Of Unicorns and Bubbles
In this blog, Dr Mike Lynch OBE FREng discusses the realities of the Silicon Valley ‘unicorn’ trend and his advice on building a billion-pound business.
It is normally the minds (and letters to Santa) of little girls that are filled with thoughts of bubbles and unicorns, but this year, mine is too. Unicorns, the latest trend from Silicon Valley, are private companies with a valuation of over $1 billion. A year ago, everyone aspired to be one, but the trend is cooling somewhat, and the voices of caution are starting to be heard.
In the main, tech company public markets are showing normal ranges for technology company valuations. However, valuations of some private companies can only be described as crazy. Many of those in the billion dollar plus valuation category, are every bit as mythical as the creatures they are named after. If one takes an old-fashioned approach and looks at the amount of money involved in these transactions, it is clear that there isn't much cash going in at the high valuation. For example, a venture capital company owns shares valuing a business at $100 million, then buys one share at ten times that value and, hey presto, the company says it is valued at $1 billion. That $1 is enough to revise the value of the business upward and, incidentally, revaluing all the VC firm's other share in it up to this new level. At the moment, this magic and similar conjuring is often how we end up with unicorns out of thin air. These investments often come with some steep conditions attached, sometimes guaranteeing that, not only will the investor get his money back, but also with a guaranteed return. Another trick the late stage conjuring investors have, is to obtain "ratchets" where they receive extra shares to compensate if the firm's valuation is reduced in an IPO. This means the valuation is not real in that there are no buyers or, as they say in the markets, "no liquidity".
These increasingly complex deals mean that the founders of the company and its employees, as well as less sophisticated investors, are the ones likely to suffer. Venture capital funds, who mark-to-market their books on these valuations, are showing great returns – for now. In fact, these investments are illiquid and have no basis in reality. The man with the million pound note could buy no food.
Another consequence of these unicorns is that nobody is able to sell, and so we have a stagnant situation of over-hyped companies with unsustainable valuations that investors can't realise. A phrase I have been hearing a lot recently is that for many tech companies, "the IPO is the new down round". Square, a payments company, did an IPO recently that valued the firm at around $4billion, a third less than its most recent private round. It isn't alone: Pure Storage also went public at a lower valuation than its last private round, and Etsy, the online marketplace for handmade products, is currently trading at around 70% of the price it listed for in April.
This hasn't happened overnight, and there have been many roads that led to this. Low interest rates have made many investors look for alternative places to put their money, and Silicon Valley has provided many interesting opportunities. Private equity funds began to tread the toes of their (usually smaller) venture capital brethren, writing temptingly large cheques. Tech companies started to describe their valuations in terms of profit margins, then revenue multiples, then they began to use proxy metrics such as "monthly users" and then, when scrutinised, would simply huff "you just don't get it". Curiously, many people have been taken in by this last line.
This is a bubble, and it won't be long before it pops. In its way, this is a re-run of the 2008 financial crisis, with people marking their investments to market when that value doesn't really exist. There is absolutely no liquidity in these valuations. My concern began when we began to see fewer technology specialists investing and general investors such as hedge funds, oligarchs, princes and property developers filing the gap.
Now that IPOs have lost their allure for many founders and certainly aren't in the interest of the venture capitalists, the only way to raise money is on the private market, which is creating behemoths. The number of entities that could acquire any of these unicorns is very small.
Finally, another problem with the amount of money being pumped into these businesses is that they spend it! Lyft, a taxi-hailing firm that is a rival of Uber, suffered losses of almost $130 million in the first half of the year, on less than $50 million in revenue and rumour has it that food delivery company Instacart, loses $10 on every order it fulfils. Clearly, this isn't sustainable, however you are valued. This isn't true of all unicorns. Airbnb, for example, has $2billion on its balance sheet and a run rate of $100 million a year. When things get tough, it isn't hard to guess which company will suffer most – fiscal prudence usually pays off.
We will be hitting an interesting period and things must normalise soon, though I dare that when the bubble does burst, we really might see some unicorns fall from the sky. Please, those of you about to write in and tell me "I just don't get it" don't bother: its true, I just don't.
So, my tech investing advice is rather less exciting it's …buy low sell high.