Will Silicon Valley's 'unicorns' gallop off a cliff in 2016?

For most people, a unicorn is a mythical horse with a pointed horn in a flutter of fairy dust, but in Silicon Valley, it's a pre-IPO start-up valued at $1 billion or more. If a collection of these beasts of the fairy dust variety is called a blessing, the proliferation of Silicon Valley unicorns is anything but, as more and more of then become "unicorpses."

A "unicorpse" is venture capital parlance for an overvalued start-up, galloping into oblivion.

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After years of easy monetary policy, Wall Street is awash with cash seeking yield. Pouring that cash into start-ups has driven billion dollar startup valuations as investors buy the vision that a nascent enterprise can build a dominant business and yield huge returns. It's a compelling notion given the astronomical gains for investors in Google or Facebook before their IPOs.

Unfortunately, just like a unicorn, those gains can be a fantasy. Now, with so many investors chasing the same dream, we stand on what could very well be the cusp of a technology bubble in venture capital.

Bill Gurley, a partner at Benchmark Capital who has been calling this bubble for some time now, recently told the MIT Technology Review: "When these markets correct, they correct hard. There's no soft landing in Silicon Valley."

That raises the question: What happens to unicorns — and their backers — in 2016?

Unlike the catastrophic Nasdaq crash of 2000, this latest bubble will spare the retail investor, instead hitting venture-capital funds and their investors — family offices, mutual funds and pension funds that have wandered into choppier waters than they had imagined when they placed their bets.

The omens are everywhere. LoanDepot recently postponed its $2.6 billion IPO and Square's IPO's valuation was half of what it was said to be worth in its financing only a year ago.

Presently, 143 private companies are valued at more than $1 billion, with a total value of $508 billion, according to CB Insights, which tracks venture capital and angel investing. But the pipeline of 163 companies ready to go public is 25 percent below 2014's level, according to Renaissance Capital. It's almost 70 percent below the record of 480 IPOs in 1999, according to law firm WilmerHale.

Another harbinger of souring sentiment is the fact that tech firms now account for only 14 percent of IPOs, the lowest since 2008 during the global financial crisis, according to Dealogic.

Some venture-capital funds and their investors will get burned. Public pension funds have been a growing source of VC funds, according to a Dow Jones survey. In 2014, investments from public pension funds made up 20 percent of the sector.

Finance professionals should recognize venture-capital investments as long-term holdings, but many pension managers have been seduced by high annual returns posted by rock star endowment managers, such as Yale's David Swenson. Yale can place long-term bets on alternatives ranging from start-ups to forests, and smooth out the uneven nature of those returns over time. Most pension managers don't have that luxury and are instead judged on quarterly returns against their benchmark.

Some pensions are already pulling back on VC investments. The California Public Employees' Retirement System (Calpers), for example, is reducing its exposure to 1 percent from 7 percent over the next decade. Arizona is cutting its $90 million investment.

The recent spate of dead unicorns is partly a result of the complexities of the asset class.

In poker, they say if you don't know who is the shark and who is the fish, you are the fish. The sharks know game theory and the mathematics of betting and anyone without such insight is the fish, almost certain to become the sucker in the bet. Investing in start-ups can be similar.

For example, start-ups often try to build a high valuation, perhaps to offset a high burn rate, by offering protection to late-round investors called ratchets. Such protection typically promises extra shares if an IPO prices too low, in order to protect investors from losing money.

A study by law firm Fenwick & West found that, during the year ending March 31, 2015, 30 percent of 124 venture-backed companies that raised capital when their valuation was $1 billion or more used ratchets or other IPO protections. Anecdotal evidence suggests that percentage is higher today.

Such arrangements guarantee late-stage investors against losses, but come at the expenses of early investors, founders and employees with stock options who are diluted and so would see their returns diminished, or even eradicated entirely. That produces a chilling effect that snowballs. As more late-stage investors in private companies demand increasingly better terms, fewer investors are interested in making earlier investments.

Eventually, the IPO pipeline freezes up, unicorns get frostbite and lose their precious horns. Unfortunately, that is where we are today.

The good news is that just like after the 2000 Nasdaq crash, the ensuing shakeout will separate the great companies from the bad ideas. Investors will then have a contrarian buy signal, because many of these imaginatively valued high-flyers will become bargains.

Commentary by Phil Wickham, CEO of the Kauffman Fellows. Founded in 1994, Kauffman Fellows is a Silicon Valley-based leadership program for venture capitalists and innovators. The more than 400 graduates from this two-year apprenticeship, collectively known as the Kauffman Fellows Society, now lead venture capital, government, corporate, university and startup innovation in over 50 countries around the world. Reach them @KauffmanFellows.

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