“A billion here, a billion there, pretty soon you are talking real money?” Or are we?
This quote, attributed to the late Senator Everett Dirksen (1896 – 1969), was a reflection on government spending. As hot as it was then, it's just as hot now - especially with election day around the corner.
Nowadays, in the land of innovation we call the “tech world”, a $1B “valuation” (a word we'll explain in a moment) elevates a private company to the status of “Unicorn” - the mythical animal, endlessly sought but never found.
By some account, there are now 174 or so such “rare creatures”. It would seems that, at least in the tech world, rarity alone doesn't make a unicorn anymore.
What's So Magical about $1 Billion, Anyway?
Other than the fact that it is a BIG round number, I couldn't find a rational explanation. It seems as arbitrary as becoming an adult on your 18th birthday - without any arbitrary injection of wisdom.
But are we even talking about “real money”? No, we aren't.
And that's the problem. To illustrate, let's dig into another world that has participants spending sometimes insane amounts of money on quadrupeds: the horse world.
I'm an avid dressage rider and have been around the greatest champions - both riders and horses. The value of a horse is what someone is ready to pay for it. And when I say “pay for," I mean with cold, hard cash. When a horse is sold for $1M, there is a real exchange made: the horse for one million dollars! Not so in the realm of tech companies that are equated with our mythical unicorn.
What Does Startup Valuation Mean?
When it is said that a company’s valuation is $1B or more, it simply means a group of investors (who ow shares of the company) believe (and want others to believe) that said company is worth that amount. That does not mean, as is the case in the horse world, that those investors paid $1B for it or that an outside party is ready to pay that amount. Sure, many investors and founders want to bring that size of exit to their companies, but very few have been able to catch the pot of gold.
Rather than reflecting actual value, Unicorn valuations are inflated by intricate rounds of financing. Some will say that any private company valuation is somewhat arbitrary. Very true. However, there are metrics that have been used for ages to estimate what a business is really worth: multiple of revenue, multiple of profit, discounted cash flow, comparable in an industry, cost of replacement, etc.
In other words, there are methods that can be, and have been, applied to put a “fair” price tag on a business. None of those metrics are applied today to “unicorns” to determine their value.
How Does a Startup Become a Unicorn?
Well, then, how does a business become a “unicorn”? Mostly because the investors say so or think so.
“The market is huge!" So is the population of China - but how are you planning to make them clients?
“They have acquired gazillions of users!" Sure - but how much did they pay to get them on board, and how many of them are actual paying customers?
What characterizes those Unicorns besides their $1 billion valuation is that most of them do no generate any significant revenue (if at all), let alone profits and are burning cash like there is no tomorrow.
Anybody who has been involved in the process of investing in emerging companies knows that attributing a value to a startup is speculative at best, as the value is almost always in the future.
By the same token, everybody knows that at some point in time, the value MUST be realized via one of two ways: an IPO or a sale of the business to an acquirer. That is when the REAL value is determined. Just like horses, only when someone is ready to write a check or come with a suitcase of cash is a valuation real.
But What About the Winners?
We have seen mega acquisitions of some unicorns.
WhatsApp was famously acquired by Facebook for a cool $19B. The breakdown was as follows:
A Shares: 177.8 million A shares of Facebook
Cash: $4.9B in cash
Restricted Shares: 45 million restricted shares to the employees.
Not a bad pay day for an application which, as of today, reached the billion user mark but has yet to figure out how to generate any revenue.
Unless I am not up to par on current events, you cannot take “1 billion users who use your product for free, have done it since day one and have zero intention to ever pay for something they have used without paying” to the bank and ask for a loan. It used to be “eye balls” and now it’s users.
So What's the Catch for Facebook?
Paying for an acquisition partly with tradeable securities (shares) is not uncommon. It became all the rage during the dot.com bubble and, when the bubble exploded, it resulted in a lot of pain for shareholders for two reasons.
First, when you pay with your stock, you dilute earnings. In the case of Facebook, by something like 10%. A dilution of earnings is equivalent to a dilution of value.
