The world has been captivated by the growing number of unicorns—private companies theoretically valued at more than $1 billion based on their latest round of funding. According to CB Insights, as of October 2016, there were 176 unicorns globally, with a cumulative valuation of $628 billion. Ninety‐nine of them were in the United States, led by Uber, with a valuation of $66 billion. Number‐two among U.S.‐based unicorns is Airbnb, valued at $30 billion. If you were an early investor in any of these jewels, you're likely to win big! Get ready to pop the champagne. But what about investors who got in later, especially in the very latest fundraising rounds? How worthwhile are those investments going to be?

It's All High Risk, So Get in Early When the Biggest Returns Are Possible

We've said it before, but it's so fundamental that please pardon us for repeating it several times throughout this book—venture capital investing is a high‐risk/high‐potential‐reward endeavor. Most deals wind up losing, often the entire amount invested. The industry norm is for about 15–20% of deals to generate some gain.

Our firms have exercised extreme selectivity and due diligence rigor, investing in only about 40 companies over the past 33 years. We've invested only in ventures we love. Our success rate shows the fruits of that concentration; it's double the industry norm, at 37%. Four of the ventures we supported have even become billion‐dollar+ home runs. Nevertheless, that still means that, despite all‐star performance, nearly two‐thirds of our deals have lost money. Roughly 50% have been total losses.

The formula for venture capital investment success is to hit some big home runs, deals that return 10, 20, 30, or more times the amount invested. That requires selecting highly promising ventures early, while valuations are still low.

Notwithstanding the success of Len's multiple firms over the past 30+ years with an unconventionally small number of investments, our counsel for most individual investors would be to select a number of early‐stage ventures for some diversification. While you can do that by investing in our pooled account that participates in all of our deals, we even understand when our investors invest as well with other firms, though in our heart of hearts we think they would be better served just to wait for more of our current firm's selections.

To be clear, we're not talking about individuals adopting a mutual fund–type (or worse yet, a passive index–type) approach to venture capital, investing in dozens of ventures. That's not the way to win at venture capital. We're talking about investing in perhaps five or six really high‐potential ventures that you love. While there's no guarantee that they all won't lose, we do believe the odds should be with you and that this approach of extreme selectivity will pay handsome dividends long term.

Excessive Unicorn Valuations: All the Risk without the Big Reward Potential

Let's get back to the subject of unicorns. Many unicorns have already achieved notable marketplace success and will undoubtedly survive and even thrive over the long term. Nevertheless, even in the case of those making considerable strides in the marketplace, some of their current valuations strain credulity. We believe that, in many cases, their late‐round investors risk vulnerability to substantial losses, just like with early‐stage deals, but without the huge return multiples possible with early‐stage deals. We may be proven wrong, but really, how likely is a big win when the venture is already valued at $10 billion or $20 billion or even $50 billion or more?

Let's look at Uber and its latest financing round valuation of $66 billion. According to Bloomberg Technology, Uber's net revenue for the first half of 2016 reached about $2 billion. By net revenue, we mean the revenue they keep after the drivers are paid. At the bottom line, for the first half of 2016, Uber lost $1.2 billion before interest, taxes, depreciation, and amortization. In 2015, Uber lost at least $2 billion before interest, taxes, depreciation, and amortization. Uber, which is seven years old, has lost at least $4 billion in the history of the company.

Admittedly a portion of those losses will go away now that Uber has closed down its business in China in exchange for a 17.5% stake in China‐based ride‐hailing leader Didi Chuxing as well as a $1 billion investment in Uber from Didi Chuxing. However, it has been reported that Uber also slid back into a loss position in its lead U.S. market in the second quarter of 2016.

While Uber still has many markets left to conquer and its achievements to date are indeed impressive, do those results really point to a future justifying a $66 billion valuation? Remember, a future value of anything less than $66 billion will mean a financial loss for Uber's latest investors.

How about Airbnb, America's second‐highest‐valued unicorn, with a valuation of $30 billion? According to San Francisco Business Times, Airbnb revenues were estimated at $900 million in 2015 and in late 2016 were projected at $1.7 billion for the year. Experts' best guess is that they are not yet profitable. Yes, they're still growing rapidly, but they're also already well known and broadly used. So are they really going to grow so much and so profitably as to be worth $30 billion? That's nearly as much as the market capitalization of the vast Marriott Hotels operation. It's possible, but do you really want to risk your money on that bet? And even if it does sustain such a value, how much opportunity is there for further gain?

