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Sighs of relief could be heard across Wall Street late last week following Square’s initial public offering, which was priced on Wednesday. After a stream of reports that called into question the valuations assigned to the digital-payments start-up and other pre-IPO companies, the company’s shares ended the week at $12.80, more than 40% above the $9 issue price. That said, the price was within the $11 to $13 range that had been indicated when the deal was announced, and it was significantly below the $15.46-per-share price at which the firm had sold stock during its last private funding round.

In reality, while many viewed Square’s IPO as a possible turning point for the “unicorns”–a term first used by TechCrunch’s Aileen Lee to describe the $1 billion-plus stars of the pre-IPO market–it did not detract from the fact that private market valuations have gotten far ahead of themselves, especially in comparison to publicly-listed counterparts. That reality was seemingly confirmed by reports that Fidelity Investments, one of the most active investors in the pre-IPO market, had in recent months marked down the value of its holdings in hot-prospect companies such as Blue Bottle Coffee, Dataminr, Zenefits and Snapchat. Fidelity reportedly reduced the value of the latter by around 25% in the third quarter.

More than valuation alone

It’s not just valuation that’s a problem. Some venture capitalists and others who are familiar with the space believe that many of today’s late-stage privately-funded start-ups might have a hard time staying in business. Reid Hoffman, the VC who founded LinkedIn Corp., believes that “many private companies with multi-billion-dollar valuations are unlikely to see those values recognized in the public markets,” according to Bloomberg, and he expects that “only a third to a half” will actually “survive and thrive.” Microsoft CEO Satya Nadella said in an October Bloomberg interview that he believed “a correction [was] coming in the private equity markets.” Of the 150 unicorn companies in the marketplace, Nadella thought that only “about 10 percent [would] succeed.”

To fly, to fall, to fly again

Even some of those who are members of this exclusive club believe that the privately-funded start-up market is looking shaky. The CEO of one of those firms said In a June conversation with Jim Edwards, the founding editor and editor-in-chief of Business Insider UK, that he “was very sure that all these unicorns lying around means we’re in a bubble,” and that it was “going to end badly for many companies.” In fact, he suggested that it was “all coming to an end sooner rather than later.”

Not everyone sees things this way. The standard retort to the notion that the unicorn market is a replay of the dot-com era boom-into-bust is that many of the companies involved have revenues and profits, and no small number have scaled up to become major players in technology and various non-tech sectors. They are disrupting industries such as hotels, taxis and data storage, and are building “real businesses,” according to proponents.

Even “real businesses” can be in a bubble

However, these factors don’t necessarily mean the industry is free of irrational exuberance. Other markets that appeared to have similarly positive fundamentals–such as the residential property market of the early 2000s, where a bubble formed amid assertions that the supply of land was limited and everybody needed a home–eventually tumbled back to earth when the prices being paid moved too far away from what people could actually afford.

But valuation isn’t the only cause for concern. There are indications that at least some of these enterprises are built on shaky ground. As Business Insider’s Edwards notes, many face various challenges, including high cash “burn rates,” business models that are “dependent on ‘one thing,'” and the prospect of margin compression as their businesses mature and competitors enter the fray. Arguably, the fact that the unicorns haven’t been subjected to the same pressures that publicly-listed firms regularly deal with, including assertive shareholders and heightened transparency, has probably facilitated some level of delusion among the companies and their shareholders alike.

Needless to say, the unicorn market has, as with other markets, been pumped up by ultra-accommodative central bank policies, which have fostered aggressive speculation as well as an underpricing and under-appreciation of the risks associated with illiquid investments. In the face of what now looks to be a “new normal” of rates that are higher than zero, it is likely that that market will be confronted with the kinds of pressures that have been seen in the activist hedge fund segment.

Plenty of pent-up supply

In other words, it probably wouldn’t take much to undo the sense of relief that Square’s IPO inspired. Unicorn shareholders, their employees, and public market investors could become increasingly unnerved, leading to jitters that would make it difficult for any of them to go public. Given the potential supply of equity that exists, that could be a serious problem. According to Fortune’s Steve Gandel, “if all 90 of the U.S.-based unicorns went public, selling a standard 35% of their shares at a 20% premium to their last valuation, IPO investors would have to buy $131 billion worth of newly issued shares.”

Under the circumstances, it appears that rather than shoring up the market for other unicorns, Square may have simply slipped through an ominous and growing hole.

Michael Panzner

Michael Panzner

Michael J. Panzner is a 30-year Wall Street veteran and the author of three books, including Financial Armageddon, which predicted the 2008 global financial crisis.
Michael Panzner

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