IPOs: The Unicorns Moment of Truth

It has been said that in finance things take longer to happen than you would expect, but then unfold faster than you would have thought. This fact seems to be occurring in the mythical land of unicorns. I am fascinated with unicorns because their purported valuations seem to violate basic economic logic. Values not dependent on cash flow, risk and time would upset how we approach mergers and acquisitions. Rest easy as it appears unicorns do not violate the first principles of finance. Rather, their financing round based implied valuations are worse than theoretical (the usual compliant against discounted cash flow models)-they are just fanciful.

Some many unicorns are getting long in the tooth at 5-7 years of age (tech firms age in dog years). Investors are pressing for liquidity AKA an IPO. The IPO process or test is exposing some of the inconvenient facts I have previously highlighted about unicorn implied valuations. A stark example is provided by the pricing range assigned to the pending Square IPO. Last year Square was valued at over $6B based on its last financing round. Fast forward to the present and the IPO values Square in the $4B range. So what the!@#$ happened?

Something could have dimmed the prospects for Square such as the loss of Startbucks next year and continued large operating losses. Also, IPO market conditions have softened somewhat following the August correction. Worse yet is the possibly that Square was never was worth $6B. It seems that investors in the 2014 financing round did not receive ordinary shares. Rather, they received “super shares” providing them with protection against an IPO priced below their financing round value. Basically, they get more shares at bargain prices to make them whole if the IPO is priced at less than their investment. Thus, unicorn values may be inflated and exposed during the IPO process. No wonder many unicorns are trying to postpone going public for as long as they can. It will get even more interesting after they are public when they face scrutiny of real market disciple. Perhaps, things may not be so different for unicorn valuation after all.

J

Venture Capital and Rational Bubbles

This post continues my journey to explain the seemingly over priced, high risk and difficult to value venture capital market. It is well known that the empirical security market line is too flat compared to theory. This means higher risk-higher beta stocks have lower than predicted returns. Conversely, lower risk-lower beta stocks (just like the ones Warren Buffett favors) have higher than expected returns. This phenomenon is called betting against beta (BAB). Two possible reasons exist for its existence.

The first is based on leverage constraints facing institutional investors like pension and endowment funds. These investors are forced to reach for asset risk to satisfy their higher risk appetites. Furthermore, leverage constraints may impede margin and short sales ordinarily used to correct over pricing. Leverage constraints and aversion probably tightened following the great recession given the failures and near failures on many undercapitalized institutions like Lehman.

A second complementary explanation is provided by behavioral economics. The argument is as follows:

1)     Investors over weight low probability high payoff events-even those with negative expected values. A simple example is the lotto. The number of players spikes as the grand prize increases even though the winning odds fall even lower. The large unlikely payoff dominates the negative expected value. A technical explanation is players (investors?) prefer positive skew. This is especially true when the wager (investment?) is relatively small compared to investor’s overall wealth. Thus, as investor wealth tends to be pro-cyclical-so is the demand for lottery type investments like venture capital (IPOs and Private Equity as well).

2)     Two additional behavioral effects reinforce the above.

a)     Representativeness-investors focus on winners like Uber and hope their investments will be winners. They are ignoring the higher base rate failure of such investments.

b)     Overconfidence-even if investors realize “home runs” like Uber are rare they believe they possess special skill enabling them to spot “Ubers”.

Add to the above the difficult to value nature of venture investment and it is easy to see how investors can get carried away in a rational bubble.

A third more traditional factor underlying the current market is low interest rates. The Federal Reserve has keep rates artificially low following the great recessions hoping to stimulate the economy. This means projected cash flows are discounted at lower rates leading to higher values. Additionally, on the demand side, low rates forcec investors to search for higher nominal (non risk adjusted) yields by going further out on the risk curve.

Thus, the venture capital market may be experiencing a rational, albeit still dangerous, bubble.

J

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

Investment Banking: The Dark Side of Corporate Finance

Investment banker valuation and securities pricing are heavily used inter alia in IPOs (e.g. offering pricing ranges) and M&A (e.g. fairness opinion). They involve translating a firm’s expected operating performance into a price in markets subject to asymmetric information. The price estimates are often more influenced by momentum than fundamentals. Thus, they can diverge from intrinsic value based discounted cash flow measures-sometimes intentionally.

Investment bankers can help bridge the gap between price and value among buyers and sellers of capital and firms. They do so by posting their reputation (the value of which varies considerably) as a signal, for a fee, to give the parties comfort that the offered price is fair based on their due diligence and technical analysis. The analysis is based on well know business tools like discounted cash flow and risk adjusted returns-at least on the surface.

The techniques used, however, are frequently a fig leaf behind which many other factors (sometimes conflicting) are taking place. These include:

1)     Objectives: What price (value) is the investment banker seeking to justify for his client or himself?

2)     Inputs: How were the inputs selected based on the firm, industry and market considerations? There is a great deal of (black?)“art” (subjectivity) in selecting key estimates for sales growth, operating profit margins, taxes, working capital, CAPEX,  and WACC.

3)     Who does the Investment Represent? For example, with IPOs, although representing the issuer, the investment banker is frequently more concerned with maintaining good investor relations as the source of his long term franchise value. Therefore he is inclined to under price the offering.

4)     Reverse Engineering: Is the valuation really independent or reverse engineered to justify a desired result? Remember, Investment Bankers do not get paid unless the deal closes. As Warren Buffet notes -fees too often lead to transactions rather than transactions leading to fees. This why his 2014 annual report contains so many Investment Banking “slams”.

In theory, there should be no difference between practice and theory, but in reality there is a big difference. Surveys showing an alignment of academic valuation approaches and investment banking practice (see valuation from the field which references once such survey) should be taken with more than the customary grain of salt. Investment Bankers herd and like to hide behind “best practices” (i.e. “me-too-ism”) to look smart and reduce legal liability. No one wants to admit they are using “primitive” earnings multiples unadjusted for risk or the time value of money in their analysis.

Having practiced the black art for many years, I can assure you that Investment Bankers are in the sales business. Therefore, the real motivation behind the various valuation estimates must be considered when reading their presentation booklets. Cash flow matters, but the question is whose cash flow are we discussing-the client or the banker’s? The Salomon Brothers quote from Liar's Poker  says it best-“do you want to be a winner or the client?” Bottom line-do your own analysis and come to your own conclusions. Academic finance as practiced by Investment Bankers can be dangerous to your wealth.

Joe- a hopefully reformed ex-Investment Banker.

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 20^th 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.

J