What about Palantir, that secretive data‐crunching resource to the FBI, CIA, and other mega‐institutions? With 2015 revenues estimated by CNBC at $1.5 billion and its employees already housed in nearly two dozen Silicon Valley buildings, is it really going to continue to grow at such a pace and to such a scale as to be worth $20 billion?

You could go on and on, but the point is simple. Are these 99 U.S.‐based unicorns really worth their nosebleed valuations? Or are their valuations being driven to excessive levels due to: (1) too much institutional money chasing after too few significant growth opportunities; (2) too many institutions and uber‐wealthy folks wanting the bragging rights of claiming some ownership in these rock‐star businesses; or (3) just plain old FOMO (Fear of Missing Out)?

Business Valuation 101

This isn't meant to be a dry textbook. If you're thinking about investing in venture capital, chances are you wrapped up your formal education long ago. So we've purposely stayed away thus far from academic‐type lecturing. But a quick review of some traditional fundamentals regarding business valuation may help you think through this subject in order to reach your own point of view about unicorns and, more generally, about venture capital investment.

Finance experts traditionally define a business's value as the net present value of projected future discounted cash flows. For those of you without an academic grounding in the world of finance, let us try to explain what that means.

If you were thinking about buying a business and needed to figure out what was a fair price, you'd want to know how much money the business was expected to generate for you going forward. That would be your return on investment. You'd certainly want to get back more than you put in. Otherwise, why buy?

So you'd use your best understanding of the business situation and your plans for the business to project how much could be returned to you—the business's future cash flow. You'd also need to recognize what it would cost you to come up with the cash to buy the business. For example, if you borrowed money, how much would the interest on your loan cost? If you used cash you already held, what would you be giving up in terms of a return you could generate by investing that money in some other way?

You'd also need to consider the risk, because buying any business is never risk‐free. That's why when businesses borrow money, for example, by selling bonds, the interest they pay is more than, say, what the U.S. government would pay on its bonds. The business's ability to survive and thrive and pay back the loan is a riskier bet than counting on the U.S. government to pay its obligations.

Considering these factors—the cost (real or opportunity‐based) as well as the risk premium—you'd come up with what economists call a discount rate. For example, if you decided the appropriate discount rate was 10%, then an investment today of $1 would require a return a year later of $1.10 to make the risk of the investment worthwhile. If you had to wait two years for a return, you'd want to get back at least $1.21 ($1 + 10%/year compounded annually).

Even though you've been hearing about minuscule interest rates on things like U.S. Treasury bills, and even home mortgages have been available for years now with interest rates below 5%, large U.S. companies considering a substantial investment for a factory or to buy a smaller company might consider an appropriate discount rate (i.e., their cost of capital plus a risk premium) of perhaps 10–20%, depending on the relative risk of the investment under consideration.

Applying Business Valuation 101 to Venture Capital Investment

Let's look at an illustration applying this textbook approach to your consideration of venture capital investment. Let's say that you invest $25,000. You recognize that this investment is not liquid and that you are likely to wait five to seven years for a return. We'll assume that you're going to get your payout in seven years. We'll further assume that you require an expected return of 15%/year to justify the risk of investing in venture capital. To achieve a return of 15%/year on your initial investment (i.e., your $25,000 must grow by 15%/year, compounded annually) you'll need to get back $66,500. That's 2.66 times your original investment. If you want to see for yourself, pull out a calculator and run through the numbers.

Let's say that your $25,000 investment is deployed by the VC firm in equal amounts of $5,000 in five separate ventures, and that four of those ventures are total losses. That means that the one winning $5,000 investment would need to return all $66,500, a multiple of 13.3 times that single investment. That's reasonably typical of what would be considered a highly successful outcome among individual venture deals. That's how money is made in venture capital. You expect most the venture deals to lose, but expect and hope that at least one will strike some gold.

Many VCs will tell you that this kind of traditional valuation methodology is impractical for venture capital. There's just too much uncertainty and too much that seems immeasurable. They suggest that venture capital valuations rely on perceived potential along with passionate commitment and a dose of hope.

