UNICORN-MANIA: The Valuation Follies

Introduction

Welcome to Distilling Venture Capital.  I am your host, Bill Griesinger Distilling VC is a visionary podcast that provides an insightful and informed view of the key trends affecting the VC and tech startup world.  My mission is to cut through and go beyond the hype and Silicon Valley pop-jargon that tends to dominate the tech landscape.  I seek to provide transparency and 

 

Opening Observations:

Given that this is my inaugural episode under the Distilling VC label, I thought it would be appropriate and useful to provide you with some brief background regarding the podcast and the type of content you can expect in the future and a little about me… First, the podcast;   The vast majority of episodes I will bring will take you inside the insights, challenges, successes and the journeys revealed and shared directly through the words and experiences of tech company entrepreneurs, sometimes from the VCs who back them and others in the tech and VC community…So, I’ll usually have very interesting guests.

 

Some brief background on me, your host:  I have spent a large part of my professional life (last 20 years) working in the Venture Finance business assisting VC-backed tech companies in procuring the capital they need to grow Over the years, I have had the opportunity and good fortune to meet and work with incredible, visionary management teams, many savvy investors and have had the privilege of underwriting and financing ground-breaking technology companies, many of which continue to have an impact on the technology landscape today (like Google; a $10M deal in 2001, for example). 

 

With that as backdrop, today I want to focus on a topic that I believe signals something has gone awry in tech startup and VC land over the last 4-5 years.  And it concerns me greatly.   Have you noticed, Everyone seems to be fascinated with “unicorns?”  Venture capitalists, tech company founders and management teams, the tech press and the financial press and many others,   So, today’s episode will delve into and distill down, “Unicorn-mania” so we can make sense of what’s really going on. Let me state for the record, It Is a big distraction from what’s really important in evaluating and valuing venture-backed tech companies.  Furthermore, it really touches upon the issues of transparency and accuracy, and ultimately the credibility of the industry itself, in my view  The longer this mania continues, I believe it presents dangerous consequences for multiple players inside and outside the VC industry.  

 

So, what am I talking about?   Let’s unpack this…  First, some definitional context:  What is a Unicorn company that we hear so much hype about today?  In tech and VC parlance, it is a private startup tech company that is valued at $1B or more, in theory, referred to as its “Post-money Valuation.”   Great, what does that mean?  Not what you may think it does, as I will explain… And for historical context, The term unicorn, in VC, originated…in late 2013 when Cowboy Ventures Partner, Aileen Lee, coined the term for what she described as a tech company with a $1B valuation – and noted it was a pretty rare thing, as she pointed out then – which was correct.  There were 39 companies identified then in the ‘Unicorn Club.’  27 of those were in the Bay Area!   So, it really was just a Silicon Valley phenomenon in the beginning…

 

Lee admitted the term probably wasn’t the best or most well-thought-out description but went with it nonetheless.  

“Yes we know the term “unicorn” is not perfect – unicorns apparently don’t exist, and these companies do – but we like the term because to us, it means something extremely rare, and magical”

Aileen Lee, Cowboy Ventures, Nov. 2013

 

The term was reinforced further in a 2015 interview with Crunchbase, and it has unfortunately, been with us ever since, to the detriment of the industry, in my view.   The Cowboy Ventures’ website, even contains, to this day, a link to what it calls its “Unicorn Handling Guide” or protocol insisting that anyone using the term give proper attribution to the firm.  No one actually adheres to this “guideline” today, of course – but there it is.        This is not to malign or denigrate Cowboy Ventures as a reputable VC firm in any way.  It is, by most measures, a successful venture firm boasting a number of impressive investments and it has had a substantial number of notable exits, which you can find on their website.  So, I’m sure their LPs and their portfolio companies alike are pleased… The real issue is not about Cowboy Ventures at all…but rather a group-think mentality that has gripped and permeated venture capital…with no discernable benefit…

  How Many Unicorns Are There?  It depends on who you ask & upon whose data you rely:

(Q2 2019), there were around 450 companies globally designated as ‘Unicorns’ Fast fwd to Feb. 2020 and it’s alleged to be 580! Valued at ~ $2T (From Recent Crunchbase Unicorn Leaderboard) Q4 2019 CB Insights states there are about 390  (CB Insights) Roughly 48% to 50% are in the US About 24%-25% are in China UK and India come in 3rd and 4th with roughly 5% each

 

Here’s the central problem – The $1B+ valuations ascribed to so-called unicorn companies are not true market valuations at all.  They all utilize a metric called “post-money valuation” that inflates their value.  In fact, based on a Stanford Univ. Study, which I will dig into in a moment, 100% of all unicorns are actually over-valued to some degree when applying proper market valuation metrics based upon the terms and conditions found in the Preferred Stock rounds.

