Unicorns Hiding From Index Funds

We are going to change subjects a little bit today and discuss unicorns instead of financial independence. Now by unicorn I don’t mean the mythical horse-like creature with a horn on its head, I mean the startup companies, which are usually in the technology industry, and reach billion dollar valuations in just a few short years.

Back in 1997 a little company known as Amazon was looking for some capital and was ready to expand. So they did what every other company did when it got to this point, it tapped the public equity markets. It had an IPO (initial public offering) and raised $54 million, and after its IPO its valuation grew to $438 million. IPOs give a company capital through selling equity shares, which they use to invest back into the company, and also give shareholders of the company an easy way to “cash-out” and liquidate their investments, and at (hopefully) a decent price. When 99.99% of your net worth is tied up in a tech company you founded, it may be a good idea to sell at least a few shares to diversify a little, wouldn’t you think?

Let’s fast forward to December of 2015. Amazon now has a market cap of $315 billion (yes billion with a “b”). What this means is if you invested $10,000 in Amazon’s IPO in 1997, you would have approximately $4.4 million today (according to Business Insider). For the many index investors in this community, this type of unicorn is a great thing. By investing in total stock market index funds we unfortunately invest in some companies which go bankrupt (luckily the most you can lose is your investment), but at the same time we’re able to ride these unicorns which appreciate our original investment exponentially and in essence wipe out the losses of the companies which go belly up.

But something structurally has changed in the past few years in the way which companies seek to raise capital. Unicorns today don’t act like Amazon. A couple unicorns that come to mind are Uber which has a current valuation of over $50 billion and Airbnb which has a current valuation over $25 billion. Unlike Amazon, we have been unable to ride these unicorns since they didn’t seek our money as an investment through an IPO, but rather tapped the venture capital and private equity markets, which are extremely tough for people without seven plus figure net worths to invest in.

There are a few reasons why these technology companies have not IPO’d like similar companies have in the past, which I have outlined below:

  1. Today, companies are getting venture capital and private equity investments at some pretty high valuations, which back in the 90’s was much more possible through an IPO. These venture capital and private equity markets weren’t as lush as they are today.
  2. There is less regulation for non-public companies. No quarterly reporting requirements, less compliance, no SEC or PCAOB regulation, and less investors and analysts to answer to.
  3. There is less public scrutiny over your business when you aren’t public. Public companies get beat up pretty hard in the public eye. Miss one quarter’s earnings target and the media acts like you’re going under. When the only people seeing your financial results are a few investment firms, it becomes easier to manage expectations.

Now you’re probably asking – so what FF? What does this actually mean? That’s a good question. Could it mean smaller returns for equity index fund returns? Maybe. Could venture capital and private equity money dry up and growing companies start tapping the public equity markets again and find their way into our index funds? Maybe. Could it mean absolutely nothing? Maybe.

If Uber or Airbnb do IPO someday, they’ll be doing it with valuations over $25 billion and not $438 million like Amazon did in 1997. Therefore when our index funds buy these companies’ shares when they IPO, the potential ride higher has definitely been cut short due to how late in the game they are IPOing. I guess for the time being I’ll sulk a little knowing unicorns are hiding from my index funds, but at the same time I notice they may come back in the future.

Have you tried investing in venture capital or private equity? Does it even matter to an index fund investing strategy that companies like Uber or Airbnb are choosing to tap private equity / venture capital markets instead of IPOing?

27 thoughts on “Unicorns Hiding From Index Funds

  1. InsiderAccountant

    Hey Fervent, you’ve got a new theme that looks quite different! It’s very minimalist, so does this mean that you’ll be ramping up the minimalist angles in the future?

    I understand what you’re saying about the unicorns, but it’s so difficult to pick the good ones at that stage that I’m not sure that it matters that much if they don’t IPO. There would be plenty of duds that actually do IPO now (that your index fund would invest in) so you probably need the odd unicorn to offset them!
    InsiderAccountant recently posted…How to fix your broken treadmill for freeMy Profile

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    1. Fervent Finance Post author

      No new them here – but thanks! 🙂 The great thing about unicorns (if they IPO early on) is that they’ll wipe out a lot more than a few duds. But lately the unicorns are no where to be found, so we’re stuck with the duds.

