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Taming unicorns worth $1 billion: How to lower investor risk

October 03, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Unicorns in tech investment

There is a new species of investment roaming around these days, known as a unicorn. Investors have put more than $500 billion into these unicorns so far. But before you join in, you need to ask whether this investment proposition is an opportunity to capture a rare and valuable creature, or get skewered by a sharp and dangerous horn.

After all, these unicorns are not something out of fantasy literature. A unicorn is the name that is given to tech companies that have stayed privately-held and yet have amassed valuations of more than $1 billion. Large private equity investors and retail mutual fund investors can find ways to invest in these privately-held companies. But as their valuations rise, the question of whether or not these investments are wise becomes more compelling.

The case for companies staying private longer

In the dot-com generation, the goal of many an entrepreneur was to cash in by taking the company public. So why are many of their counterparts today choosing to remain private? Here are four good reasons:

1. Management can avoid a quarterly earnings focus

The short-term pressures of public investors can be distracting, especially when a company is still in the early stages of development.

2. Private equity is plentiful

Between low bond yields and a weak stock market, investors are desperate for alternatives to traditional investments. This makes it easier for private equity to attract money.

3. The private market discount has been reduced

Entrepreneurs typically receive lower valuations from private investors than from public ones. But as money has flowed into privately-held tech companies, they have had to give up less of a discount.

4. Reporting requirements are not as stringent

It takes a team of legal and investor-relations specialists to keep up with the reporting requirements of a public company. So the attraction of avoiding these headaches for as long as possible is understandable.

Some of the things that make staying private beneficial to entrepreneurs come at the expense of private equity investors. Traditionally, private equity investors have been willing to put up with limited liquidity and less transparency in exchange for the potential for higher returns.

The idea is that investing before a company goes public means getting in on the ground floor. However, when private company valuations become inflated, it may take a pretty steep climb to get to that ground floor. Effectively, high valuations diminish future return potential. Thus, they negate some of the reward investors are supposed to receive in exchange for the higher risk of private investments.

5 tips for investors: Taming your unicorns

If you understand the drawbacks but still find privately-held tech companies to be compelling investments, here are some things you can do to try to tame the unicorns in your portfolio.

1. Limit your exposure

Understand the role these should play. As high-risk/high-return propositions, you don't need a huge position to make a difference if things go well. Limited position sizes will help control the damage if things go poorly.

2. Understand these are long-haul investments

Unicorn companies typically are still in the developmental stage, meaning they are still formulating their business models, refining their product lines, and building scale. As a result, most have not yet reached profitability, and that could still be a long ways off.

3. Look at them as individual businesses, not an asset class

The problem with unicorns being a trendy investment is that people tend to look at them collectively as a type of investment rather than as what they are, as a series of very different companies with distinct business and valuation characteristics. These companies have little in common with each other, so don't look at them as an asset class that is likely to rise or fall in unison.

4. Be careful of cash flow sink holes

These are R&D-heavy companies which don't always know just what they are looking for, so they can burn through investor money with alarming speed.

5. Look at public/private valuation comparisons

Compare valuations with similar companies that are publicly held. One premise behind making private equity investments is that you can benefit from the valuation expansion that typically occurs when a company goes public. If there is little difference between a private company's valuation and comparable public valuations, this potential benefit is diminished.

There is something of a mystique around these unicorn tech companies these days, and mystique is one of those things that tends to lead investors to overpaying for a company. That's always a danger with any trendy sector, but the danger is heightened by the limited liquidity and lower transparency of a private company. In other words, exercise extreme caution if you decide to go unicorn hunting.

More from MoneyRates.com:

A guide to incremental investing

10 steps for getting started in investing

5 strategies to invest during a sideways stock market

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