They may be right about that for the individual investor investing in a single deal, that crunching all the numbers in textbook fashion is an impractical exercise. Nevertheless, at the end of the day, when you make an investment, you do need to consider the return you expect, or hope, to receive at some time in the future, as well as the risk you are taking. And you hope the VC investing your money in multiple deals is thinking along those lines.

In venture capital investment, you recognize the riches of potential success, but need to discount those hoped‐for future values sharply to reflect inherent risk. Of course, if you invest in a number of deals, or in a pooled fund that in turn invests in a number of deals, that diversification manages and reduces your overall risk.

Try Applying That Logic to Unicorns

Let's say you decide that, instead of investing in a pooled fund focused on early‐stage investments, you will invest in a fund focused on unicorns. We'll further assume your $25,000 is divided equally among five unicorns. Since these unicorns are much further along in their development, you expect to get your payout in just two years. We'll assume you're hoping for the same 15%‐per‐year gain. That would require a payout after two years of $33,063. Try the math: $25,000 plus 15% after a year, and then plus another 15% after the second year.

Let's further assume that two of those five unicorns drop in value by 25%, one returns the $5,000 initially invested, and two of the five account for all of your gain. Those two would need to double in value over the two years to meet your overall 15%/year return objective. Do you want to place such a bet? We wouldn't.

Before you accuse us of stacking the deck just to support our position, you need to recognize that those assumptions about drops in unicorn values aren't crazy. According to Fortune.com, during 2016 Morgan Stanley marked down on its books, relative to latest fundraising‐round valuations, the value of its holdings of three of the largest unicorns—Palantir by 32%, Flipkart (India‐based) by 27%, and Dropbox by 25%. Others similarly marked down on their books the values of much‐publicized VC‐funded ventures. Fidelity slashed the values on its books on its holdings of Dropbox, Snapchat, and Zenefits. T. Rowe Price marked down the value of its Dropbox holdings by more than 50%. Unicorn valuations don't always go up. Some also go down.

Why Many Unicorn Valuations Don't Make Sense to Us

The problem with some unicorns' soaring valuations is that they seem to assume the stars are perfectly aligned and everything will go right. That rarely happens. Yes, it may have for Microsoft, Google, and Facebook, three huge winners over the past 40 years. But how many of those are there? Even Apple had to survive near disaster before its remarkable success.

In order for it to make sense to us, Uber's $66 billion valuation would require that its annual earnings before interest, taxes, depreciation, and amortization ultimately reach and sustain at somewhere around $3 to $5 billion per year. That's in the range where their revenues are today, and they're hardly at an infant stage, already enjoying broad followings in many markets. We recognize that self‐driving cars may eventually drive up Uber profit margins. However, what if governmental regulations block portions of the company's planned expansion? What if, before self‐driving cars are available broadly, Uber drivers are ruled to be employees rather than independent contractors, changing the company's fundamental economics? What if municipalities figure out ways to level the playing field for conventional taxis versus Uber cars? The risks are real. We wouldn't bet on a $66 billion value, never mind hoping for a big gain to justify the investment risk in the first place.

How about Airbnb's $30 billion valuation? Again, they're hardly an infant startup; 2016 revenue is estimated at less than $2 billion, and they are not believed to yet be profitable. Again, fundamental risks to their economic model are substantial. For example, on October 21, 2016, New York Governor Andrew Cuomo signed state legislation that would impose a fine of up to $7,500 on anyone advertising a short‐term (less than 30 days) rental apartment on a home‐sharing website. If either of us lived in New York, that sure would discourage us from listing our apartment on Airbnb, even though we'd love the rental income if perhaps one of us were going to be away for some period of time.

While many homeowners, renters, and travelers love Airbnb and use it repeatedly, others have had the kinds of disappointing experiences you wouldn't have in a name‐brand hotel and so won't be back. More importantly, many cities are wrestling with Airbnb properties' lack of compliance with their lodging‐related laws and regulations, especially their lodging/hotel tax requirements, which in many cases are not being followed. Similarly, many condominium associations and co‐op boards are wrestling with enforcing more tightly their rules and regulations restricting or prohibiting currently active Airbnb rentals.

These sorts of risks really call into question for us the wisdom of Airbnb's $30 billion valuation, never mind hoping for a big, relatively short‐term gain on an investment at anywhere near the current valuation.

