Some are just donkeys with a horn.

I will remember 2019 as the year when many unicorns were exposed as donkeys in disguise.

Invoking the rarity and mystique of the mythical creature, a “unicorn” is the term the financial market coined for companies worth US$1 billion or more. The year opened with high hopes for such companies that sought an initial public offering (IPO) in the following months. And while some have done well – video-conferencing company Zoom has almost doubled its initial offer price while plant-based food producer Beyond Meat is trading at more than four times its value at listing – the market has not been kind to the most high-profile unicorns.

Take Uber. In the fictitious animal kingdom, the ride hailing, cab industry-destroying app was the ultimate unicorn. Its disruptive business model had taxi drivers striking to protest. So far-reaching was its impact that the company name has become a verb: commuters would just “uber” there; even lawyers are not spared, being threatened by the “uberisation” of their industry.

But Uber’s IPO this year received a lukewarm response. Its share price has tanked by 37 per cent. Lyft, its closest competitor, also listed earlier in the year and has suffered a near-40 per cent fall off in its trading price.

Another market disruptor, this time in the office leasing space, was even worse hit. WeWork, arguably the originator of the hip co-working space concept, had to cancel its planned October listing due to poor market demand for its shares. Its IPO was mired in allegations of corporate governance breaches and poor financial management. Its major shareholder, the world’s largest tech investor SoftBank, has taken a US$4.6 billion (S$6.3 billion) hit from the investment. WeWork is now expected to lay off thousands of employees and is facing a probe by the New York State Attorney-General.

From magical beasts, many unicorns now look like dressed-up donkeys. What has gone wrong?

Not every disruptor is a unicorn

First, not all startups are created equal. And not all are kings of disruption.

Since the early triumphs of Amazon and Apple, and the more recent phenomenal financial performance of Facebook, Netflix and Google (now Alphabet), the market has been on the hunt for the next FAANG success story, using the acronym that comprises the quintet’s initial letters. Because of the exponential growth of these companies, investment banks and venture capital investors who have put money into disruptive startups have a big incentive to identify the next one and bring it to IPO. A US$1 billion valuation automatically places the company in the stellar league, giving it an outsized chance of success.

Disruptive startups are not valued on traditional models of profits, but on their growth and development potential. Basically, they are as good as their trajectory, which is measured in revenue, clicks and customers. In some cases, valuation is based on GMV, the gross merchandise value of all sales made on the platform, which is much higher than the revenue that the platform would earn from those sales. It is a business model that needs to burn a lot of cash to offer customers incentives, effectively buying business revenue.

But doubt has been cast on their valuations at IPO.

In a research paper, Stanford School of Business Professor Ilya Strebulaev states that the reported valuations of unicorns are on average 51 per cent above their true worth, and that one in 10 unicorns is overvalued by at least 100 per cent.

Unicorns raise multiple rounds of funding before IPO, with successive fundraisings valuing the company at higher amounts. To attract these rising valuations – and blue-chip investors whose association with the company is its own advertisement – companies provide later investors with sweeteners. These range from preferential rights in exit events and veto rights, to guaranteed returns at IPO. For example, an investor may be promised more shares issued for free if the company’s valuation at IPO does not meet a minimum return threshold.

It has been estimated that the average unicorn has eight classes of shares, a complex share structure that makes it hard to determine a company’s worth at IPO. The market uses a rough-and-ready method: it multiplies the last fundraising price by all the company’s issued shares. But the differing rights mean that each class should, theoretically, be valued differently. Professor Strebulaev states that the market’s method is an “inappropriate valuation model” that significantly overvalues these corporates.

Not every startup is a disruptor

And then there is the problem of the business model.

The FAANG companies were legitimate disruptors.

Facebook changed the way the world relates and communicates, but has used the platform to make money from a traditional business model – advertising. Amazon, the “first mover” in online shopping, has for years ploughed its revenue back into building a phenomenal network and now dominates the space. Apple put a miniature media machine in our hands, selling us something we didn’t know we wanted, which we can no longer imagine life without. Netflix killed the DVD store, forever changing the way we consume video content. Google, well, I don’t have to tell you about the search engine. You can google it.

But not every startup is a disruptive force of nature, no matter their corporate taglines. WeWork talked a good game, stating in its IPO filing that its mission was “to elevate the world’s consciousness”. At its core, WeWork was a hipster landlord selling a lifestyle to millennials but faced the same challenges of other landlords – matching supply and demand for commercial office space. Peloton, which IPO’d in October, was similarly ostentatious in its ambition to “sell happiness”. Instead, the company sells exercise equipment. It touted itself as a media company simply because it streams fitness classes to touchscreens on its treadmills and stationary bicycles. Seeing through the hype, the market punished the company with a share price drop of 11 per cent on the first day of trading.

Uber and Lyft’s poor showing post-IPO also reflect the challenges their business model faces. Ride-hailing apps have had to pay heavy subsidies to buy customer business, resulting in huge cash burn. In addition, they do not have high barriers to entry or customer stickiness. They also contend with intense competition to attract drivers.

Unicorns need to forge a path to profit

The market appears to be demanding what all investors ultimately require: profits. Of this year’s IPOs that have performed well, Zoom and Beyond Meat have both turned a profit. Notably, both WeWork and Peloton are loss-making. Uber, in its IPO filing, stated that it “may not achieve profitability” ever, based on its current business. This may have contributed to the drubbing in its trading price.

The success of the FAANG companies has shown that true disruptors which have sound business models and can give investors what they want – even if this takes a long time – will be rewarded. But the market needs to discern between unicorns and asses. Using a ride hailing app while it is in its cash burn phase may be a surer way to make money than investing in the stock of a company with no clear pathway to profitability.