      Reply
    1. Fervent Finance Post author

      There will definitely be many more, I just hope some go public a little earlier so my index funds will scoop them up!

      Reply
  2. B

    Hi FF

    It’s really about going in early, taking a spot and ride the winners from there. It sounds easy as it seems, but for every so many vc there, only a tiny bit gets successful exit there.

    Also, i find valuing a vc company totally different than valuing a publicly listed company there, where every information is more apparent and public uhm.
    B recently posted…Are You Having Problem With Your Cashflow?My Profile

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    1. Fervent Finance Post author

      VC firms plan on having few successful exits, but they plan on those few to WAY MORE than make up for the duds.

      Totally agree on the valuation comment. Hard to value something from the outside when you don’t have all the financial information required for a public company.

      Reply
  3. Norm

    I am a staunch index fund investor and only own a few shares of individual companies. Missing out on unicorns doesn’t bother me in the slightest. Do Groupon and Zynga also count as unicorns? Because I’m happy never to have invested in those.
    Norm recently posted…Japan Trip, Part 2: KyotoMy Profile

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    1. Fervent Finance Post author

      Well if you own a total stock market index fund then you have invested in Zynga and Groupon. The good thing is your loss is limited to the amount the index fund has invested in them. Whereas Amazon has appreciated several hundred times since its IPO. All I’m saying is the Amazons of today (Uber or Airbnb) haven’t gone public and it’s a change in the historical norms we’re used to, and therefore we can’t invest in them through our index funds. Take care.

      Reply
  4. Matt @ The Resume Gap

    Thanks for pointing this out. I don’t think there’s much the average investor can do to hedge against this trend, but it’s concerning when thinking about the long-term prospects of index fund returns. To use a few more Seattle examples, Microsoft’s market cap at IPO was something like $800M. Starbucks’ was around $300M, I think. These days, IPOs at those valuations would be nearly unheard of for rapidly growing companies. When companies have easy access to PE money and can avoid all the Sarbanes-Oxley reporting requirements by staying private, it’s a no-brainer.

    Existing regulations also make it challenging for non-high net worth individuals to make private investments. To be an accredited investor, you need at least $1M net worth or an income of $200k/year (single) or $300k/year (married). If you don’t meet those criteria, investment opportunities are pretty limited.

    I invested in one company through a crowdfunding platform called MicroVentures (they’re able to open a few spots per investment for non-accredited investors), but I’d liken that more to gambling than index fund investing. Another way to hedge is to work for a start-up in exchange for equity (which I’ve also done), but then you’re effectively betting your employment and some of your portfolio all on the fate of one company.
    Matt @ The Resume Gap recently posted…We Bought a VanMy Profile

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    1. Fervent Finance Post author

      You hit the nail on the head with easy access to PE money and avoiding all the headaches and expenses that come with SOX.

      I’m not an accredited investor, but according to Financial Samurai, you don’t have to be and can tell a little white lie on your application since no one checks 🙂 I haven’t done this but it’s nice to know it’s an option.

      Any money I ever invest with VC will definitely go into my expense category on my income statement. I would treat it as a gamble and not expect a return, for sure. Great points! And thanks for stopping by.

      Reply
    1. Fervent Finance Post author

      No new theme here, but thanks 🙂 Lower returns for index funds is the part I worry about…

      Reply
  5. Alyssa @ GenerationYRA

    Okay, so funny story. For Halloween, I tried to convince my fiancé that we should dress up as a unicorn & an investor so all night he could “chase” me (just like the unicorn tech start-up trends)…my nerdy-ness didn’t win out this time unfortunately. I have not tried investing in venture capital or private equity yet, but that’s one of my next biggest goals to focus on in the next couple of years – specifically to local businesses in my city. The idea of investing in a start-up within my own community generates more excitement to me because I can see the direct result of it’s accomplishments. I think in terms of index funds it’s more of a long term investment strategy that, void of companies like Uber and Air Bnb tapping into private equity instead will not hinder you. I know I still have so much more to learn through investing that my commentary is more towards the elementary side!
    Alyssa @ GenerationYRA recently posted…The Inverted U-Curve of Personal FinanceMy Profile

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    1. Fervent Finance Post author