Unicorns Having Difficulty Exiting and Delivering Investor Returns

You may hear a lot about how these unicorns are staying private because they want to. Some will profess that they just don't want the short‐term market pressures of public ownership.

That's undoubtedly true for some, but we think there may be a different problem as well for some others behind their remaining private for longer than expected. The marketplace simply may not be interested in some of these unicorns at the prices their owners expect and are hoping for. Given the billions of dollars invested in unicorns, many of their investors are probably eager for exits in order to realize a return on their investments. Their reluctance to accept haircuts on those investments, selling for less than they had paid, may be what is getting in the way.

The mergers‐and‐acquisitions (M&A) scene for unicorns has been particularly bleak. That's not because of a lack of potential acquirer appetite for large, high‐potential tech companies. According to CB Insights, as of late 2016 there had been 21 acquisitions of private tech companies during the year for over $1 billion. Unfortunately for the unicorn owners, only 2 had been unicorns, valued in their last fundraising round at $1 billion+. We're guessing that a number of the unicorns may have wanted to be acquired, but that their share price expectations were too high to tempt suitors.

The respected venture capital industry tracking resource CB Insights believes, as we do, that many unicorn valuations, and hence price expectations, are simply too high. Those valuations were based on growth expectations that now in many cases seem far too optimistic. As CB Insights put it, they are “priced for perfection,” and, as we suggested earlier, such perfection—such ideal alignment of all the relevant forces—rarely happens.

Unicorn valuations have been inflated so high that, in the world of corporate buyers, who tend to act much more based on the “Business Valuation 101” approach described earlier, there is little M&A appetite until valuations drop back down to levels that prospective buyers can make sense of. CB Insights points out that, “in some cases, private market unicorns are actually valued at much higher multiples than their public market counterparts.” Ironically perhaps, due to these exit hurdles, there is pressure on some unicorns to accelerate achievement of positive cash flow, a pragmatic shift that will reduce growth rates and could preclude achievement of the lofty growth expectations that drove the valuations in the first place.

Now You Know Why We Believe in Early‐Stage Investment

Now you've seen why we're not interested in investing in ventures already valued at $1 billion+, where a return multiple of 2 or 3 looks unlikely and a return of 10 or 20 times investment seems virtually impossible. Gambling in Las Vegas would probably be a better bet.

We believe in the more traditional venture capital success formula, focusing on early fundraising rounds—often after venture potential is qualified through angel/seed funding but before valuations escalate wildly. For early‐stage investments, where ventures may be valued at $5 or $10 million, or even $10 to $20 million, while most fail, success could mean an exit valuation in the tens or even hundreds of millions of dollars. Four of the ventures we've supported over 33 years have even exited at $1 billion or more, though, of course, you can't count on that.

This early‐stage focus has worked well for our investors over three decades. While the VC industry's average deal success rate (i.e., achieving any positive return on investment) is in the 15–20% range, through rigorous screening and due diligence, our success rate has been 37%. Our gross IRR in aggregate has been 28%. To get there requires some exits at 10, 20, or more times the initial investment to offset the nearly two‐thirds of our deals that lose.

Our Concerns for the Venture Capital Industry and Individual Investors

Getting in on a unicorn round is great for bragging rights, but for late‐stage investors, getting out with a profit can be tough. We're betting that FOMO results in lots of loudly bursting unicorn bubbles.

Nevertheless, we're not concerned about a repeat of 2000's broad dot‐com bubble, which hit dozens of high‐flying, young, publicly traded companies, devastating the finances of millions of Americans. Today's soaring valuations belong to companies that are still private. Their investors are primarily institutions and ultra‐wealthy individuals who can weather the risk, so impact should be contained.

We are concerned, though, that a series of loud unicorn bubble bursts could cool the flow of investment dollars feeding life‐changing innovation. That would be unfortunate, since conditions for tech‐enabled startups have never been better. It would be especially unfortunate for the estimated ten million accredited investors (defined by the SEC as having net worth of $1 million+ excluding primary residence or ongoing annual income over $200,000), who finally—thanks to the JOBS Act—have access to professionally managed venture capital investment.

We believe that following the traditional early‐stage venture capital investment approach will continue to generate attractive returns for investors who partner with proven professional management and practice appropriate deal diversification. In contrast, we're betting that late‐stage investors in unicorn deals will increasingly find themselves under water.