Unicorns and Bubbles
“What we learn from history is that people don’t learn from history” – Warren Buffett, 2006.
A financial bubble is characterized by an unsustainable increase in the divergence between the price of an asset and its true intrinsic worth. Speculative enthusiasm is always to blame for such irrational exuberance. However, in the end, all bubbles see the price of the underlying asset decline to a level more in line with its fundamentals. Our financial history consists of countless bubbles. The underlying assets have taken many shapes and sizes. For example, something as silly as a tulip bubble (Tulip Mania: 1634-1637), as important as a railroad (British Railway: 1840), as disruptive as the internet (Dot-Com: 2000) and as tangible as a house (Housing bubble: 2006).
A similar level of speculative enthusiasm appears to be taking place in the startup investment scene where valuations of these emerging companies, known as unicorns, have reached astronomical levels. Factors other than fundamentals appear to be having a material influence on their valuations and for those that are enthusiastically embracing this sector, some context and history may be helpful.
A unicorn is considered a privately held startup company valued at over $1 billion. There are currently 138 unicorns in the U.S. with a cumulative valuation of over $500 billion (source: Pitchbook). In 2008, there were less than 20 unicorns in the U.S. with a cumulative valuation below $25 billion. In just ten years, valuations of all the unicorns in the U.S. have increased 20 times! Total deal value for this year is now expected to exceed $100 billion in the U.S., levels not seen since the dot-com bubble. China is said to currently be hosting 168 unicorns with a cumulative valuation of $628 billion. It takes just four years to achieve a unicorn status in China compared to nine years in the U.S. Chinese startups raised $84.5 billion in the first half of this year, which is double the amount raised during the same period of last year (source: Zero2IPO). In June, Ant Financial, a Chinese fintech company, raised $14 billion in one of the largest private-capital raises in history. It is now the world’s most valuable unicorn with a valuation of $150 billion!
Investment in the startup space has skyrocketed as capital availability is at an all-time high. The number of venture capital firms has soared and non-traditional players, such as private equity and even mutual funds, have now also entered the space in search of higher returns in a low interest rate environment. The entry of these new players, flush with capital to invest, all competing for a limited number of ideas, have had consequential side effects; most notably, putting upward pressure on company valuations. With so much available capital, cash available for investments behaves as if it were a price insensitive commodity. As a result of this, the value proposition and competitive advantage of investment firms is no longer based on discipline but instead on its scale. An investment firm is advantaged if it has more capital to outbid their next competitor. This behaviour results in bidding wars that inevitably lead to the investment firms having to pay higher prices. A higher price paid means a lower future return for the investment firm. Therefore, these mega investment funds are now tasked with deploying records level of cash at a time when prospective returns are at their lowest. When capital is not allocated efficiently, risk aversion ceases to become important and overall return suffers.
One such example of a mega fund is Masayohsi Son’s Softbank Vision Fund which is armed with a $100 billion in capital. Mr. Son is known for his risk taking and willingness to do so on enormous scale. The Economist reported in May that the fund has already invested $30 billion, which nearly equals the $33 billion that the American venture capital industry raised in 2017. The size of this fund has caused a ripple effect across Silicon Valley increasing both the size of funding rounds and valuations. Last year the median late stage deal size was just $11 million, now funding rounds of $100 million are more common. This has forced other investment firms to increase their scale and adjust their risk/return tolerance hurdle rates to remain competitive. Media headlines often tout the emergence of such large funds as justification for the booming startup scene. We believe such headlines should be viewed as a red flag, not as justification, but as a warning to the excess in the industry. It is important to remember that in the last Tech Boom Softbank lost 99% of its market value. A clear sign of overindulgence, if there ever was one.
A majority of startup companies have no earnings in the beginning and therefore their valuation is solely reliant on their expected earnings power sometime in the future. With this in mind, it is worth highlighting the speed at which many of these early stage companies have seen their valuations rise. Bird, an electric scooter company, was the fastest company to reach a billion dollar valuation after raising its fourth round of funding in less than twelve months. DoorDash, a food delivery company, saw its valuation triple to $4 billion in less than four months. The consistency of which startups are seeing their valuation increase in lockstep with each funding round, is reminiscent of the Tech Boom when the NASDAQ skyrocketed from 2,000 in 1998 to 5,000 in 2000. The parallels between the Tech Boom then and today largely rest in the observation that the valuations of the companies involved are once again significantly outpacing their future earnings power. In most cases, these companies have no chance of living up to the earnings implied by such valuations.
If a company’s first funding round resulted in a valuation of $100 and the second a valuation of $150, did the earnings power increase to justify this 50% higher valuation? Did the startup find a more efficient way to sell its product/service? Did their total addressable market increase? Is its business model now better protected by a competitive advantage? It is ironic that with many startup valuations, the only aspect of their business model that isn’t believed to be disruptive is their own projections of earnings.
The National Bureau of Economic Research has estimated that, on average, unicorn valuations are 50% overvalued. Furthermore, researchers at the University of British Columbia and Stanford examined 135 startups and concluded that nearly half of the startups should in fact be more accurately valued at less than a billion dollars. This is a reminder that a great idea and a bad price can coexist. Valuation has to matter and an investment should only be made at an attractive price, which includes an element of caution.
Possibly because of extreme overvaluation in the private market, emerging companies are waiting longer before accessing the public market. Historically, private companies would list their shares on the stock exchange after five years, today it is nine. The public market tends to do a reasonable job of valuing companies and reflecting this value in their stock price. It is therefore interesting to note that of the ten unicorns that went public between 2009 and 2014, today only three trade above their peak private market valuation. So far this year, only three of the fifteen tech IPOs (initial public offerings) have had positive earnings in the preceding year before going public. Blue Apron, for example, had a private market valuation of $2.1 billion but has declined to less than $500 million in the public markets. Fitbit had an initial IPO valuation of $4 billion, today it is just $1.3 billon. In both these cases, the public market was able to recognize that neither of these companies had a competitive advantage preventing competitors from replicating their business. Their private valuations were obviously too optimistic and focused on growing customers and sales regardless of cost. In the public market, earnings and cash flow are what matter, and are the essential value drivers of its business and valuation.
With each passing day we hear of a new startup company receiving more and more funding and reaching astonishing valuations. It is naïve to believe that once this steady stream of capital dries up, which it surely will at some point, valuations will be unaffected. A company unable to generate cash flow to sustain itself internally will see its valuation evaporate. The Tech Boom of 2000 was a prime example of this, despite the fact that the internet was indeed changing the world: valuations were too high and many of the unicorn sightings proved to just be an ordinary horse with a glued on horn. For those investing in unicorns in these private markets today, CAVEAT EMPTOR!
The Summerhill Team