Startup companies typically have a high failure rate. It is said that 90% of all startup companies fail. The percentage of companies failing keeps on reducing as the company grows and obtains more funding.

Ideally, when a company becomes a unicorn i.e. achieves a valuation of $1 billion, then there shouldn’t be any chances of failure. However, surprisingly even unicorn companies fail. Many times, they end up causing a lot of damage to the investor’s funds as well. Hence, it is important for investors to understand the reason why unicorn companies fail.

Why do Unicorns Fail?

It is important to understand the common reasons behind the failure of unicorns in order to be able to predict these failures.

1. Overvaluation: The number one reason behind the trouble faced by unicorn companies at later stages is overvaluation at early stages. There is a glut of investors in the private market who are willing to buy in the hype and invest huge sums of money in startups that do not have a proven track record. A lot of times, this leads to unicorns succumbing below their own weight.

   Companies often try to convince investors that they will achieve dramatic growth in a very short span of time. It is not uncommon for unicorns to claim that they will grow the company at the rate of 15% per week. This immense speed comes at a cost. Often this leads to large-scale mismanagement in the company. Of course, scalability is an important aspect of the business model of startups. However, there should be reasonable assumptions, or else the growth process can turn into an operational disaster.

2. Increased Cost of Acquisition: A lot of startup companies are working on very thin margins. This is because they price their products abnormally low in order to gain customers. At earlier stages, they tend to incur a loss. However, at later stages, the company tries to raise prices to recoup its losses. Companies still do not have pricing power and hence keep the price of their products abnormally low. Such companies are dependent upon keeping the cost of customer acquisition low. If the cost of customer acquisition rises even a little bit, then the company tends to go underwater. Also, if the market is close to saturation, then it is normal for the cost of customer acquisition to rise. Hence, these companies are prone to financial turmoil at later stages.

3. Difference in Investor Mindset: A lot of unicorns fail since they are not able to make the transition from privately-owned companies to publically owned corporations. The world is full of examples where the stocks of privately-owned companies have tanked after their public listing. This is because public investors evaluate investments in a completely different manner as compared to private investors.

   Public investors tend to focus on value which is found in the financial statements. On the other hand, private investors tend to focus more on the future. They believe more in the dreams being sold about the potential that the company has to change the world. Startup companies need to go public only after the transition is complete. If the company is not able to justify its valuation based on the numbers in the financial statement, then its stocks will be pounded in the open markets.

Predicting the Failure of a Unicorn

It is common for unicorns to list on the stock exchanges. However, some of them succeed whereas the others fail. Investors need to look out for some of the symptoms which are an indicator that a startup might fail.

1. Stagnating Employee Counts: Investors need to keep an eye on the employee count of the startup company. It is very difficult for a startup company to grow at 15% per week with a stagnant workforce. Hence, a rapid increase in the headcount is often an indicator that things are going well. If the company stops hiring people or slows down the rate of hiring, it often means that the company has run into some kind of trouble. This fact can be used by an investor as an indicator to predict the success of startup companies.

2. Declining Social Media Attention: The brand value is a large part of the overall value proposition of a startup company. This is largely because startup companies are generally customer-facing corporations and hence need to be continuously connected to customers. Declining social media attention could often be the result of budget cuts. Since lesser customer engagement is often bad news for a startup company looking at rapid growth, budget cuts in this area often mean that the company is heading for trouble.

3. Secured Excessive Funding: As a company obtains a higher amount of funding, it should actually be close to becoming profitable. However, if a company has already raised millions of dollars and is still no closer to turning profitable than it was on the first day, then the company is surely headed for trouble. Hence, investors must try to steer clear of such companies.

The fact of the matter is that all types of companies are prone to failure and unicorns are no exceptions. Investors must be aware that sometimes the hype surrounding a unicorn can turn out to be just hype that is not backed by any substance.