This final piece to our five-part series – marking the 20th anniversary of the peak of the dotcom bubble this week – illustrates that, whereas the 2000-04 crisis proved the corrective power of public markets, the fact that unicorn breeding has mostly taken place in private hands raises unfamiliar questions.
Q4 2019 hedge fund letters, conferences and more
Mind The Valuation Gap
The value granted by investors to a business always factors in several years’ worth of growth. The difference between a very mature, publicly-listed corporation, trading on 20 times net income, and a private equity-owned company valued at 20 times EBITDA, or a very nascent, unproven VC-backed enterprise valued at 20 times revenues, is one of expectations. Start-up investors are prepared to price significant future expansion in today’s value because they finance businesses experiencing exponential growth.
But the recent spurt of extravagance in venture capital has altered valuation metrics. More specifically, the word ‘valuation’ is not what it used to be. The main misconception originating from unicorns is the idea that post-money valuations are the equivalent to enterprise values for publicly-listed firms. There are two main distinctions:
- due to the small number of parties involved in negotiations, private markets cannot offer as reliable and efficient a price-discovery mechanism as that provided by stock exchanges and their higher levels of liquidity;
- perhaps more importantly, the capitalization reported by public markets only concerns itself with common stock. There is no value indicator provided for more senior equity instruments, such as preferred stock. By contrast, venture capital seeks to derive a valuation for start-ups that is negotiated between stockholders who possess two different equity instruments: common stock, typically held by founders, and preferred stock, in the hands of institutional investors, primarily VC firms.
The valuation assigned to a start-up is not the equivalent of a public corporation’s enterprise value because preferred stockholders receive downside protection thanks to their liquidation preference, a benefit that no common stockholder in a publicly-listed company has. Thus, when introduced to stock markets, VC-backed start-ups should undergo a negative valuation adjustment (a down-round) to reflect the downside risk public investors are exposed to. Many recent unicorn IPOs have gone through such experience, demonstrating that stock markets are aware of the distinction.
The media does not appear to grasp the nuance. Sadly, neither do some founders and early-stage investors. A recent commentary reported by AngelList read as follows:
“A growing number of entrepreneurs and venture capitalists are now deciding whether or not there’s something wrong with the IPO market, given that these IPOs are proving to be more and more inhospitable.”
Public investors might possibly counter that ‘there’s something wrong with the VC market.’
Rigging The Valuation Game
Further proof that start-up transactions are not settled the way they are for publicly listed stocks is provided by the skewed distribution of valuations assigned to unicorns.
According to CB Insights, as of December 2, 2019 one-third of unicorns had a valuation set exactly on the $1 billion mark. Only 4.5% of unicorns were reported to be ‘worth’ $1.1 billion while 4% of them were valued at $1.2 billion.
Already in 2014, venture capitalist Brad Feld declared that he had ‘never, ever felt like the “billion dollar” aspiration, which we are now all calling “unicorn”, made any sense as the financial goal of the company.’
Yet there are two key reasons why, six years later, there are between 420 and 450 unicorns worldwide.
First, because their manipulation of public markets gave them a bad reputation twenty years ago, start-up investors decided to try a distinct approach. In a way, generalizing the unicorn status within their portfolios is a safer, or for now less controversial, method to engineer, even manufacture, extravagant valuations away from the prying eyes of regulators. Today’s VCs have privatized the ‘first-day pop’ so familiar to the dotcoms.
Second, tech entrepreneurs often make unsubstantiated claims to build hype - what was termed ‘management by press release’ during the dotcom boom. Start-ups announce several months in advance that their next round of fundraising will be set at $1 billion, $5 billion or $10 billion. This negotiation tactic - called anchoring - serves to influence prospective investors, the media and business partners, but it rarely (if ever) reflects the true fundamentals of the company.
Membership provides a high level of free press coverage to the unicorn club’s representatives. It is a promotional ploy. This kind of ‘blitzmarketing’ is extremely valuable in a crowded start-up environment, yet it renders valuations meaningless.
Beware The Pendulum’s Swing
In early April 2000 the Nasdaq, a composite of mostly technology stocks, dropped 40%, notifying the end of the bubble. By July of the same year Amazon was down 60% from its peak. In 2000 alone, about 2,000 companies and $1.5 billion of equity value disappeared.
That amount looks quaint when compared to today’s herd of unicorns and decacorns. But such species were not totally unknown during the dotcom era. In March 2001, online retailer eToys, once worth $20 billion, filed for bankruptcy. Its stock had gone from a peak of $90 a share to $0.09 when it folded.
Who knows when the end of this investment cycle will come? Some expected last year’s lacklustre Uber IPO or WeWork’s scuttled listing to act as starting pistols to a rush for the exit. When vaping pioneer Juul lost two-thirds of its value earlier this year, critics made similar predictions. Could the coronavirus pandemic strike a fatal blow? In truth, what the 2000-04 crash emphasized is that there will likely be many false starts before the private markets turn south for a prolonged period.
For now, price adjustments have happened sporadically and on a case-by-case basis. Once a unicorn, meal-kit service provider Blue Apron has lost 98% of its value in the 30 months since its IPO. Wearable firm Fitbit saw its market cap erode by almost 95% before Google chose to take an interest at a $2 billion valuation - it was once ‘worth’ over $13 billion.
The most likely scenario is that of a gradual erosion in appetite for unhedged risk in unproven business models. It might take several years for the full correction to run its course, but the cumulative losses will be much greater this time around. Today, over $1.3 trillion in paper value is stamped on unicorns worldwide. The larger this number gets, the steeper the write-downs.
Value Creation And Creative Destruction
When reality can no longer sustain investors’ exaggerated expectations, the laws of gravity will catch up. All parties involved must remember that unicorns must somehow remain grounded since they cannot fly. Otherwise they would be called pegacorns. The current cycle hasn’t bred any start-ups of this species, so it might not have reached its climax yet.
Of course, deliberate culling would be welcome. As was the case twenty years ago, despite the hype, there is something very real about some products and services currently being developed. The process of creative destruction needs to happen to identify which unicorns can justify their valuation, and which ones are just fairy tales.
After all, today’s GAFAs only came into their own in the wake of the dotcom crash. Apple launched iTunes in 2001, and following the roll-out of product hits, it now has one of the largest market caps in the world. Facebook was created in early 2004, vying for audience when social media was still figuring out a revenue model. The same can be said about search engines. Google’s 2003 revenues were below $1 billion; last year, they topped $160 billion.
Big Tech Generations
In 2000, five technology companies dominated: Microsoft, Oracle, Intel, Dell and Cisco. Only the first two have seen their market capitalization rise above the dotcom era. Cisco’s stock still sits 45% below its 2000 peak. Dell went through a painful downsizing.
Today, we have the GAFAs and Microsoft dwarfing all other companies in the sector. No one can predict who the next tech giants will be. For years, Amazon was pummeled by critics and variously dubbed amazon.toast, amazon.bomb or amazon.org for operating as a not-for-profit entity.
It is only after this bubble has burst that unicorns with a viable model will stand out. Well over 90% of the dotcoms have since disappeared or become irrelevant, including former titans like AOL, Excite@Home and Yahoo! Are Tesla, Uber and Snap the next GAFAs or the next AOLs? Eventually, the market will decide.
