Monday, May 18, 2015

Game or Illusion: Unicorn Valuations

I have been puzzled by seemingly irrational venture capital implied valuations. The number of unicorns (start-ups with implied values greater than $1B) just keeps growing-The Economist estimates over 100 worldwide. Some possible explanations include:

1)     New Paradigm: AKA this time is different-it never is. If something cannot go on forever then it ends (Stein’s Law). The “this time is different” explanation was the justification mistakenly used during the late 20th century dot com bubble.
2)     Investor Irrationality: not so sure about this-just seems too easy an excuse. Usually reflects we just do not fully understand the economics underlying the set of facts.
3)     Pseudo Pricing/Valuation: price comparisons are difficult as unreflected /underpriced terms (e.g. downside liquidation preferences) are involved. As Ralph likes to remind me you can name the price if he can name the terms and he will win every time (yes-Ralph is tricky). Further complicated by inefficient markets without short selling to correct optimistic momentum based investors.
4)     Manipulation: interesting Fenwick & West report suggesting later round implied value prices are manipulated. The reasoning - reaching Unicorn status is an important badge of accomplishment for young firms. The increased credibility that comes with it conveys advantages in attracting employees, customers and additional financing. Thus, “wanabe” unicorns will work with investors to structure the terms specifically to reach the unicorn threshold. The report offers some interesting stats:
a)     The average price increase in the unicorn financing round is 100% higher than in the prior financing round.
b)     The unicorn financing round is led 75% of the time by nontraditional (not venture capitalists) investors.

An obvious implication is (a) later round financings led by nontraditional investors, (b) in which the price is substantially (e.g. 100%) higher than the previous financing round price and (c) the implied post money value magically reaches unicorn status are rigged. This manipulation hypothesis gets my vote for what is happening-combined with too much VC capital chasing too few deals (VC fund raising is at its highest level since the dot com crash). Remember, there is no SEC to worry about as these are private offerings-sometimes characterized as private IPOs (inter alia-limited due diligence and disclosure). Someone can sue if harmed, but caveat emptor may bar their claim-no one forced them to buy. Do not think courts should protect those who do not know what they do. Everyone should know the base rate success for venture capital is very low (i.e. most such investments fail). Thus, they should take the implied values with more than one grain of salt.

Provided investors realize it is all a game like fantasy football, and not real, things will remain benign. Unfortunately people can sometimes get confused and start to believe the prices/values are real (e.g. noise traders). Then, trouble occurs when everyone realizes there was gambling going on and they have been had.


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