- “Unicorn math” is basically pure fiction.
- Nobody knows how profitable these companies actually are.
- Rising interest rates could cause the Unicorn bubble to pop.
How about that Unicorn bubble? “Unicorns,” as most investors now know, are Silicon Valley startups worth $1 billion or more in the private market. Once rare and mythical beasts, there are now more than 100 of these things.
Here’s the thing though – “unicorn math” is basically pure fiction. Like Enron math, but legal!
Here’s the secret to how Silicon Valley calculates the value of its hottest companies: The numbers are sort of made-up. For the most mature startups, investors agree to grant higher valuations, which help the companies with recruitment and building credibility, in exchange for guarantees that they’ll get their money back first if the company goes public or sells. They can also negotiate to receive additional free shares if a subsequent round’s valuation is less favorable…
Let’s say your cousin owns a junkyard. He wants to say it’s worth a million dollars so he can take out a big bank loan against it. So your cousin’s drinking buddy Fred officially buys one-half of one percent of the junkyard for $5,000, and the local podunk news station does a two minute story. Boom – million dollar valuation, confirmed by the media. Totally legit. And Fred has first dibs on scrap and title if there’s any question at all of getting his five grand back. Magnify that process by a couple orders of magnitude and hype and glitz, and you’ve got unicorn math.
It’s led to some pretty trippy places, as Zero Hedge and The Economist point out.
…the top 10 highest valued [Unicorns] have a combined private valuation of $156 billion, on just about $4 billion in revenues and employ a whopping 19.5 thousand people.
In other words, the universe’s combined historical Price/Sales ratio is 39x and each employee is worth about $8,000,000.
Bwahaha. But hold on, it gets funnier…
The biggest unicorn of them all, ride-share startup Uber (Pending:UBER), recently saw valuation numbers hit a new breakout high of $51 billion. The only other private market startup to break $50 billion was Facebook (NASDAQ:FB)… and Uber did it two years quicker.
Uber Technologies Inc. has completed a new round of funding that values the five-year-old ride-hailing company at close to $51 billion, according to people familiar with the matter, equaling Facebook Inc.’s record for a private, venture-backed startup.
Uber raised close to $1 billion in the round, one of the people said, bringing the San Francisco company’s total funding to more than $5 billion. Uber had briefed investors on a plan to raise between $1.5 billion and $2 billion in the round, The Wall Street Journal reported in May.
Why would investors still be piling into Uber at the +$50 billion valuation mark?
For one thing, we are talking about relatively small amounts per investor in comparison to total investor size. These are big institutionals, Sovereign Wealth Funds, large corporate entities, and so on. Microsoft, for example, was said to invest $100 million in Uber. That is chump change. Back when he was CEO, Steve Ballmer could have flushed that much down the toilet by lunchtime on a typical day. Then too, a lot of investors remember Facebook, and the pain of regret for not stepping up when Facebook was in the tens of billions. And on top of that, you just don’t have that many compelling areas for growth. These Unicorns are like Picassos – the supply is fixed while the buyer’s pool capital has expanded.
But here is the funny thing. Nobody even knows if Uber is profitable… or how much money they’ll actually make.
Uber reputedly had more than $400 million – in REVENUE – last year. And they are supposed to do more than $2 billion in revenue for 2015. But how much are they spending?
There is an argument that Uber is “subsidizing drivers” – paying out big extra dollars to maintain position or jumpstart growth in competitive markets. According to Kevin Kinsella of Avalon Ventures, there are rumors Uber is spending $10 million per WEEK on driver subsidies in just one city – San Francisco. Then you have the huge cost of public relations and fighting political battles… even bigger subsidies in other growth markets… it’s no wonder that Uber has seemed to be raising another billion every time someone turns around. They are burning through capital like dry leaves in a bonfire.
The idea is that, at some point, Uber becomes so big and so dominant that they own the global rideshare market. At a certain point they will have their app saturated in all or most of the important cities around the globe, and then they will make a ton of money. Supposedly.
But how MUCH money will they make? How profitable is the rideshare business, really, when you back out all the costs? And what happens when drivers stop getting subsidized – how deep is the moat?
A Unicorn valuation in bubble times can be whatever Silicon Valley wants it to be… or rather whatever crazy price the last guy into the pool is willing to pay for his tiny piece (like spending $100 on a slice of pizza two inches wide). But in the real world, after all the smoke and mirrors go away, a business is only worth cash on the barrelhead – the dollar amount that some other purchaser would actually give up to acquire the business, in exchange for its stream of cash flows and strategic value.
By this reckoning, it’s not at all implausible – certainly not guaranteed, but plausible – that Uber’s valuation could fall by 90 percent (still allowing smart early VCs to get their money back!). A 90% valuation haircut for Uber, while not a prediction, is not as crazy as it sounds: If Uber’s valuation got smoked in the private market, to the extent that 90 percent was vaporized, the company would STILL be worth more than five billion dollars. That’s still a lot… more than double the current market cap of YELP, for instance, which trades at a goofball valuation.
And then there is Airbnb (Pending:AIRB), worth more than $25 billion (according to Unicorn math). How much money are these guys really making? What kind of defensive moat can they maintain? What does the cash flow stream REALLY look like? Who knows – they’re still burning up all the cash.
Kevin Kinsella points out that there is a “magic business model” type euphoria going on. Put something on a smartphone app… strip out the employee and logistics costs… boom, infinitely expandable revenue stream! Except it’s not that simple.
…there has to be some adult supervision of the expansion and the marketing plans and the world dominance visions of some of these people. I think mobile web enabled services can be great business but A): it doesn’t apply to everything, I think the markets will ultimately get a bit fragmented when the crunch stars to happen. And the other thing is, B): it doesn’t necessarily work with everything.
I heard a pitch from some Stanford Business School grads in a café in Palo Alto. So they were smart guys – late 20’s, early 30’s. They had great academic credentials, Stanford Business School, knew a lot about entrepreneurship and all that sort of stuff, but what they were proposing to do was, taking the metaphor you’re talking about which is ‘you don’t have any inventory, you don’t have any employees, you just take a cut of these transactions.’ So they had this great idea that they were going to solve the on-time, on-demand delivery for pharmaceuticals.
So I said let’s analyse that a minute. First of all, for venture capital, one of the original principles is people you want to invest in are people who’ve done it before with someone else’s money. Not people who’ve just came out of business school.
Kinsella thinks that rising interest rates could trigger the implosion of the Unicorn bubble.
At some point cash becomes worth more than zero… and overinflated stock markets start declining… and that last guy willing to buy his Unicorn slice at ever nuttier valuations finally stops hitting the bid.
If only there was a way to make a massive put options bet on the San Fran property market…
Source: Seeking Alpha