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Evaluating the Risks and Rewards of Unicorn Capital

July 2, 2015

This post originally appeared in TechCrunch.

This is the best time to raise money for your startup. At least since 1999. But raising money can be a double-edged sword for entrepreneurs—and receiving a high valuation can cut two ways.

First, some context. According to the April 2015 MoneyTree report from PwC, investments in later-stage companies rose by 50 percent, to $4.2 billion, in the first quarter of 2015, the largest quarterly total invested in later-stage companies since Q4 2000. Meanwhile, CB Insights recently reported that mega-financings in billion-dollar unicorns increased to more than 300 in 2014, compared to fewer than 70 in 2010—a staggering 394 percent increase.

Even in this frothy environment, it’s important for entrepreneurs to have a deliberate financing strategy. It’s great to raise money with little ownership dilution to existing shareholders. But raising money at a high valuation comes with its own unique set of challenges; it increases the “Preference” (the private equity raised all gets paid back before Common shareholders, the founders and employees get a dime), and it adds increased pressure for performance to justify the price.

It also comes at a time when exits are hard to find. The IPO environment is tight and, on the M&A front, a sky-high valuation makes a startup harder to acquire if ultimately it’s not going to become a standalone business. The numbers are starting to bear this out. Last year, six VC-backed companies exited for over $1 billion via M&A by May, with a total value of $30.9 billion, according to CB Insights. However, during the same period this year, there was just one unicorn exit:, which was acquired by LinkedIn for $1.5 billion.

In spite of these challenges, investors are still bestowing unicorn status on questionable startups in crowded markets. Why? Plain and simple: FOMO. But not every unicorn is an Airbnb or an Uber (where Menlo is a Series B investor). These two companies, along with several others, have proven business models and are disrupting massive industries. They have phenomenal unit economics and market leadership. Most unicorns, however, are not in the same league.

And if you’re not, you can’t assume there will be a future investor willing to pay a higher price. That’s why you need to make sure your financial results—revenue, growth and profit—justify your valuation. Neither can you assume the current multiples on financing rounds will continue.

Yes, raise money when it’s available; but spend it wisely. And remember that too much growth too fast can sometimes backfire if it isn’t profitable and sustainable.

As a founder, it’s also important to understand how high-value rounds are structured. The unicorn rounds of today are not traditional growth-stage venture investments. Often, they’re led by deep-pocketed mutual and hedge funds with entirely different expectations than a VC, including the kind of return multiples they expect to make and the length of their holding period.

For these investors, it may make sense to participate in a unicorn round, or, better yet, a whole basket of them. With many companies deferring public offerings, and with so much value accruing before the IPO, they can get a lot more upside by getting in before the company goes public. These growth-equity players are not necessarily looking for venture-like returns. Plus, their investments in these rounds are a tiny fraction of the capital they have under management.

What’s more, valuations on paper mean nothing until there is a market for the company’s equity. Many of these high-priced rounds have a ratchet or even a discount to the IPO price. In the case of companies like Box, New Relic and Hortonworks, all of which went public at a valuation lower than their final private-round price, their investors effectively got to reprice their shares at the IPO, so there was very little downside risk for them.

So, a billion-dollar valuation can be subject to revision in the public market. Who gets hurt? The employees and early stage investors who might be taking more dilution than they expected at the notional price of the prior financing.

Despite the current hype over unicorns—and the desire of many startups to be one—successful entrepreneurs know that great companies are built over time. Ultimately, the markets will determine your company’s valuation. Create a financing strategy around the milestones your business needs to achieve, not as an end in and of itself. Follow those objectives and you’ll succeed in building an enduring, market-leading company—unicorn valuation or not.