Why San Francisco’s herd of tech unicorns could be culled

Having unicorn status used to mean that a company was primed for the public markets. But there’s little chance that any more than a small fraction of the hundreds of billion-dollar startups will head to Wall Street, venture-capital and public-market experts say. Instead, the vast majority will likely be acquired or go out of business, they said.

“There is not an infinite amount of capital for all these companies” to go public or even continue to stay afloat, said Neil Kell, the chair of Bank of America’s Equity Capital Markets unit. “There’s likely to be a lot of consolidation.”

The fate of the unicorns is highly pertinent to San Francisco. The City is home to 157 of them — 22% of the national total, by far the largest concentration of such companies around the country.

Over the last 20 years, previous unicorns helped transform San Francisco into the tech hub it is now. After making the transition from billion-dollar startups to highly valued public companies, Airbnb, Uber and Block, for example, have become some of San Francisco’s biggest employers. Restarting the process, many of the former employees of such companies, having seen windfalls from the initial public offerings or the increase in their share prices as public companies, have gone on to found or invest in other startups in The City.

That so-called virtuous cycle can start to break down if fewer of the next generation of companies go public or are acquired in lucrative deals. But Wall Street, at least, is an unlikely destination for most of the unicorns, whether based in The City or elsewhere.

In 2021, 175 venture-backed companies and 121 tech companies went public in IPOs, according to data collected by Jay Ritter, a finance professor at the University of Florida. Those were, by far, the highest tallies since 2000, at the end of the dot-com boom. But even if the market returned to that kind of pace, it would take more than four years for all of the unicorns to go public.

And market experts say they generally don’t expect the market to reach anywhere near that pace anytime soon. In 2022 and 2023 combined, just 15 tech companies and a total of 38 venture-backed companies went public, according to Ritter’s data.

Although the recent successful IPOs from San Francisco-based Reddit and Santa Clara-based Astera labs indicate the IPO market is starting to rebound, investment bankers and other experts generally believe the number of tech companies that will go public this year will be around 15 to 20. Many expect next year to be better, but don’t expect to see any more tech companies going public than the historical norm — about 40.

There are around 200 tech companies that could make a credible case to go public in the next two years, said Kristin Roth DeClark, global head of technology investment banking at financial giant Barclays. Many of those will likely merge with other companies or be acquired instead, she said. But even if they all went public, that would still leave hundreds of unicorns in the private markets.

“The IPO backlog is pretty big,” said Kyle Stanford, an analyst at PitchBook. “There’s obviously going to be some companies that don’t make it” to the public markets.

The number of unicorns has been growing for years, but it ballooned as the tech industry boomed in the immediate wake of the COVID-19 pandemic. In 2021, even as some 77 unicorns went public, the number of privately held billion-dollar U.S. companies still more than doubled, going from 191 from 517, according to PitchBook. The number of unicorns grew by another 165 in 2022.

In retrospect, many of those companies didn’t deserve such lofty valuations, market and venture experts said.

At the time, the Federal Reserve, hoping to stave off a recession sparked by the pandemic-related lockdowns, was flooding the economy with cash, in part through ultra-low interest rates. With capital so readily available, investment in public and private companies surged. As the stock markets and public company valuations soared, private-company valuations expanded in tandem.

But when the Federal Reserve raised interest rates and tightened the money supply, the stock markets fell. Many startups ended up with valuations that were unjustifiably high compared with their public-company peers and unsupported by their underlying businesses.

“There are a lot of these companies ... that were overvalued,” said Robert Siegel, a lecturer in management at Stanford Graduate School of Business. “The valuations had gotten ahead of the business realities.”

Some of those companies are now unicorns in name only. Unlike public companies whose valuations change from day to day based on the price their shares fetch on the stock market, private-company valuations generally only officially change when they raise new rounds of funding or allow a mass sale of stock by insiders.

Although some startups, such as South San Francisco-based Stripe, have made that trade-off, accepting a so-called down round, others have resisted it. That’s allowed them to keep their arguably inflated valuations, at least for now.

