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

Venture Capital Valuation Confusion

How real are the nosebleed high implied venture capital valuations being tossed around? For example, Pinterest raised $370 million which gave it an implied value of $11 billion. Snapchat has an implied $15 billion value following an Alibaba investment. The number of “pre-IPO” venture capital backed firms with implied values exceeding $1 billion (AKA unicorns) has increased from under 50 last year to almost 80 this year. My suspicion many of these implied values are “funny money” i.e. not real.

What passes for valuation in venture capital is really relative pricing based on what someone else paid for something similar, which could be wrong. This is especially true in today’s environment where investors are driven more by FOMO (fear of missing out) than reason. Implied value is at best a proxy for market value and is often misleading. Implied value is determined by dividing an investor’s dollar investment by the proposed ownership percentage the investor receives. For example if you will receive 10% of the firm for a $10 million investment, then the implied value is $100 million.

Looks simple, but there are serious complications to consider including the following:

1)     The ownership percentage is a negotiated item reflecting relative bargaining positions and not a traditional market price. Comparables used to substantiate declining ownership percentages can result in an overvaluation when the comps themselves are overvalued.  Venture firms flush with newly raised capital have reduced bargaining power with potential issuers. Thus, they are accepting smaller ownership percentages which inflate implied values.

2)     A reality check is needed to justify the implied price. This can be estimated by determining the future performance required to justify the price paid. The aggressive future performance estimates, currently exceeding 15X+ next year revenues, are often based on continued assumed weak competition due to first mover or network effects which are as elusive as merger related synergies. Thus, the needed future performance is becoming more difficult to achieve.

3)     Beware of receiving different terms. Venture firms usually invest in preferred not common stock. Liquidation preference (AKA the ratchet) differences in preferred stock can impact real values and are often ignored in implied valuations. These liquidation preferences allow the holder to receive more shares upon a liquidation event (e.g. a sale or IPO) if the price received upon that event is below their investing value. This gives certain investors an in-effect look back re-pricing option, which is valuable and needs to be considered when pricing an investment. Warren Buffett refuses to invest in situations when he is not pari passu with other investors and so should you.

4)     Limited financial information, due diligence and issuer financial infrastructure increases the risk of error or worse yet-fraud for pre-IPO unicorns. Also, there is no guaranty of an IPO; hence the investments are illiquid. Holding a minority position in a non public firm is a potentially unpleasant experience. Even if there is an IPO, it may be at a lower than expected price, which can trigger a ratchet.

      You can only accurately value your venture capital investment twice-once when you make it and once when you exit. Relying on implied values going in can lead to some nasty surprises when exiting the investment. The implied values for many unicorns may not be real.

J