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Would you rather be a real millionaire or a paper billionaire? The psychology of unicorns and the toll on Q1 returns

By Dennis Keohane , written on April 14, 2015

From The News Desk

Which would you rather be: Someone who knows that they are worth millions of dollars, or a person who has been told that they are worth billions?

Human nature would tell you the former. Most people would prefer the certainty of money now versus the uncertainty of more in the future. It’s the thinking that has caused the once controversial practice of “partial liquidations”-- when part of a founder’s shares are cashed out before an exit-- to become mainstream. The hope? To keep cash-strapped entrepreneurs from going the way of Instagram.

But that seems to have changed. In the realms of venture capital and technology startups in 2015, there is a clear line of demarcation separating this more-rational group from those who put more immediate value on a big gaudy valuation, kicking the can of exit further down the road to be dealt with another day.

Everyone in tech -- from VCs, to founders, to employees -- are somewhere on this continuum, making their vote on this central question of personal financial stability and professional reward with their feet, whether they know it or not. And as silly as it sounds, it is all tied into our current fascination for unicorns.

A look at the data in today’s Q1 Venture Capital Report from CB Insights reveals two trends that have created a topsy-turvy venture capital world in 2015. And, for better or worse, they are as central to unicorns as the horn.

It’s not news to anyone that the IPO market has completely slowed down from a fervent end to 2014. Of the 138 VC-backed companies that had exits in the first quarter of 2015, only 12 were companies going public. Of those 12, only two are businesses in the technology sector while the other 10 are from the healthcare space. By comparison, the last quarter of 2014 saw 24 private companies hit the public market, 10 of which were technology-focused.

But, it's also worrisome that M&A activity has decreased. In the first quarter of this year, there were 126 mergers or acquisitions; that number hasn't dropped below 140 in well over a year.

According to Fortune, there are more than 80 privately-held companies that are considered unicorns; CB Insights reports that 24 of those companies received that status through a valuation over $1 billion in 2014. In the entirety of 2014, 13 unicorns went public,including  seven in Q4 alone.

As Josh Kopelman "tweet-stormed" last week, 231 companies raised more than $40 million in growth rounds last year. Meanwhile, 240 VC-backed tech companies have gone public in the last 10 years.

VCs will tell you that the world has changed: Software has eaten it, mobile has made every app global from day one, and companies like Uber have unleashed whole new collisions of atoms and bits that are changing the world around us -- and changing what we’re willing to pay for convenience and access within it.

But still, there’s a big gap in those numbers. Has the world changed quickly and dramatically enough that VCs and entrepreneurs en masse-- the ones not in a handful of deca-unicorns that no one doubts-- aren’t setting themselves up for a huge crush of down rounds, layoffs and evaporating paper wealth?

CB Insights numbers are not encouraging.

In the first three months of 2015, Box is the only unicorn to IPO. And after coming out like gangbusters, the company has not sustained its initial breakout performance on the public market. As of midday, Box’s stock price has dropped nearly 30 percent from a high of $24.73.

Some of the other big names to IPO at the end of last year, including many former unicorns, are trending down since the start of the year, according to data from Seeking Alpha: Alibaba is down 18.6 percent, Hortonworks is down 8.4 percent, New Relic is down 11 percent, and Lending Club is down 27.6 percent since the start of 2015.

Oddly, the less-hyped Boston IPOs from the second half of last year are all doing comparatively well on the public market: HubSpot is up 15.8 percent in 2015, while the stock prices of CyberArk (+49.4% YTD) and pre-IPO unicorn Wayfair (+64.3% YTD) are two of the better performing tech stocks of last year’s IPO class.

It’s not difficult to see why many potential IPO companies don’t seem too eager to jump into life as a public company. They have it good (for now) with $1 billion valuations and the ability to raise money seemingly at will.

And frankly, they’re getting the same pools of money they’d get if they were going out without the hassle-- although admittedly, without wider liquidity for shareholders.

A lot of the largest recent funding rounds for later stage companies are coming from the influx of non-VC money flowing into the coffers of venture-backed companies. This unique environment is affecting the venture capital sector, diluting the equity a firm may have had in a startup they helped get to unicorn status, in a way that is eerily similar to how VCs have historically treated founders and entrepreneurs.

According to CB Insights, the number of venture capital deals hit a two-year low in the first quarter of 2015, with 805 deals versus 943 in the last quarter of 2014.

And yet total cash going to venture backed companies was a whopping $17.7 billion-- up over the $12.6 billion raised in the same period last year.

But here’s the thing: Only $11.3 billion of that came from venture firms, throwing into question whether we should even still keep using the adjective “venture-backed” to describe the category.

The disparity shows just how much more money is coming from non-VCs like hedge funds, private equity, mutual funds, and sovereign wealth funds, who have watched the private valuation growth of Facebook and the rest of the deca-corns and are desperately trying to get a stake in private companies before they IPO.

This trend is better seen in the decrease of late stage involvement by VCs, where venture capital participation in late stage deals - Series E and beyond - is down 8 percent from Q4 to Q1, the lowest in a year. According to CB Insights, the lack of VC participation in deals for Uber, Lyft, and Snapchat, is partly to blame for the decline.

Things have gotten strange for VCs -- and in turn, entrepreneurs -- and the climate doesn’t seem to be improving. In the past, the roadmap was clear: invest, get a company acquired or take it public, make money for LPs. Now, a glut of new capital from sources with more financial wherewithal, and the life-is-good mentality of unicorn CEOs, is slowing that old VC money train down a bit.

There is hope that more tech companies and unicorns will go public through the remainder of 2015. Etsy, for one, is going public this week (for better or worse), and the IPO wheels are already in motion for companies like Veracode and Acquia. But the number of new billion dollar companies compared to those finding exists isn’t adding up, and there doesn’t seem to be that much motivation for a company like Uber to go public.

Really, who would you rather be? Aaron Levie who knows exactly what his 3.4% in equity of the company he created is worth (Hint: it’s less than the $90 million it was worth when Box reached $23.23 on the first day of trading), or Drew Houston who is currently a billionaire in the paper world of unicorns?

Five years ago, most entrepreneurs sloshing around the Valley would have said Levie. Today, there are a lot who believe they are sitting on a unicorn that looks a lot like the next Facebook.