The Unicorn & The Rhino
Two Ways to Grow a Startup
Since ancient times cultures have used animals as mascots for their endeavors. From Hercules taking on the symbol of the Nemean Lion to Washington State University’s beloved Cougar, humans love expressing ourselves in the anima of animals.
The world of startups is no different. Unlike the variety one might find in sports teams, startup entrepreneurship only has a handful of animals that ever get discussed. Sometimes The Tortoise & The Hare, there was even a time where it was cool to be a cockroach, and recently I’ve enjoyed reading about Zebras and Camels, but by far the most enduring is The Unicorn.
A Software Company by Any Other Name
Before we dive into an overdose of animal metaphors, it’s worth taking a minute to explore the general economic advantages software companies have regardless of animalian representation. It’s one of the most enviable areas of capitalism for many good reasons — often low startup costs, good ability to pivot, and winding down the business in the event of failure is a simple process. The only meaningful downside is that software companies nowadays have scant hard assets for borrowing against.
In my mind, their greatest advantage is the math behind their value.
The primary model that drives the valuation of companies that are too young to use standard methods is using a valuation multiple — the ratio of income to the total perceived value of the company. Across companies even in the same industry, the more unique technology and rapid-growth selling involved, the higher the multiple.
To give a relatable example, consider the automobile industry: an average business, such as a car dealership, sells for 4x revenue, plus the value of its assets. Add a little more technology, such as an automated car wash, and you can sell for about 8x revenue. If you’re a massively overvalued technology company in this space, such as Tesla, you can sell for 16x revenue.
In the world of software, the average is 24.3x.
Combined that with how high the margins on software are — the median is 76.8% — then one has a core engine for company value that is unlike any other in the world of commerce.
This is why technology companies enabled by software have such high values, have grown so quickly, are achieving the highest levels of job creation and investor valuation in modern times, and why there is still such a gold rush to make the next successful software company.
What is a Unicorn?
A rare mythical beast with magical powers, the title of “Unicorn” describes a private technology company worth a $1 billion dollar or more in the eyes of investors. Celebrity entrepreneurs like Elon Musk and Mark Zuckerberg made their careers building such companies. The biggest in the US is SpaceX, but other big names like Airbnb, Epic Games, and Door Dash top the list as well.
In my five years at LiveTiles, we very much adulated the concept of the unicorn startup. In many ways, our achievement of the expectation was solidified earlier this year when LiveTiles was named “The Fastest Growing Tech Company in Australia”. Successfully clawing from zero to $55 million in revenue less than five years is Unicorn territory — I suppose we just didn’t yet have the halo effect of Elon Musk to inflate the investor outlook to match.
What’s Wrong with Unicorns?
For most VC funds, being a potential unicorn is a prerequisite to receiving a single dollar, due to the business model of startup funding. In his book Zero to One, Peter Thiel lays out the key mathematical concept driving startup funds: Power Law Distribution.
Unlike a retirement investment portfolio, where the goal is to spread the risk across reasonable investments on the idea that you can pick some winners to cancel out some losers, Power Law investing boils down to evaluating unreasonable investments as long as any single winner has a slim chance to earn back everything lost by all the losers and more. This is achieved by making sure the equity stake is as large as possible — often double-digits per deal — and that the company spends quickly to chase growth like there’s no tomorrow.
As has been written about many time, the large stakes of the investing, reflected in the amount of money raised each round versus the current valuation of the company, has a deleterious effect on the shareholders over time — most of all the founders. As they move from Seed to Series A and beyond, the total value of the company goes up, but as the pie grows it gets sliced into smaller and smaller pieces. On average, Unicorn startups have founders with 10% or less of their company, most critically with likely even less control over the board and the direction of the company.
The pressure creates a dichotomous view on risk where they need to be sure they have an oversized piece of an oversized risky opportunity, in order to make sure the fund can be carried on the back of only one investment. This means they take far more of a company than would be normal for a capital raise and they exert far more pressure to spend money than would be wise. Then companies end up in a negative cycle of capital addiction where they have to raise to survive. The first Silicon Valley CEO I ever met put it in terms of addiction, “once you get the first hit, you’re hooked and have to keep chasing the high to survive”.
The Unicorn Olympics
To put it into practical terms, just imagine what the Olympics would be like if athletes were selected not on their demonstrable ability to likely win a medal in their single sport, rather imagine only looking for athletes that have a vague chance at winning ALL the GOLD medals in the entire event.
On the face of it, this seems ludicrous, but you’re failing to consider that in the complete analogy, we’re working in an ecosystem that values unconstrained innovation to solve problems and sees competition as part of the crucible of success. This would create a very exciting sports spectacle where steroids were required, rivalries would be lethal, and robotic augmentation was not off the table.
