations get out of hand. The bubble WILL burst!