 

There is both Good News and Bad News to report with respect to this phenomenon:   The Good News:  There is a solution, a remedy, if you will, for this self-inflicted malady of unicorn-mania.  It is The Stanford Graduate School of Business Study - And it has been readily available for several years.  Stanford GSB  (By Prof. Ilya Strebulaev and his colleague, Will Gornall) – which I’ll dig into in a moment Now, The Bad News:  Few are paying attention, and some are deliberately ignoring the solution that’s been made available.  Why?

 

The Study:  Squaring Venture Capital Valuations with Reality

Downloadable pdf found here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2955455

 

So, let’s dig into the study.  The results are astounding and vitally important to EVERYONE connected to Venture Capital, tech startups, capital markets and even consumers – I’ll explain.    Released in April 2017 by the Stanford Univ. Graduate School of Business 

The Authors: 

Prof. Ilya Strebulaev, Prof. of Private Equity & Prof. of Finance, Graduate School of Bus., Stanford University Will Gornall, Sauder School of Bus., University of British Columbia, (Gornall earned his PhD from the Stanford Graduate School of Bus.)

 

Summary of Findings – From the Study Abstract: We develop a valuation model for venture capital--backed companies and apply it to 135 US unicorns, that is, private companies with reported valuations above $1 billion. We value unicorns using financial terms from legal filings and find that reported unicorn post--money valuations average 48% above fair value, with 14 being more than 100% above.  Reported valuations assume that all shares are as valuable as the most recently issued preferred shares.  We calculate values for each share class, which yields lower valuations because most unicorns gave recent investors major protections such as initial public offering (IPO) return guarantees (15%), vetoes over down-IPOs (24%), or seniority to all other investors (30%).  Common shares lack all such protections and are 56% overvalued. After adjusting for these valuation-inflating terms, almost one-half (65 out of 135) of unicorns lose their unicorn status.

 

Important takeaway regarding the findings of the Stanford Study:  The results and findings are not predicated upon some intricate mathematical or econometric model requiring reliance on multiple assumptions and conditions to arrive at its conclusions.  On the contrary, the Stanford Study valuations are derived directly from the legal, contractual terms and conditions negotiated between the venture investors and the companies.  Therefore, the study utilizes the actual economic terms of each Preferred round as it was negotiated – No assumptions or conjecture about the values in the Study are necessary.  This is a critical point.

 

It’s a Consumer Protection Issue:

A number of the largest US mutual fund companies (Fidelity, JH, T. Rowe Price and Vanguard) have invested directly in private co. unicorns In 2015, Fidelity > $1.3B into unicorns!  That’s more than any US-based VC fund invested that year.  Including $235M in WeWork, $129M in Zenefits – A company that hired too many people, grew too fast, and the company culture spiraled out of control, and $118M in Blue Apron, the food delivery startup that IPOd in June 2017 and is now looking for a buyer… What is the common thread on all these investments by major mutual fund companies?  They all used the meaningless post-money valuation to value these private tech company assets in their portfolios.  Let that sink in for a moment.  It’s Mind-boggling Incredibly, they have accepted and used these meaningless valuations to mark their holdings of these private tech companies w/o further analysis – a completely irresponsible methodology.  It surely doesn’t inspire confidence in their ability to perform proper valuation analytics  Where’s the adherence to the fiduciary responsibility of these investment firms to their clients?  There are real financial implications for any retail investor in a mutual fund (401k or directly) related to this high-risk category.  How about institutions?  Univ. endowments, public pension funds, etc.? Are mutual fund companies fully disclosing real risk of this asset class to their retail investors?  Accurately?  How so, if at all?  (e.g. – Fidelity had to recently write down its WeWork holdings to reflect the difficulties the company has “reported” after the cancelation of its IPO.)

