Art Valuation

In the world of venture capital, there exists a special class of startups that attracts the attention of investors from nearly all backgrounds: Unicorns. These firms consist of private startups that are worth at least one billion dollars. The taxonomy goes further in order to identify the truly massive startups called “decacorns,” referring to their valuations in excess of $10 billion. Companies like Uber, Snapchat, AirBnb and SpaceX are among the best-known unicorns.
Conversations about the size of the valuations seem just as ubiquitous as the companies themselves. Headlines read of Uber’s $62 billion valuation, which easily surpasses Ford’s $50 billion market capitalization, and of AirBnb’s $25 billion valuation, which similarly trumps Hilton Group’s $22 billion market capitalization, despite having only eight percent of its revenue. In response to these astonishing sums, skeptics reverse engineered the growth expectations via traditional valuation techniques and found that, with astonishing frequency, unicorn valuation depends purely on optimism. Optimism, however, is not a new element in Silicon Valley’s expectations or in inflated valuations. The cause for this trend in inflating valuations is best explained by the changing nature of venture capital as it pertains to unicorns, and as a consequence, it is clear that valuations do not attempt to represent concrete value.

New considerations have been included into the valuation calculus. Average funding round size has increased dramatically in recent years, with some suggesting that “Series A round is the new Series B round,” referring to the notion that funding typically increases in each successive round. Over the course of 2014, average Series A funding rose 6 percent, Series B rose 20 percent, Series C rose 31 percent and Series D rose an astounding 100 percent. The increase in Series D funding picks up on a new strategy used by technology companies like Uber, in which mature companies stay private for longer and sustain operations with large, late-stage funding. Indeed, part of the inflation trend is due to the prestige of unicorn status itself, which is evidenced by the fact that Fortune Magazine lists just fewer than 100 companies that have valuations of one billion dollars, out of a total of 229 unicorns. CEOs and investors may see a startup’s unicorn valuation as a way to legitimize the company, attract new talent and over time, justify the overly ambitious valuation. Another part of the valuation inflation is due to the popularity of “downside protection provisions” as elements in funding agreements that shield investors from risk. For example, senior liquidation preferences are one common downside provision, and specify that an investor has its investment returned before other preferred stock or common investors should the company be liquidated. Another common downside protection is a provision that guarantees an investor additional shares if the company raises funds based on a lower valuation, thereby preserving the value of the investor’s stake in the company. Such stipulations have been increasingly popular as a method to shield against risk from investors, which consequently frees investors to make larger investments. As a result, it is clear that the inflation seen in valuations of unicorns represents the fact that the valuations are not pricing risk accurately.

Notable individuals from the worlds of technology and business have voiced concerns over some outlandish calculations. Jim Breyer, prominent investor and partner at Accel, a venture capital firm in California, commented early this year that he expects only 10 percent of current unicorns to survive and the remaining 90 percent either to fail or be revalued. Assuming his estimation is correct, only about 23 companies have accurate, or at least sustainable, valuations. In fact, skepticism is not uncommon. Bill Gates is wary of the future of unicorns as well, and warned of “overenthusiasm” in startups during a February interview with the Financial Times.

Regardless, some investors remain bullishly optimistic on unicorns. Scott Kupor, chief operating officer at venture capital firm Andreessen Horowitz, attempted to disabuse skeptics of the notion of a second tech bubble in a presentation this past year. He highlighted several key differences between 1999 and today, most notably the dramatic increase of Internet users (900 percent), the amount of funding (only 32 percent of the 1999 level) and the much lower median time to IPO (four years today versus 11 then), among other metrics. Evidently, he failed to convince many of his colleagues. A survey of 500 startups conducted by First Round Capital found that 73 percent of responders affirmed the existence of a technology bubble. The proportions of this bubble do not approach the frenzy of the late nineties, but there still remains an implicit understanding between startup owners and venture capital firms that valuations do not exactly equal value.

These mismatched valuations explain in part the scarcity of technology sector IPOs in 2015. Once public, markets will decide the true value of companies, so startups need to delay public offerings until fundamentals can support IPOs that reflect private valuations in order to protect investor value. Both Box, a cloud storage company, and Square, a payment service company, went public with offerings priced below their private valuations, providing a cautionary tale for executives and investors at other unicorns who have their eyes on the public market.

Like the valuations themselves, the disagreement over the existence of a second technology bubble can only be decided by the market itself in the years to come. Many of these unicorns have indeed reached incredible sizes with incredible speed. In seven years, Uber became the world’s largest taxi provider; it took AirBnB eight years to become the world’s largest hotel-provider. Perhaps it seems likely that the upper-echelon of the “decacorns” has substantial overlap with the ten percent mentioned by Jim Breyer. Yet, considering the 100 or so startups that may have wrangled for a billion-dollar valuation only for the title, many unicorns are simply overvalued, despite the “enthusiasm” attached to their future prospects. Silicon Valley and its bankrollers ought to remember that while enthusiasm is a critical asset for any startup, it is only as valuable as it is monetizable.