      THAT. IS. AWESOME. I think it’s awesome that you are thinking about investing in your community. High risk, but potentially high reward and not all monetarily speaking. Good luck, and make sure to blog about it if you decide to take that route 🙂

      Reply
  6. DC @ Young Adult Money

    I don’t think it matters for index investors. I think it only matters for investors who try to pick companies. With the way things are going it becomes more difficult for stock-picking individuals to get exposure to a potential unicorn. I don’t think the trend is better or worse, though, and I totally see where companies are coming from that put off IPOs.
    DC @ Young Adult Money recently posted…How I Got a Book DealMy Profile

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    1. Fervent Finance Post author

      I agree to an extent that it doesn’t effect index investors since the index funds only invest such a small percentage of their capital in IPOs (I think they are usually weighted off of market cap). But definitely sucks for that guy investing $1,000 in 100 stocks and hoping one goes to the moon!

      Reply
  7. The Bearded Dragon

    I hadn’t really thought of this. Of course, like you, I have no plans to change my investment style, but it’s always interesting to take note of trends and/or changes in the market. This article makes me think of a buddy of mine. He regularly invests “play money” into penny stocks, hoping that one will break out and get decent valuation. I know for certain that he’s hit on at least one big time, but he also knows a lot more about certain niches of the market than I do. I don’t really see venture capitalism going away, so we’ll just have to see what the missing unicorns do to total return. Thanks for pointing this out. Cheers!
    The Bearded Dragon recently posted…Expenses: November 2015My Profile

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    1. Fervent Finance Post author

      I’ve thought about doing the same thing with play money but I don’t have the same time or patience to do the research on top of all my other interests and work 🙂

      Reply
  8. fehmeen

    I too have heard lots of people make fortunes by investing in promising start-ups and I’ve been tempted to do the same many times, but what stops me is my risk appetite, which is pretty low. Seeing stock prices fall for shares I planned to buy gives me a giddy feeling in the gut, even though I don’t actually own the share, but just ‘planned’ to buy them someday. Stock markets just aren’t for me, but I know lots of people manage to ride the waves and make good money this way.
    fehmeen recently posted…Paying off Debt – Mitch Mitchell’s Story from Top Finance BlogMy Profile

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    1. Fervent Finance Post author

      I don’t plan on altering my investment plan of cheap index funds. The volatility doesn’t bother me as I have a long-term focus.

      Reply
  9. Money Grower UK

    Good article FF.

    It is also important to remember that there are many private equity companies listed on the markets so you still get gains in these ‘unicorns’ as an index will incorporate these private equity firms.
    An example is Harbourvest Global private equity which has investments in companies like UBEr and Snapchat. Harbourvest is part of the FTSE250 index so by buying into this index, you can still get some of the gains of the ‘unicorns’.
    Money Grower UK recently posted…BP stock purchase – First Dividend stockMy Profile

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    1. Fervent Finance Post author

      That is a good point I didn’t think of MG, thanks for bringing it up! I don’t think too many private equity firms are public, but there are some.

      Reply
  10. Fervent Finance Post author

    I never said I was going to start investing in start-ups 🙂 I just am going to complain a little that these unicorns are avoiding public equity investments, and therefore avoiding my index funds! Take care Steve.

    Reply
  11. Amber Tree

    Hey FF,

    Good thoughts on the unicorns and index funds.

    Via some listed companies in Belgium, I can get exposure to private equity. Next to that, there are some crowd funding initiatives around that allow to invest in start ups. Adding these 2 to the mix, should allow to capture some of the unicorns.

    My index funds are my core diversification of my portfolio. Over time, there should be individual stocks next to them. Some of these will be the publicly traded investment vehicles.

    Reply
    1. Fervent Finance Post author

      Good point to getting some exposure to PE via listed companies. I believe it’s a small portion of them who are though.

      Reply
  12. Our Next Life

    This is a great point that I haven’t considered before — that VC is robbing the markets of big growth opportunities. I do also wonder, though, if companies like Uber, who own essentially nothing, would have such high valuations if those values were determined by markets, not by a much smaller group of investors or analysts. But that’s a moot point! And to answer your question, this is an area of investing we have not and probably never will explore. 🙂
    Our Next Life recently posted…Of Mice and Money // 2015 Wrap-Up and 2016 RundownMy Profile

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