Do you know why Aileen Lee coined the term “unicorn” to describe tech startups valued at over $1 billion dollars?
Because unicorns don’t exist.
Somehow, this fact has escaped investors, who have unironically used the word to describe companies so frequently that “unicorn” is now a standard part of tech industry parlance.
If unicorn valuations were just harmless wishful thinking on the part of investors, that would be one thing. But the inflated, and in some cases outright manipulated, valuations we see today do more harm than good.
We’re heading towards a crisis point, and to understand why you have to understand how we got here.
How Companies Get Such Bloated Valuations
Snapchat will generate approximately $367 million in revenue during 2016. This is just top-line revenue, not bottom-line profit, which will be much lower. However, their market valuation is listed by Fortune magazine as $16 billion!
There are also a large number of unicorns that lose millions of dollars every year, yet still have multibillion-dollar valuations These types of premiums are truly very, very hard to justify, in my opinion, on further examination.
So how do they happen? Very simply.
It’s In Investor’s Interest To Inflate The Price
The most recent block of private stock sold to an outside investor creates what is considered the current value per share. Multiply that out by the number of shares issued, and voilà, you have a current valuation. Often, the largest price per share paid is for a block of 5 percent or more of the total stock issued to one major financial investment entity, which creates a sense of credibility.
If you see a major financial entity paying a large price per share as part of an investment round, it’s easy to think that it had to have done its due diligence and looked at the investment every which way it can.
Well, it sort of did its due diligence.
There are competing factors that influence its valuation model. The financial entities that make these investments use a lot of very generous assumptions as part of the models that generate these huge share prices. After a closer examination, you will often see that the financial entity making such an investment has an involvement with the company’s IPO.
Therefore, it is in its own interest to drive that number up, create even more mammoth expectations in the marketplace, charge the company a huge fee for the pre-IPO analysis it provides, and sell the stock it owns either on the day of the IPO or shortly thereafter.
It pockets a tidy profit before reality sets in as investors now have access to actual profit and loss statements (P&Ls), balance sheets, and cash flow statements, leading to a tanking of the stock price.
In my opinion, this is outright stock price manipulation that has duped too many retail investors who assumed that if certain financial giants invested at such and such a price, the company has to be worth at least that and then some.
FitBit: A Cautionary Tale
Fitbit Inc. is a great example of a company hampered by a bad valuation. It was actually a fundamentally sound business, but it had the weight of horribly inflated valuation to contend with when it IPO’d, and it almost crashed the company.
FitBit’s share price on its first full day of trading on the New York Stock Exchange, on June 19, 2015, was $32.50 per share. Smart analysts began to run numbers that showed this price was unsustainable, yet even though good analysts were releasing warnings, retail buyers of stock were scooping it up as fast as they could.
On July 31, 2015, Fitbit traded at a high of $47.60, which was about six weeks of trading post IPO. Over the next six months, the stock ran down to $12.15 per share.
The shills were still saying in October 2015 that Fitbit was still a good buy at $41 per share because it was approaching 15 percent off its high, which is just one indicator that is often used to determine if a stock is undervalued.
If you decided not to look at Fitbit’s financial statements but listened to the shills hawking misused “technicals” and decided to invest $10,000 in Fitbit, figuring it had at least a 15-percent upside, your investment would have been worth $2,825 in October 2016. But the so-called “smart money people” had retail investors convinced the investment would be worth $11,500
FitBit has carried on despite this rough start, but plenty of people lost large sums of money and the company itself was pushed to the breaking point because major investors were dishonest from the jump.
The Unicorn Crisis Is Coming
There are other terms related to unicorns, such as narwhals, which are Canadian unicorns; decacorns, which are tech startups with valuations over $10 billion.
In January 2016, Venture Beat released an infographic of the world’s unicorns, narwhals, decacorns, and hectocorns that totaled 229 companies that raised $175 billion in funding, which led to a total valuation of $1.3 trillion—yes, trillion!
The gap between the actual funds raised and the valuations they generated is staggeringly large. It will be painful when that day of reckoning comes, such as with Fitbit.
Let’s just hope that it happens one at a time rather than a sudden realization that unicorns don’t exist and all of the investors head for the exits at the same time. That would be painful for all of us.