 

In addition, 3rd party equity market platforms, such as EquityZen, are providing average retail investors exposure to this class of priv. company unicorns…never before available. 

 

 

Where are the Real Journalists?

On the Media side - There exists an almost a schizophrenic-like behavior exhibited by the technology press in its years-long coverage of unicorns; To be sure, at the beginning there were some real attempts by a handful of outlets to highlight the findings of the Stanford Study, which were astounding; On the one hand, tech & financial media and the data analytics groups (CB Insights, Pitchbook) seem to recognize the lack of rigor and reality associated with over-valued unicorn companies.  They openly refer to it at times in their reporting e.g.  - CB Insights CEO, Anand Sanwal, recently opined in an August 2019 piece that it (unicorn status) is often used as a scheme to attract top talent in a very tight hiring market for key tech talent… At the same time, however, they ALL seem to vacillate between this recognition that something isn’t quite right about the valuations, yet still breathlessly, gleefully and even feeling duty-bound to report on the next stable, class, pack, leaderboard or club of unicorn companies, which have allegedly “achieved” unicorn status as a result of their last preferred stock financing round;   Some of which are even “born,” as has been reported!  Who knew?  Just a matter of being born into the unicorn aristocracy, I guess.   From my experience, a $1B tech company isn’t ‘born.’  They are built, nurtured and grown with talent, hard work and execution with a value proposition geared to solving real, identifiable needs and wants of customers.

 

Did you ever notice that the PE industry doesn’t have an equivalent designation (Unicorns) for its $1B+ value companies, even those that are in the tech category?

 

 

Let’s Summarize Where We Are:  

So, The widely touted tech unicorn is a myth…So, why are so many tech and business news outlets breathlessly reporting about it as if there is some meaningful significance behind these widely hyped values?   We surely know that unicorns are mythical and not real – just like the post-money valuations touted and hyped by Silicon Valley and many others… How do we know that?  The Stanford Study proves it!  Again, we’ve had the empirical evidence showing exactly that since the Study was first published in 2017. 

 

Keep in mind, that I don’t care or decry that Pref. equity investors desire, negotiate and receive such terms.  It’s a matter of proper disclosure…not economics.  The market will make its own determination of value associated with such economics. However, the economics must be disclosed…before an IPO or other exit.   Every claim that a tech firm has allegedly achieved what is fondly referred to in the Silicon Valley bubble of “Unicorn” status, a valuation of $1B+, should be required to apply an asterisk * next to that proclamation.   A footnote detailing and clearly explaining that “post-money valuation” is not market value nor market capitalization and explain how it’s derived.   However, there is no such reporting requirement for these private companies.  Should there be?  You know, in the interest of transparency and accuracy;  In other words, some real “truth-in-advertising” I believe it says a lot about the state of reality in tech-land today;  A loss of focus on business fundamentals, a willingness to kid ourselves, our LPs and the public about true value… In the long run, history will reflect upon this episode in tech history, as nothing more than a silly aberration…and hopefully a forgotten footnote 

 

Conclusion: 

It’s been fun and, and I will admit, even entertaining at times, but we need to put a stop to this game before it all gets out of hand…and someone gets hurt. The WeWork debacle, among other examples, indicates some have already been harmed…And major mutual funds are in on the game and failing to uphold their fiduciary responsibility to retail investors.     Caveat:  While unicorns are definitely mythical characters, there is an identifiable, measurable valuation of priv. tech companies – it just isn’t what has been used to arrive at the purported $1B+ valuations promulgated today that are masquerading as unicorns… What I am really hoping we can do is just move on, refocus on the important and relevant metrics in building and growing successful companies, and dismiss the unicorn-mania phase as nothing more than an idyllic aberration and distraction, to be forgotten, for good…because it has served no useful purpose in understanding VC and technology.  NONE!

 

[Also See:  Silicon Valley has a Media Problem and it’s Getting Worse – Yahoo Finance]  [Note:  It’s not a media problem. It is a credibility and transparency problem, which is creating negative coverage, that SV finds uncomfortable.]