Gored

THE unicorn of myth can heal the sick and make poisoned water drinkable. The unicorn of the business world—the label given to privately held tech startups with a valuation of more than $1 billion—has the power to bewitch investors.

The past few years have seen money slosh towards anyone in a hoodie. As well as venture capitalists, who typically finance entrepreneurs, more conservative fund managers have also been investing in these new tech firms. Today there are 144 unicorns valued at $505 billion between them, about five times as many as three years ago. Most are unprofitable.

There are signs, however, that the spell is wearing off. Mutual funds have written down the value of their investments in several startups. Square, a payments firm, went public this month at a valuation (initially, at least) about a third lower than the headline figure from its previous fundraising. Funding rounds in Silicon Valley are happening less often and are taking longer (see article). Corrections are bound to be alarming, but this is one the technology sector should welcome.

True, at a time when America’s economy is fragile, there is a risk of a dent to confidence. Yet this is hardly the dotcom bust all over again. That was a frenzy in public markets; the unicorns are largely the preserve of richer investors who are better placed to cope with losses. Mutual funds do manage small-investors’ money, but are allocating only a slim slice of their portfolios to the unicorns. And if there is any borrowed money behind these firms, it is limited.

Indeed, a correction would deal with three big distortions brought on by surging valuations. The first is a blurring between the strong firms and the weak ones. When money is pouring in, firms with the best managers and ideas find it harder to stand out from their wobblier but well-funded rivals. A willingness to burn through cash disguises flaws in business models. The food-delivery industry, for example, is one in which firms, from DoorDash to Postmates to Caviar to Munchery, have been happy to incur big losses to acquire customers. Costs spiral for everyone; M&A activity is stifled by inflated asking-prices. When funding is harder to come by, those firms that have either used the boom to store up lots of cash, or can lay out a plausible path to profitability, will do better.

The second distortion lies in the desperation to attain unicorn status. High valuations in general, and the unicorn label in particular, are so coveted that founders have, in effect, been happy to hand out privileges to investors in order to bump up valuations artificially. Such agreements include giving later-stage investors priority when firms go public, by handing them extra shares if the initial public offering results in a lower valuation than before. That means less is left for the real risk-takers—the entrepreneurs, early employees and initial funders. A correction may teach startups to focus less on headline numbers, more on fundamentals.

Public, not the enemy

The third distortion is the gulf between public and private markets. The ability of private markets to sustain new firms for longer than ever means entrepreneurs have more choices when it comes to how they run their firms. That is welcome. But public markets, rulebound though they are, still do some things very well: they impose greater scrutiny, and their deeper liquidity leads to more accurate pricing. If the prospect of listing on public markets comes closer because less private capital is available, the tech unicorn ought to become more disciplined as a result. That would be a rare beast.