Fear the Walking (Dead) Unicorn

I posted several notes here, here and here trying to make sense of inflated late round technology valuations. My conclusion was the valuations were illusory rationalizations used to justify inflated prices. The private market valuation of these firms suffered from being unregulated, questionable accounting, lack of comparability due to differing provisions (e.g. liquidation preferences), and lack of short selling. The result is momentum based pricing driven by the optimism of the last investor. The number of previously rare unicorns (private firms with values exceeding $1B) increased to 124 in July of this year. Eventually, however, you run out of optimism when an event occurs causing investors to re-examine their assumptions and reduce their risk appetite leading to lower pricing. That something was the August correction.

You only really accurately value a private firm when you make the initial investment, and then when you exit. Exits had been delayed for many later stage tech firms. Only 14% of 2015 IPOs were tech related. The reasons (excuses?) given for the lack of tech IPOs was twofold. First, the founders did not want the hassle of public market scrutiny. Second, they did not need an IPO liquidity event because they could always do a “private IPO” (oxymoron?) by accessing private investor cash in subsequent financing rounds (at assumed higher valuation levels). Both reasons are nonsense.

In reality they wanted to avoid the evaluation of numerous hard-nosed investors both at the time of the IPO and the on-going trading-including short selling. You need a public market to get liquid; it is hard to access public markets at sky high prices.

Many tech founders and investors who confused bull market valuations for liquidity are now discovering the difference between paper and real liquidity. Over 40% of 2015 tech IPOs like Novo Cure are being priced near or below their last private financing round valuation. This fact has not gone unnoticed by private investors. They are balking at high implied valuations in later financing rounds forcing firms to accept lower values. For example, Blackrock which lead a prior $350M financing round for Dropbox has marked down its investment by 24%.

Pricing represents a short term belief in expected operating performance. Investors should gauge the gap between expectations and reality. This means not falling in love with stories about market growth and technology without considering how those factors translate into revenues and ultimately cash. 

This involves understanding the following:

1)     Market Characteristics: some markets have difficult characteristics making it difficult to yield superior returns. Use Porter's 5 forces framework as a starting point.

2)     Business Model: who will the firm achieve and maintain market share and pricing power when facing competitors, new entrants and substitutes?

3)     Execution: inept managers can negate attractive markets and credible business models.

If you claim this is hard because of profound uncertainty then recognize you are not investing. Rather you are speculating based on what you hope someone else will pay for the firm. This someone else can and does change his mind leading to wild price swings like those experienced this August. This in turn can turn your hoped for unicorns into unicorpses.

J

First Mover Advantages and Disadvantages

In Joe's last post The Price is Right he questioned the pricing of Uber, noting:

"Uber’s price is being justified on a winner- take- all, first mover, basis. I wonder, however, about the economic validity of this agreement. The industry entry barriers seem porous, switching costs for both users and drivers are low and international competition exists. "

Indeed, in a paper two colleagues and I published in the Review of Financial Studies, we do  find that the first acquiring firm in an industry after a long dormant period without acquisition activity earns abnormally positive returns.  We are quite skeptical of the first mover - or low hanging fruit argument, however, noting:

"Cottrell and Sick (2001), and Schnaars (1994) examine first-mover advantages and disadvantages, noting numerous cases in which the imitator ultimately gains the advantage over the first mover. Examples from the software industry include the success of the VHS tape format over Betamax, IBM following Apple, and Excel following VisiCalc. Cottrell and Sick (2001) also note the phenomena in the motorcycle industry with Yamaha, Kawasaki, and Suzuki successfully following Harley Davidson, and the Indian and European models."

The question is whether Uber can maintain a sustainable comparative advantage.  It's an open question, but my instincts align with Joes.  

All the best,

Ralph


References

Cottrell, T., and G. Sick. 2001. First-Mover (Dis)advantage and Real Options. Journal of Applied Corporate Finance 14: 41-51.
Schnaars, S. 1994. Managing Imitation Strategies: How Later Entrants Seize Markets From Pioneers. The Free Press, New York.

The Price is Right or Is It?

The latest financing round values Uber at more than $40B. Uber’s transaction volume is around $2B of which their take is 20% or $500MM. Yes its revenues are doubling each year over its short existence. Still this seems richly priced. How long and fast can they grow, and when do they start earning a return? Keep in mind Uber’s value exceeds that of Aetna, CBS and KKR among others. Uber’s price is being justified on a winner- take- all, first mover, basis. I wonder, however, about the economic validity of this agreement. The industry entry barriers seem porous, switching costs for both users and drivers are low and international competition exists. Furthermore, as the Wall Street Journal notes, some smaller tech firm valuations have recently fallen prior to their planned IPOs. So, is Uber immune to such a reversal?

Some VC observers like Play Bigger Advisors have tried to explain away a possible bubble by inventing a new metric- Time to Market Cap (TTMC). They believe special firms like Uber represent mythical Unicorns endowed with unique market characteristic justifying what at first glance appear to be nose-bleed valuations. Past Unicorns included Apple, Microsoft and Google who capture a disproportionate share of their market categories. They cite the TTMC of $1B for Unicorns has fallen from 8.5 years in 2000/2003 to now just under 3 years. VC are focusing on a few winner Unicorns with big investments and driving up their values. Conversely, they are pulling back from losers referred to in the Wall Street Journal article just as quickly. Therefore, they conclude there is no bubble.

This sounds like another version of the “This Time Is Different” justification. How do you operationalize the invest in winners (Unicorn) strategy? Is it like buy low and sell high? Can TTMC slow down and mean revert? The problem with these types of relative value approaches is they lack an intrinsic value anchor. They can quickly degenerate into a herding or momentum investment strategy. Over optimistic investors ignoring the base case who have excess liquidity and are eager to invest will keep pushing prices higher until there is no one left who believes and the process corrects. The price is right, but which one-the price going up or the price coming down? Finding mythical Unicorns may be more difficult than thought. Even if you do, at what price does investing in Unicorns cease making sense?

j