The Allure and Pitfalls of Unicorn Investing: FOMO, Reputation, and
Non-Monetary Incentives

Welcome to the second part of our new series, Unicorn Investing, where we explore the what, why, and the “how to invest in” of companies valued over a billion. In the first part, we discussed what they are, how they become unicorns, and the gravest dangers to this rare breed.

Today, we move on to the investors’ side: what makes investors so excited about investing in unicorns and how we might keep an open eye to the risks and pitfalls of aiming to find the next one.

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Risk-takers’ gambit

We have already established that investing in startups in hopes that they become unicorns can be a very alluring but also a risky endeavour. These companies have the capacity to bring a high return on investment, but of course, they also present a number of challenges.

Since they are still privately traded, unicorns do not have the same accountability or transparency as publicly traded companies obliged to disclose quarterly earnings or face activist shareholders. Valuations, which at times are based on hype rather than actual performance, carry a risk of financial trouble if the growth expectations are not met. Or even if they are met, some companies collapse under their own weight if the right management, structure, and growth strategies are not established. (source: Faster Capital )

But risk is not inherently a bad thing when it comes to investors. It can be a thrill and a driver too. As such, the risk inherent in investing creates interesting waves. Whether by the nature of the field attracting adventurous souls or by constant exposure, people who make a living in venture capital generally seem to have a higher risk tolerance. And the prospect of higher returns is likely to alter how one perceives risks too: Daniel Kahneman and Amos Tversky's proposed Prospect Theory suggests that individuals evaluate potential losses and gains relative to a reference point, rather than in absolute terms. 

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Fortune may favor the bold

This potential for enormous returns is arguably one of the biggest allures of investing in unicorn startups. Stories of early investors striking gold with companies like Airbnb, Uber, and Snowflake have fueled dreams of large paydays for both venture capitalists and angel investors. 

Seeming to prove Prospect Theory, when it comes to unicorns, investors are more likely to overlook negative cash flow and high burn rates in favor of steep growth curves and the possibility of enormous returns. 

But how huge really are these gains? In the history of venture capital investing there are many examples of unicorn investments that delivered unprecedented returns giving investors
life-changing wins.

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Winning big is a bright and clear motivation to get involved, but definitely not the only one. What other reasons might attract investors to this exciting corner of venture capital?

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The Role of Fear of Missing Out (FOMO) 

The Fear of Missing Out is the anxiety that an exciting or profitable opportunity may pass someone if they don’t try to capitalize on it immediately. FOMO exists even amongst the top investors and venture capitalists, which creates a sense of urgency and scarcity, thereby short-circuiting some, more sober considerations (and also why fundraising startups are so eager to hype up existing investors and so keen to find their first significant sponsor). While in this specific case one might fear being left out of an amazing opportunity as well as the subsequent fame or prestige, the mechanics of the emotion are much the same. 

In unicorn investing FOMO can be a driving force to push individuals or funds so that they don’t miss a potential billion-dollar opportunity. The success stories of disrupting companies help to fuel FOMO making investors eager to jump into a deal before it’s too late.

When interviewed during a time of extreme market volatility, Warren Buffett reportedly advised investors not to "watch the market closely." He wanted to avoid investors making rash decisions about purchasing or selling due to fear of market swings. The creation of a system employing a tactic like dollar cost averaging would be a simple approach to invest "without watching the market closely". DCA investing in a methodical, emotionally controlled manner works well because the investor can continue to make investments without feeling pressured to continuously monitor changes in price (Unicorn Financial Solutions).

While ordinary human FOMO is often driven by social media, ads or just that one party-animal friend, investor FOMO is often fueled by media hype, which can create distorted perceptions of success and growth potential.

Startup founders are also not beyond employing FOMO as a tactic, so much so that there are articles warning them not to overdo it. This is prudent not only because a fake illusion of exclusivity and scarcity will in the short to long term harm investor relations but also by the side effects.

The bigger the noise, the larger the players who are attracted by it: smaller investment firms may find it challenging to get momentum due to the exclusivity created by the media's exaggeration of unicorns. This may result in a concentration of resources around a small number of well-known companies and a lack of diversity in the startup ecosystem. 

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Beyond Financial Returns: The Appeal of Unicorns

Prestige and credibility

Returns are important, but not the only product of unicorn investing. Successfully identifying and investing in unicorn startups enhances the reputation of the investor or VC firm. It implies good instincts, stronger than average fortune-telling abilities, and generally great decision-making, strengthening their brand. And who wouldn’t want to partner with people who have the edge of catching a glimpse of the future?

Funder’s trust

Demonstrating a track record of successful investments provides reassurance to investors that the firm can consistently generate substantial returns, making them more likely to invest with them. As investors build on multiple unicorn investments it can provide access to strategic partnerships with other leaders in the industry, including other VC firms, high-profile entrepreneurs, and other companies.

Fame and influence

Even if investment is predominantly about numbers, very few people are immune to the allures of fame and influence. With the media fanfare comes fame and recognition, and, combined with the material gain, a certain level of influence.

Follow the numbers

Despite the heavy reliance on data, numbers, and analytics, unicorn investing can be driven by emotions and psychology to a surprising degree. The thrill of the hunt, the fear of missing out, and the desire for prestige and influence are powerful motivators. This may serve as a reminder, that while all of us human beings fancy ourselves as rational beings, decisions often come from emotions, sensations and the body. So much so that Antonio Damasio proved half a century ago that individuals with damage to the emotional centers of their brain, such as the prefrontal cortex, struggle with making decisions, even when their logical reasoning remains intact. This is because emotions help us prioritize options and assess risk, which is crucial in [financial] decision-making.

Nothing is more powerful however than being aware of our own emotionally driven nature. It helps to double down on due diligence, analytics and search for facts. Stay tuned for our third and final issue, walking through approaches and tips for doing just that.