In August, Uber, the on demand taxi service, reached a valuation of over $50 billion, as first reported in the Wall Street Journal. To put it in perspective, according to a report by PricewaterhouseCoopers, Sabmiller PLC, a British company ranked 100th on PwC’s list of the largest companies globally, only has a market capitalization of $85 billion. This rise in valuation is not limited to Uber, or even Unicorns, companies that are valued at over $1 billion. For example, according to CB Insights the amount of startups that raised rounds of money over $100 million has gone from 50 to 100 companies. There has been a systematic rise in the valuations of startups.

Many observers see this rise in valuations as a bubble. They argue that a combination of low interest rates, aggressive strategies by venture capitalists, and our obsession with finding the next Facebook, have produced an environment where companies can receive extraordinarily high valuations with little justification.

The theory that there is a bubble in startup valuations, misses a few key points. While it certainly is true that low interest rates have led to higher valuation, and that certain startups have artificially high valuations because venture capitalists wanted to be included in their round, these aren’t the only reasons for the high valuations. These companies are not like the notorious online grocery stores of the dot com era, rather there are other factors at play that justify the increased valuations. Maybe not to the extent being seen now, but still high enough where it is hard to call the current climate a bubble.

The causes of the rise in investments in private companies are partially explained by more companies staying private for longer periods of time. An article in the New York Times, states that the median amount of time it took for a tech company to go public from 1980 to the present was seven years. Yet, tech companies that went public in 2014 waited, a median of eleven years before going public.

This push towards more privatization has been caused by a number of factors. Changes in certain financial regulation, specifically Sarbanes Oxley Section 404, which increased the degree of financial transparency a company must have, prompts startups to stay private for longer, as they wouldn’t have to file cumbersome earnings reports, and can instead focus on increasing productivity. With increased focus on financial transparency, it’s now in a company’s best interest to avoid the scrutiny of going public. Also by not going public, firms don’t have to worry about investors who are likely to sell of their stock if they don’t meet earnings. Finally, startup founders now have the ability to sell some of the shares of their startups on alternative markets, yet another reason to remain private. Companies like Equidate and SecondMarket, allow people to sell their shares in a startup, effectively enabling them to cash out of a private company. These secondary markets have made it increasingly more tolerable for founders to keep their companies private, as both they and their employees can make significant amounts of money without doing an IPO.

Companies have also been going public later because of empirical evidence that shows investors prefer larger tech companies. According to Barron’s, the median returns for tech companies on their first day of going public are significantly larger for bigger companies. Companies valued between zero and $500 million returned only seven percent, whereas companies valued over $1 billion which returned 32.2 percent. This difference is even more pronounced after the first year of being public. After the first year of being public companies valued between zero and $500 million dollars returned a median of -25.9 percent, as opposed to those initially valued at over $1 billion returned 30.1 percent. There is a clear incentive for companies to wait before going public and first mature in the private sector.

The increase in privatization has led to the increase in valuations. More mature companies that generate substantial revenues are holding funding rounds. This trend allowed companies to raise more money as investors are more trusting of companies that lead multiple rounds of funding. For example, Uber, which was valued at $50 billion, expects, two billion dollars in revenue next year. In the cases of late round funding, many of their high valuations are justified by established revenue streams. Three partners at Andreessen Horowitz, Scott Kupor, Morgan Bender and Benedict Evans, made this argument in a presentation, where they showed that P/E multiples for tech companies were actually quite low, (about 15 times earnings) similar to where they were in the early 1990’s. In contrast, multiples hit 50 at the height of the dotcom bubble. These companies would probably receive similar valuations on the public market, yet for reasons mentioned earlier have decided to stay private.

Another reason that the high valuations are justified is because these markets are significantly larger than they were during the dotcom bubble. For example, according to Time, in 2000 only 738 million people were online as opposed to 3.2 billion people in 2015. Scott Kupor, in a Forbes article, argues that part of the reason for the dotcom bubble was that there weren’t enough users to justify such high stock prices. Now, however, with the advent of mobile devices, and the overall increase global access to the internet, tech companies have enough users to account for these valuations.

Finally, even though the market for tech products is already huge, there is still legitimate room for growth in the technology sector. According to an Andreessen Horowitz presentation, over the next five years an additional billion people will be on the internet and 2 billion people will get smartphones. Ecommerce also has a lot of room to grow. While, according to the presentation, ecommerce is just six percent US spending on retail, this number should grow dramatically over the next few years as more companies, shift to online stores, and more people gain access to the internet and smartphones internationally. One of the reasons valuations are so high is because, according to even conservative estimates, there should be an explosion in online activity over the next few years.

The tech industry is not experiencing a bubble. While the dotcom era has produced a lot of hypersensitive investors, this time the pricing of private tech companies is actually justified. If interest rates rise, funding for tech companies will certainly come down a little, but they are not the main force driving this growth.