Second, you put a lot of “goodwill” on your books - an official accounting term to define the difference between the value you paid for a company and its book value like liquidity, assets, etc. In the case of WhatsApp, the acquisition resulted in $18B of goodwill on Facebook balance sheet. So what’s the big deal The goodwill must be re-evaluated every year to make sure there has not been a loss of value. It there has been, then the goodwill impairment is taken as a one-time expense.
So let us say accountants estimate that the value of WhatsApp should be reduced by $1B, it would immediately be charged as an expense. In 2014, it would have wiped out 30% of Facebook profits for the year! That would mean wiping out 27B of value of FB’s enterprise value (about 8%).
Trouble in Paradise
When you look at these numbers, it becomes less and less likely that Unicorns will find an exit via a strategic acquisition unless they can go from “life as we know it is going to be wonderful some distant day in the future” to “life is great today” in a hurry. The risks to an acquirer are just too great.
What about an IPO? Not anytime soon. The stock market may, at times, resemble a mad house. Yet, once you enter the world of the public markets, the reality of quarterly results disclosure does not allow for wild speculation. Some industries with high potential are given more rope than others. But do not be mistaken, there always is a rope and all too often all it is used for is to hang yourself. Twitter comes to mind.
Thus not only the valuation of these companies is “Unicornic” but it severely reduce the opportunities for investors’ exit at anywhere those valuations (if there is an exit at all).
How Did We Get Here?
That is a fundamental question because the spontaneous generations of Unicorns has a significant impact on the entire emerging companies’ ecosystem. The answer is simple: money follows money.
The investors industry is now looking, with futility, for the next $1B opportunity, knowing full well that said “opportunity” will require gargantuan amounts of cash. Thus, VC funds have raised tons of investment money over the past 3-4 years. So much money that they cannot deploy it in “small chunks”.
The average seed ticket is now $6M. In other words, if your project requires say $2M and the early stage fund you are talking to only invests in chunks of $5M or more, they will turn you down even if you have a perfectly OK concept, a product and even a customer.
In other words, the inflated valuation of the unicorns was created by and has resulted in the emergence of mega-funds (unicorns in their own rights) who are focused on investing in unicorn companies, to the detriment of plenty of perfectly viable projects which do not have a chance to be part of the Unicorn stable.
So what’s wrong with a company with a product based on defendable intellectual property, a great team, a market need, some customers and the potential to grow revenue and profit? Well, today, if it can't prove it can reach a $1 billion valuation - everything.
Do not get me wrong, there are plenty of great tech businesses that receive funding in spite of not being “Unicorn material”. But it must be said that this obsession with stratospheric valuations is not healthy. And the tech world is starting to understand why.
So Who Are the Unicorns?
So what’s so special about these companies that they deserve to be valued at +$1B in spite, for the most part, of not being able to generate either substantial revenue, or profits? Well, here they are!
If you go through the list, as I have, you will see that they are TINOs (Technology In Name Only). Most of them are simply marketing some form of services via a web or mobile platform. I am not questioning that there could be a market for what they sell. I am questioning the fact that, unless you actually build a defendable technology position with proprietary IP, you are not a tech company, you are a retailer using technology. Lots of businesses do that: banks, Wal Mart, and others.
I picked one at random. Delivery Hero, valued at $3.1B. Sector: software? You mean that the person who delivered a pizza to us last night is actually in the…software industry? When was the last time you saw the Domino’s car stop in front of your door and said to yourself: “This is the future of the tech world coming to deliver my medium everything pie”.
During the first tech bubble, I was running a perfectly great (publicly traded) company building awesome products that we could actually deliver and that were deployed in… airplanes. Nobody cared because we did not have an “internet strategy”. Tell you what: the last thing my customers wanted was an internet strategy. All they wanted was that the tools we provided to them made their airplanes fly safely. And now we have Unicorns. The more things change, the more they stay the same.
Unicorns are mythical creatures. If they ever existed, they lived in a mythical land called the Atlantis. As for what we have been discussing, those “unicorns” are nothing but ponies with a plastic horn stuck to their forehead. It certainly provides subject matter for the media. It definitely fuels the ego of the “Unicorn” riders (the CEO of these companies). It also allows the finance world to believe they have created value. But in the end, it is all a dream. We have been there before, and we will go there again, no doubt.
In the meantime, for all you entrepreneurs who are building real companies with real products for real paying customers, do not despair. Your time is coming!