Pros and cons of investing in unicorns | The Financial Express

Pros and cons of investing in unicorns

Whether you’re an angel investor or investing in private equity, or even a retail investor looking for the next opportunity, unicorns look like an exciting option.

Pros and cons of investing in unicorns
ost unicorns have a valuation because a big investment or consulting firm has valued them, and several seed funders have made good money off them already (even if they haven’t encashed yet). (Representative image)

By Sanjay Dangi

Nowadays, India is full of chatter about ‘Unicorns’, i.e., start-ups with valuations of $1 billion or more, which have not been listed on the market yet. India is expected to have 250 Unicorns by 2025 – and everyone I know wants a piece of the investment action. The questions to answer are: What is good about investing in them? What are the risks?

Before we answer that, remember that there is no magic formula for predicting the next unicorn unless it’s a soonicorn, but even then, it’s hard. Many fast-growing unicorns are, to cite Elon Musk, money furnaces. Some have long crossed the billion-dollar valuation and are still to turn in their first annual profit, with Oyo and Flipkart being the most familiar names (even though they make the biggest revenues). Indeed only 18 of India’s top 100 unicorns make a profit. And without a pathway to profit (even if a long one), no unicorn will ever become a corporate lion.

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Whether you’re an angel investor or investing in private equity, or even a retail investor looking for the next opportunity, unicorns look like an exciting option. Let me list out the apparent pros of investing in them (before or after listing):

1. Demonstrable Growth: A Unicorn didn’t become one unless it found a market niche with unmet demand and got it quickly. Oyo found a way to link small hotels and lodges to those looking for cheap places and created consistent branding (though it is sadly plagued by some of these places having terrible quality issues); Zoho found its niche in networked office software where organizations struggled with multiple formats; Byju’s hit paydirt with mobile-driven lessons just as the pandemic shut schools. Each has demonstrated success, a pathway to keep that success going in the future and has attracted capital. For an investor, that’s a safe bet.

2. Sunrise Outlook: Your usual unicorn is also based in a sunrise industry with little crowding or need for heavy capital investment. It’s unlikely that we will see a unicorn that will drill for oil. Most unicorns are in ‘soft’ fields requiring little hard infrastructure – Artificial intelligence being the number 1, followed by e-Retail, Cybersecurity, Data Analytics, Fintech, Health Tech, and Supply Chain. The last, shown to be severely vulnerable during the pandemic, is seeing much innovation. A few ‘hard’ fields are also seeing the emergence of unicorns, such as electronic cars and telecommunications. From an investor’s POV, the whole vertical has an upward growth trajectory so that the wave will lift all boats. If you’re in one of these boats (unicorns), you can expect to make high returns.

3. Stress-tested: Most unicorns have a valuation because a big investment or consulting firm has valued them, and several seed funders have made good money off them already (even if they haven’t encashed yet). They’ve shown a business model that works well enough to attract new funds (caveat: this isn’t the same as a business model that attracts customers). Private investors can thus seek a slice of these companies, and they usually have a good listing, if not overvalued.

That said, unicorns aren’t without their downsides as well.

Unicorns are not retail-investor friendly. Most unicorns aren’t listed on a stock exchange, so you have to approach them via the private equity market. In other words, you need deep pockets and good networks. Nevertheless, there are now unicorn-based ETFs and Mutual Funds that you can try your hand in. These don’t just give you access to what is otherwise inaccessible but also balance out your risk by investing in a basket of unicorns.

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Valuations don’t imply true value. As unicorns are private, there is no market-derived value for them. They have a valuation made by investment banks or consultants, which isn’t the same as the company’s paper finding its value in the open market. Many investors have found this out to their regret after overvalued IPOs crashed upon listing. Once listed, a company must follow strict standards of governance that require it to publish many financial details; getting the same of an unlisted unicorn is as good as finding the animal of the same name in real life. So, you need a big appetite for risk in the unicorn business.

The valuation of a unicorn is neither transparent nor predictable. The founders will obviously try and inflate the valuation based on their own rosy pictures and expectations of changing the world. Investors, on the other hand, will try to beat them down by trying to pare down their actual prospects and getting market pictures. This is a constant struggle. Some may sink in a booming market because of internal mismanagement or the founders’ lack of long-term vision. Some unicorns might flame out if market conditions change, such as the emerging crisis in EduTech as schools have reopened. Some are more resilient and may go on to become the lions of the market (aka blue chips).

Unicorns are unpredictable. And sometimes unreliable. Companies reaching a hundred million dollars or two below the psychological mark can be tempted to take shortcuts (especially their founders and initial investors). Be ready to expect massaged valuations and excess leverage. Those wanting to cash out on an IPO want a bigger bang for their buck. This is not to say unicorns are deceiving intentionally, but the billion-dollar number can sometimes turn heads.

Beware the sheep and the copycats. Investors are notorious for their herd mentality. If a company has reached unicorn status, investors may attribute it to the entire industry (say AI or drones) and be ready to invest in its rivals – letting them reach unicorn status without demonstrating that they have the chops of the OG player.

Changes in the market. Unicorns can fly – and suddenly, the bottom may drop out of the market (remember the dot com bust?). Or the regulatory environment can change, killing their main USP. For example, Uber is facing headwinds as countries move to protect existing taxi businesses, modify labor codes, or expand customer right. Data privacy laws are affecting several data analytics-based unicorns. And finally, China is, um, China.

These cons aside, a unicorn is still a good investment option. After all, it is exploiting new markets, meeting unmet demand, and solving existing inefficiencies through technological innovation. Some will unfortunately fail, but several will go on to change life as we know it. We can ride the wave, or we can let it sweep us by. The choice is ours.

Disclaimer: The author is Director – Authum Investment and Infrastructure Ltd., & Financial investor to many start-ups. Views expressed are personal and do not reflect the official position or policy of Financial Express Online. Reproducing this content without permission is prohibited.

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