How to spot and invest in a unicorn company

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Just don’t get caught on its pointy horn.

© Helen Alderton—Moment/Getty Images

What do Google (in the 1990s) and Grammarly have in common with Quibi and Jawbone? All four were valued at more than $1 billion at some point in their start-up phases. They were what Wall Street now calls unicorn companies, a term highlighting the statistical rarity of such sky-high valuations for a start-up.

And although $1 billion-plus valuations early in the game might captivate some investors, such massive levels of capital don’t guarantee a successful outcome.

Of the four, Google and Grammarly have become staples in today’s digital grind. Quibi (a streaming service) and Jawbone (a maker of wireless devices), however, have gone quickly from cradle to casket. We might say the same thing about the money behind each company.

Few companies reach unicorn status, although the benefits of investing in one can potentially be extraordinary. But there are also risks, and distinguishing a good investment from a bad one involves extensive analysis (and perhaps a bit of luck).

A unicorn company is a privately owned start-up that has been valued at over $1 billion. Some unicorns choose to go public by launching an initial public offering (IPO); some opt to remain private using their funding rounds to avoid going public; and still others end up getting acquired by bigger companies. (Think of Alphabet’s acquisition of YouTube or Meta Platforms’ purchase of WhatsApp; both companies were valued in the billions.)

Venture capitalists and private investors determine a company’s valuation during its funding rounds. These valuations are based on factors including market potential, growth rate, capacity for innovation, and company leadership, in addition to other metrics.

In many cases, such early-stage companies haven’t been market tested, at least not on the scale their initial investors are envisioning for success. So the early funding rounds represent a wager on a company’s overall potential and future growth.

In rare instances, the amount of capital raised—or the valuation these investors estimate in excess of the company’s raised capital—can exceed $1 billion, making the company a unicorn.

When private investors infuse enough capital into a company to raise its valuation above $1 billion, it’s likely because they see the company as having potential for substantial growth and the ability to deliver outsize returns.

Regardless of the industry or sector, unicorns tend to have characteristics that distinguish them from most start-ups:

Spotting a unicorn is relatively easy. Several major news sites like The Wall Street Journal, Fortune, CNN Business, and Morningstar’s PitchBook track and publish unicorns. Spotting them is easy; it’s the investing part that gets a bit tricky.

Early funding rounds are largely off limits. Unless your net worth is high enough to place you in accredited investor status, early private funding rounds are inaccessible, meaning you’ll have to wait for a company to launch an IPO to get your hands on its shares. Despite missing out on the early private funding rounds, your eventual payoff can be substantial if you choose a winner. It’s not quite like getting in on the ground floor, so to speak, but it’s still pretty close.

Of course, your loss can also be substantial if you back the wrong unicorn, especially if the market disagrees with the $1 billion-plus valuation.

Unicorn IPOs can be extremely volatile. Jumping in on IPO day can take you on a harrowing ride, even for companies that eventually succeed. Take Meta (META), then known as Facebook, for example. A “super unicorn” valued at $104 billion, it made its Nasdaq debut in May 2012. After its initial offering price of $38 a share, Meta’s stock plunged over the next five months, shedding more than half its value upon hitting a low of $17.55 per share in September. But a little over a decade later, Meta’s market cap hit the $1 trillion mark.

Due diligence is critical. Not all unicorns have a significant track record to showcase viable fundamentals. In situations where information is lacking, you might have to think like an angel investor and do the onerous legwork by:

You might also do some industrywide research—a SWOT analysis, or an assessment of a company’s competitive advantage or new market creation—to assess how it might compare to its potential rivals.

Getting in close to the ground floor of an emerging company can be as rewarding as it can be risky. Although billion-dollar backing indicates strong confidence in a start-up’s longer-term prospects, it doesn’t mean you have to make a big bet. If you’re interested in investing in a publicly traded unicorn, purchasing shares with a focus on diversification, portfolio balance, and risk management is perhaps the most prudent way to go about it.

You might even consider investing in an exchange-traded fund (ETF) or mutual fund that holds shares in the unicorn company you’re interested in. By approaching your investment through these vehicles, you can still gain exposure to the upside while minimizing the damages that a bad unicorn can bring.

This article is intended for educational purposes only and not as an endorsement of a particular financial strategy or company.