The Fallacy Of Unicorn Hunting
Eric Benhamou BGV Founder and General Partner shares his perspective on the fallacy of Unicorn hunting. These days, it is hard to escape the Unicorn fetish phenomenon in the world of Venture Capital. No self respecting VC blog would be complete without a few postings on the subject. This one captures the perspective shared by the partners in our firm, who sometimes obsess about their portfolio companies but hardly ever on Unicorn hunting. As a mental exercise, let us imagine that a venture firm, through a combination of skills, experience, relationships, “proprietary deal flow” sources, high quality brand and other attributes has developed a strategy for unicorn identification with a 95% accuracy rate. This would be a remarkable feat. Surely, this firm would qualify for top decile – or even “three sigma” – status. Now, let us suppose that this firm would invite you to co-invest in a deal alongside with them, and essentially ride along their term sheet. Would you take this offer? Most people would. The allure of capturing a mythical beast, combined with the greed to realize outsized capital returns would take the better of most of us. But then, think again, and remember the lessons of your undergrad statistics class. I know, this may have been a long time ago … In his August 13, 2015 post (https://www.linkedin.com/pulse/herd-unicorns-reid-hoffman?trk=vsrp_people_res_infl_post_title) , Reid Hoffman reminds us that just 39 out of approximately 60,000 U.S.-based technology companies that received venture funding from 2003 through 2013 attained public or private valuations of $1 billion or higher. Let’s call it 1 in 1000, to use round numbers. Give or take a few basis points, this is the natural unicorn sighting base rate. Now, our hypothetical three sigma venture firm, applying its 95% accurate unicorn identification algorithm, may evaluate 1000 companies in the course of a year or two of deal flow processing. 950 times, it would correctly conclude its deal analysis with a “non unicorn candidate verdict”. The other 50 times, its verdict would be the opposite: unicorn candidate. The problem is, 49 out of these 50 would be false positives, as the natural unicorn base rate is only 1 in 1000. So, if presented with an opportunity to co-invest in a unicorn candidate selected by this firm, your odds of hitting the jackpot would be … approximately 2 percent! You would be better off going to the roulette table in Las Vegas and placing your bet on any number. There, the odds on a single number would be 2.63%! The basic point of this parabole is to remind us that past the glamor of unicorn stories and the genuine qualities of the recent breed of unicorn companies such as Facebook, Twitter, Uber, AirBnb, and a few others, unicorn hunting is fundamentally a vane pursuit and potentially a distraction from the core business of venture capital investing. At BGV, we focus our attention on enterprise IT companies, a domain where unicorn sightings are even more rare than the domain of consumer oriented companies (who benefit from the acceleration potential of fashion, combined with network effects). Our deal selection is based upon fundamental criteria such as the emerging existence of a sizeable market with dynamics favorable to startups, differentiated technology innovation that deliver tangible economic benefits, a short time to value, and a team of smart of entrepreneurs that we enjoy working with through the thick and thin moments of building a business. We certainly hope to stumble upon a unicorn from time to time, but our business assumptions and portfolio construction assume that we won’t. Yet, we do expect that most of our companies will begin their existence in a valuation range of single digits to low double digits, and that thanks in part to our involvement, they will build themselves into businesses whose value expands into the $100 million range within a horizon of 3 to 5 years. What is the base rate for this value creation ramp? 5% to 10%. Tough handicap, but we like it better than 1 in 1000. And if we are only right half of the time, then statistics show that we will be a true three sigma firm.