What would happen if the athlete won the competition? Read on to find out.
Reflecting back on the first five years of LiveTiles, this outlook and expectation was the area that caused the most ongoing pressure inside the company. High cash burn and constant rapid experimentation meant working at a company that suffered more layoffs in 5 years than the rest of my career combined. From my perspective as a co-owner, I actually do still view the layoff as necessary given the economic situation — paradoxically even though I was one of the people ultimately laid off this year — but I also readily acknowledge it as a side-effect of the growth-at-all-costs operating model that trying to be a Unicorn creates.
An Average Unicorn?
For the purposes of this article, we’ll call a “successful” startup as one that has an exit of some kind. An exit would be an IPO or acquisition — and 93% of the time it’s an acquisition — regardless as to whether or not it improved the finances of the shareholders.
I would, of course, much prefer to figure out how many startups meaningfully improved the world by achieving their mission statement, but alas, there is no Crunchbase for that — yet.
If there is good news in the numbers, it’s that most venture-backed companies don’t ever become Unicorns at all. Almost half of all successful exits happen on Series B or before. That said, in 2020 the combined funding of a Series B startup could be north of $50 million dollars and funding at that level coupled with an early exit means the final math on the exit can be terrible (read on).
According to a sample from Crunchbase in 2018, the average funded SaaS IPO takes 9 years, 5 rounds of funding, and $119 million in capital — but that is an extraordinary outcome. Based on dated numbers, the average Unicorn-style acquisition takes 5.6 years, arriving after Series C funding, and totaling $41 million from investors. Their average exit value was $292 million. It may sound like a lot of money but that would be a disappointment to the Power Law obsessed VC backing the company given that 85% of the startups in the portfolio have already failed on average by Series C.
What is a Rhino?
The rhinoceros is a real animal that can get up to 4 tons and run 40 miles per hour. Its only natural predators in adulthood are human poachers and can hit more than twice as hard a car, not even accounting for their sharp horn magnifying the force.
Cheetahs may have more speed and elephants may have more mass, but Rhinos are so efficiently balanced at both they are — in the physics definition of the word — the most powerful land animal on Earth.
In the context of startups, I would say a Rhino is a company that fundamentally focuses on customer retention & profit margin over customer acquisition & investor relations. Stylistically, they should have a clear vision and laser focus like any other startup, but the acceptable economic means to make it happen varies. Keeping conscious control of their business and their vision when it comes to shares and board seats, organic growth over acquisitions, and scaling smart rather than blitzscaling would all be indicators of a Rhino. Finally, they understand that the long-term life of a company requires resilience against crisis, rather than simply top-line growth, thus they maintain a tough hide.
I’m fairly certain that there will be a crash of Rhinos that survive the 2020 Dot Com Crash, pivoting to an operating model where they made it despite investor interest falling off a 10–30% cliff due to COVID-19.
Around the middle of the last decade, I did hear anti-Unicorn companies like this — specifically ones designed to withstanding economic nuclear holocaust —being called cockroaches. While I respect the memorable image with an emphasis on not just growth, but survival, cockroaches are gross and Rhinos are majestic.
Most bootstrap success stories — like that of Basecamp told in the book Rework — capture this sentiment of focusing on sustainable growth instead of cash-burn. My favorite Rhino story is Spanx founder Sara Blakely. She became the world’s youngest self-made female billionaire starting with $5,000, working the first 2 years of Spanx as a side business, and never taking any outside investment to this very day.
In the early days of LiveTiles, we actually held up Atlassian as a huge role model on how to be a Unicorn. In my eyes, and despite having raised $210 million dollars on their path to being valued over $40 billion dollars today, they have many Rhino traits. First, they were started on $10,000 in credit card debt, made a viral growth engine without a sales team that drove 12 years of profitability before taking any outside funding, and the two co-founders still own almost 60% of the company after only two rounds of investment — almost unheard of in Silicon Valley.
An Average Rhino?
It’s almost impossible to find information on companies following the Rhino vs Unicorn duality without simply falling back to bootstrapped vs funded as the main point of comparison. Based on that, Crunchbase seems to offer the notion that unfunded exits are just over 50% the size of a funded exit, but take about 3.6 years on average — much faster than a Unicorn.
PS: The numbers also confirm once again it’s better to have more than one founder, so if you’re a lonely maniacal genius reading this thinking you’ll be fine going alone, go get a capitalism companion right now!
Can a Rhino Win?