What happens to those companies will depend on individual factors, analysts say. Some will have enough cash on hand to grow into their valuations. Some — as Reddit did — will accept a lower initial market capitalization in order to go public.

But that option is only likely going to be open to the best-positioned unicorns. To go public, they likely will need to have reached significant scale — somewhere in the neighborhood of $250 million to $300 million in projected annual revenue for their coming year, DeClark said.

They’ll need to be growing their revenue on at least a steady pace. They’re also going to need to rank among the top two or maybe three companies in their particular category, Kell said.

And they’re going to need to either be profitable or on the path to being that way.

“You’re not going to be able to get out if you haven’t nailed down some real fundamentals in your business still,” Siegel said.

But that could prove a big problem for many unicorns. In 2021, when startup valuations peaked, public investors were paying a premium for revenue growth. Many startups built their businesses with that, rather than profits, in mind.

“A lot of them have had business model challenges,” DeClark said. “They were massively unprofitable at the time that the market really shifted, and have had a hard time getting that mix shift right around growth and profitability to something that would be attractive to investors.”

When money was flowing more freely, such companies might have attracted further investment that would buy them time to figure things out. But many of the outfits that used to invest in late-stage startups were non-traditional investors, such as mutual funds and sovereign-wealth funds. With the spike in interest rates and few startups going public, many of those investors have stepped away from the startup market, Pitchbook analyst Stanford said.

Unfortunately for the unicorns, there are only about 50 traditional venture firms that have the resources to support them at their current scales and valuations. But many of those firms are unlikely to want to invest in such companies at this point, because if they do go public, the payoff will likely be much lower than they could get by investing in other, earlier-stage startups, Stanford said.

For venture investors, “it’s not a good return profile,” he said.

As a result, many unicorns aren’t going to have the time to get back on track. Many will likely be acquired — or their technology and teams will be, analysts say.

The mergers-and-acquisitions market is starting to pick up, the experts said. But a merger isn’t a surefire plan B.

In the past, much of the M&A activity in the tech sector was driven by the Big Tech companies — Apple, Amazon, Alphabet, Microsoft, Meta and the like. But such mergers have come under increasing scrutiny in recent years from antitrust regulators, putting a damper on such deals.

Other, smaller but still large-scale public tech companies and private-equity firms might step into the acquisitions market in their place. But they may not have the scale or the appetite to buy struggling unicorns. Indeed, since the start of 2022, just 16 unicorns nationwide — only one of which was San Francisco-based — have merged with or been acquired by other companies or purchased by private-equity firms, according to PitchBook.

“I would like to think there will be a great home for most” of the unicorns that can’t go public, said Rick Kline, who helps companies prepare for IPOs as a partner in the Menlo Park office of law firm Latham & Watkins. But, he said, “I’m not sure that will be the answer for everybody.”

In a streamed conversation with The Information last month, Rich Wong, a partner with Palo Alto venture firm Accel, estimated that less than 20% — and possibly less than 10% — of unicorns will go public. Somewhere between 40% and 60% will get acquired, he said. That would leave at least 20% that are in danger of shutting down, according to his estimates.

Some already have. Since the start of 2022, at least 12 unicorns — none from San Francisco — have gone out of business, according to PitchBook.

While none of the experts who spoke with The Examiner offered an estimate on the percentage of still-active unicorns that will meet the same fate, they all agreed that at least some will.

“An IPO is definitely the goal for most tech companies,” said Avery Marquez, an assistant portfolio manager at Renaissance Capital, a financial firm that closely tracks the IPO market. But that’s not going to happen for most of the unicorns, she said. “Some of those companies are going to be acquired by bigger companies. Some of those companies are going to fail.”

Correction: A previous version of this story misstated the number of venture-backed private companies worth $1 billion or more in the United States and San Francisco. There are 730 in the U.S. and 157 in San Francisco, not 715 and 155, respectively. This story has been updated.