As the number of privately held companies valued at $1 billion continues to grow--there were 100 by last count--so too does the worry that the tech world has finally reached bubble territory.

The question this time, experts say, is not about whether these companies, known as unicorns, have sustainable business models, which many tech companies in the 2000 dot-com crisis did not. Instead it's whether the sky-high valuations themselves are the problem. A number of financial experts have expressed worry over what effect collapsing unicorns could have on the broader economy. Some fear the fall of even a single unicorn company could trigger a broader market meltdown, not unlike what happened during the mortgage crisis of 2008.

What does that mean for you? While you may not have a billion-dollar company, you may be counting on the venture capital community opening its coffers at some point. If the VC community gets burned by collapsing companies, they could pare back their investments--making raising funds all the more difficult for small companies and startups. 

Cause for Concern

One of the reasons for worry this time is the amount of institutional money flooding into late-stage financing deals, which drive values up without an expectation for an exit, most typically through an initial public offering.

"Private companies are staying private [longer], so the institutional community is simply going where they can get access to larger growing companies in need of capital," says Drew Nordlicht, partner and managing director of HighTower Advisors in San Diego. "The worry here is that these funds have an investor base that can redeem on any given day, causing a liquidity drain and forced selling inside the portfolio."

While institutional investors, which include mutual funds, pension funds, and some hedge funds, have long participated in venture capital rounds as limited partners, what's new is that they are investing directly in more late-stage financing rounds of private companies.

Why that troubles some financial experts is that institutional investors lack the experience of venture capital firms, which stake their success on their ability to foster and grow early-stage businesses through the experience and connections of their general partners.

Perhaps more important, mutual funds, unlike venture capital, are owned by public investors. But as their investments in private companies are relatively fixed, a dying unicorn could cause a selloff in other parts of the portfolio that are liquid, which in turn could put downward pressure on the market, Nordlicht says.

While the net effect could be, worst-case scenario, a precipitous drop in the stock market, financial experts say the most likely scenario would be a drop in values for all the high flyers, and a retrenching of venture capital investment.

"Some of these companies won't live up to their valuations, and as a result we will see some of these valuations justifiably go down," says Ross Fubini, partner at venture capital firm Canaan Partners, in Menlo Park, California. "And not every deal will look like it's going to be a huge one."

Investor Shakeup

Institutional investors have become increasingly important investors in the tech world over the past five years.

The five most active institutional investors are Janus, Fidelity, BlackRock, Wellington Management, and T. Rowe Price, according to venture capital research firm CB Insights. Collectively, they've participated in nearly $9 billion in financing rounds in 2014, compared to $1.7 billion in 2011.

And they've invested in some of the most well-known tech names over the past few years, including Facebook, Twitter, and, of course, Uber. In 2015 alone, they've invested in Jawbone, Pinterest, SpaceX, and Zenefits.

To put things in perspective, however, the total value of unicorns is about $211 billion, slightly less than the value of Facebook today, CB Insights notes. Hence, a correction in unicorn valuations might not be a major market event, says David Zilberman, a partner at venture capital firm Comcast Ventures. Comcast recently participated in a $233 million round in unicorn Docusign, whose value is estimated at $3 billion.

Zilberman points to the example of Fab, which in 2013 essentially folded after burning through $200 million of its $336 million in cash, which valued the company at nearly $1 billion.

"Fab collapsed, and the ramifications were not that substantial for the broader market," Zilberman says.

Still, the willingness of institutional investors to write large checks for potentially overvalued companies has a number of downsides. For example, they are investing in companies that have stayed private longer than historical norms, and which show no particular hurry to go public. That means new investors would be dependent on the next round of investors coming, for an increasingly big valuation, in order to benefit, venture capital experts say.

"What is going to happen if this money runs out, and the companies are not profitable? And they are burning through cash?" says Mike Irvine, a partner at the San Francisco office of Gunderson Dettmer, one of the biggest law firms working on venture-backed deals. "If this money evaporates in 24 months, is there still going to be private money?"

More Risk in Term Sheets

What troubles Irvine, he says, is that late-stage investors in the really big deals don't seem to be protecting themselves from downside risk as other investors have done in the past. That would include insisting on term sheets, for example, that allow them to convert preferred shares into common shares, or other liquidation preferences that guarantee they get their money back.

Part of the reason these investors are willing to accept more risk is the pressure simply to own parts of high-flying companies, with their potential for outsize returns, Irvine says.

"I am seeing [institutional investors] asking for the same terms as existing investors, paying a higher price, and agreeing to take their pro rata portion," Irvine says.

Nevertheless, venture capitalists and other financial experts say there are key differences between today's tech environment with its increasing number of unicorns, including companies like apartment share site Airbnb and big data analysis company Palantir, and the tech bubble of 15 years ago.

"The vast majority of these companies are really good companies," says John Backus, founder and managing partner at venture capital firm New Atlantic Ventures. "One might have a healthy debate about whether Uber is worth $50 billion, but no serious person would debate whether or not Uber was a real company."

And new technology has a pretty powerful ability to create new markets and industries, venture capitalists say.

"The challenge for entrepreneurs and VCs is to make sure that you are going after a truly big idea, so you can justify a large valuation," Fubini says.

Published on: May 13, 2015