For people who came of age after the Dot Com Bubble and saw the movie The Social Network not as entertainment but career advice, there may be bewilderment as to why someone would forego the hyper-valuation of going Unicorn. Suppose you’re too much Gordon Gekko to consider any of the subjective points of thinking like a Rhino — like focusing on your purpose and not your pitch deck — there are still selfish reasons to go Rhino and bootstrap as long as you’re able to make sustainable progress.
Consider the following Unicorn vs Rhino shootout through the eyes of the founders:
Assuming the average successful Unicorn-style exit mentioned above were true, you would have a $292 million dollar company with $41 million worth of investor dollars up to the Series C stage from the “Equity Dilution & Value” graph. That means 31% left in the hands of the founders & employees and 69% in the hands of the investors.
Contrast that to a perfectly analogous Rhino that perhaps made a similar product with a similar business model, just lacking the resources to have grown their market share to the same heights. Assuming average relative sizing applied between these two companies, the Rhino would only be 55% the size in valuation at $160 million, but the founders & employees would likely own the whole thing.
It should be obvious a founder team with all of $160m is better than 31% of $292m (that’s $91m in total). Assuming the apples to oranges comparison were to continue to hold up, the Rhino would also have exited almost 2 years faster than their Unicorn analog, meaning their return over time is even higher. But I know what you may be thinking right now:
Surely that oversimplification isn’t correct.
You’re right, it’s actually even worse for the Unicorn.
Carving Up a Unicorn
An inexperienced student of business might assume the investor dollars would work like debt and the exit would pay back just the $41 million. However, a more experienced individual would have checked the dilution graph again they actually own 69% of the company. Someone immersed in the world of startups would know that most VC investors would have signed with a Liquidation Preference in place, which means it’s really whichever one they want — with the potential for it to be a multiple of the initial amount!
The Unicorn is likely are selling out of financial necessity because they’re running out of money— either because it’s a legitimate cash emergency or they’re making the shrewd choice of evaluating M&A before going out for more funding. This means they’ll likely take on a Bridge Loan to finance their business short-term while finding a buyer, doing due diligence, and juicing the top line that whole time as much as possible. Since the average sale time is 6 months, this can be a lot of money for a business with the burn rate of a hyper-growth software company.
Finally, as a founder, you may not be able to simply walk away from the business. You will certainly get something for your trouble up-front, but parts of your compensation on the transaction may be tied to an earnout or revesting on the deal tying to the founder to the new business for potentially years. This is hard for an entrepreneur. Tony Hsieh of Zappos famously walked out on millions from Microsoft during his earnout period after selling LinkExchange because the money was costing him too much happiness.
The combination of these elements coming together can quickly turn nine-figure success stories into mathematical disappointments. After paying back the financier of the bridge loan and the investors take potentially multiples of their investment value, many “successful” Unicorn-style exits can have disappointing outcomes for the founders and employees. In some cases, outcomes so disappointing they need a carve-out — a fee to the leadership team of the startup company itself— just to make sure they get something for their trouble of having launched and grown the business.
To revisit the Silicon Valley Olympics, should the athlete win the event, all of those gold medals would be given to the selection committee of the home country that found them and the athlete would get a Bronze. Then the athlete would be allowed to compete again in two years in an even deadlier bloodsport in the hopes they could win all the golds, all the silvers, and all the bronzes — perhaps enabling them to join the selection committee after that so they can make some real gold.
Conclusion
Ultimately, the shrewd financial strategizing and focus on happy customers extolled here as virtues of a Rhino are exactly the qualities an investor would want anyway. Despite any mythology to the contrary, only the most charitable or foolish investors would take a piece of a pre-revenue idea or company burning cash without a real product or demonstrable growth strategy. The average first round of investment happens 3 years into the life of the company and the average valuation during that first funding round has grown to over $10m (meaning about 2.2 million for the business) with the vast majority already having mid-six-figures or more in revenue.
The ultimate goal in my mind is still to take no investment whatsoever. Software’s core value growth engine — that 24x value — coupled with the concept that code is zero cost to copy and pennies per user to host, means one can build a business on margin & retention from Day 1. Unless your company must start with a roster of PhDs for their product or a global sales team to blitzkrieg the market, then focus on chasing the right kind of money.
Despite Rhinos being the most powerful animal on Earth, their every muscle is built from plants, not steroids.
Erik Ralston is Co-Founder & CTO at Soundbite.AI and has seen Rhinos on three continents — with plans of seeing them wild in Africa one day. He is an innovator with 18 years of education and experience, having spent the last five years in leadership at the fastest-growing tech company in Australia. Erik is also co-founder of Fuse Accelerator in the emerging community of Tri-Cities, WA, where he works on connecting people and sharing knowledge to turn new ideas into growing startups. You can find him on LinkedIn, Twitter, or the next Fuse event.
