The fundamental idea behind Initial Public Offerings, or IPOs, is that when companies need capital, they get themselves listed on public exchanges such as the NYSE and NASDAQ, instead of approaching institutional investors such as investment banks, venture capital firms, and mutual funds. In such a scenario, the investors also enjoy the ability to make either a full or partial exit. Meanwhile, new investors expect better returns in the future even for stocks that do not fare well to begin with.

But is such optimism warranted? Not at all! The Wall Street Journal analyzed in an article dubbed: For IPOs, earning a profit matters again, and published on October 15, 2015, the profitability of IPOs. It found that after the second year, the returns of unprofitable companies gradually declined even further while those of profitable companies continued to rise.

If we look at the current state of IPOs, it seems that the market is bouncing back. However, the major players still aren’t gravitating toward IPOs, and it’s not certain that the latter will be able to meet the on-paper valuations set by private investors.

What about Middle Eastern unicorns and investors?

There are over 3,000 startups in the Middle East, with the top 100 funded outfits having raised $1.42 billion. Last year’s startup investments totaled over $870 million; each company raised over $500k.

Currently, Careem, the on-demand cab-hailing company, is the only unicorn in this region. Careem has raised capital from eight investors based in the Middle East and North Africa, apart from those in the US, Japan, and Russia.

The ecommerce company Souq.com had reached $1 billion valuation before its acquisition by Amazon in last March for $750M. Although Souq.com does not report its financial health, it appears that its turnover reached AED500 million (US$136 million) in 2014, and it was expected to make AED1 billion (US$270 million) in revenue in 2015. Other major unicorn investments by MENA investors include Jetsmarter, Uber, and Apttus. According to Bloomberg, the IPO market in the Middle East is poised to rebound.

It is important to note that private investors have become more patient in terms of cashing out, meaning that they allow companies to stay private and reap the rewards of hypothetical returns. Amid all this, few investors are considering IPOs and fewer still have moved to the public market. So what’s fueling the sky-high valuation of these unprofitable unicorns, and what happens when they hit the public market? Will investors get enough returns from them?

There will be cash

Uber, the highest-valued private technology company, is probably the poster boy of the ‘next-time-it-will-be-priced-higher’ pipe dream. While its revenue is growing rapidly, it remains highly unprofitable. With a net revenue of $6.5 billion in 2016, it registered a net loss of $2.8 billion. This is happening at a time when Uber is operating with the cheapest possible labor cost. Uber’s model will be sustainable only if it runs its own fleet of autonomous cars, but that would prove even more capital intensive. In the meantime, it continues to secure capital via debt financing and equity. The last known round was led by Saudi Arabia's Public Investment Fund for $3.5 billion.

Those who are investing in Uber are not looking at the price-earnings (P/E) ratio. They are investing in the belief that one day Uber will transform the transportation market with flying cars and Ubereats. Another crucial motivation is their fear of losing out. If investors miss the current opportunity, in future they’d have to pay more. There is no dearth of wealthy people willing to place blind bets, so investment firms like Morgan Stanley and Bank of America Merrill Lynch are pitching Uber to their rich clients. This will probably continue for the foreseeable future. The Series G might go up to Series Z, as the investors are flush with cash and will keep on feeding their unicorns!

If we compare Uber with its Middle Eastern counterpart, Careem, it’s interesting to note that Careem claims higher revenue per user. Also, Careem’s growth is the fastest in Saudi Arabia and the UAE, while Uber is able to woo new users in Egypt at a more rapid rate.

But the most heartening sign is that Careem is eyeing profitability in 2018, having secured an investment of $150 million in the Series E round led by Saudi-based Kingdom Holding and Daimler. Kingdom Holding had also invested in other unicorns such as Twitter and Snap before they went public.

Did investors Snap?

When a company lists itself on the public market, the story doesn’t end there, as it would need access to capital in the future. This is a recurring theme for all those involved in the company, so there has to be a balancing act ensuring that the interests of both the buyer and seller are addressed. Sellers would like to raise maximum possible capital without losing much control, and buyers would like to gain control via shares without paying an exorbitant price. In the case of Snap, the app that lets users send ephemeral photos and videos, the IPO was different. At Snap, the investors had infused capital into the project so as to gain private shares before the IPO ended up earning voting rights, and the company was able to avoid certain public declarations regarding pay and board structure. This means that Snap’s shares were offered to public without the latter being able to acquire voting rights. Long story short: Snap’s stock closed at $24.48 per share on opening day, rising 44 percent from the offer price of $17 and gaining a market value of $28.33 billion.

About a month after the opening day, Snap released its first earnings report, which indicated that it had added 8 million daily active users in the period (global DAU of 166 million), with $150 million in revenue and year-on-year growth declining to 36 percent (Facebook’s copycat model at play?). These numbers didn’t match the market expectation, and stocks tumbled to $17.12 – not much more than the initial offer price – at the end of trading hour. If you’re someone who has purchased stocks and aren’t happy with how the company is performing, then understand that, with non-voting stocks, your hands are tied.

Note that Snap CEO and cofounder Evan Spiegel received close to $750 million for closing the company’s IPO. At the end of the day, the founders got millions for an unprofitable camera company and retained overall control. Think about this; had they taken more time and gone public with a couple of more quarters of discouraging results, they wouldn’t have retained this much control and cashed out. That said, it’s interesting that the early investors – Benchmark Capital and Lightspeed Venture Partners – stand to lose $604 million and $410 million, respectively, for every $5 drop in the stock.

When it comes to the fate of unicorns, it is quite evident that Snap's post-IPO results augur badly for the mythical creatures as well as the venture capitalists feeding them. What happened with Snap is a cautionary a tale of a unicorn that won the race, but whose backers didn’t win as much as they had expected in return for betting on it. So when the next VC-backed unprofitable unicorn trots up to the market, let’s hope investors tread carefully.