The Problem with Unicorns

The idea for this post came mostly from two articles in the Economist, so if you’ve happened to have read them I probably won’t offer anything new or useful. If you haven’t, however, I thought that there were some interesting ideas that deserved to be shared.

If you’re unfamiliar with the term unicorn:

“A unicorn is a privately held startup company valued at over $1 billion. The term was coined in 2013 by venture capitalist Aileen Lee, choosing the mythical animal to represent the statistical rarity of such successful ventures. (Wikipedia)”

While it was quite rare in 2013, only 39 companies were considered unicorns, that seems to be less and less of the case today. As of 2018, that number has exploded, resulting in 260-300 unicorns worldwide. Many of these unicorns are the same companies we’ve been talking about all year: Uber, Airbnb, WeWork, Bird, Reddit (we should have talked more about Reddit); along with former unicorns (i.e. they’re now public companies): Facebook, Twitter, Snap, Pinterest, Lyft, and Spotify.

While you may look at many of these companies and think “yeah, these are all great, innovative companies, Matt. They’re worth that much”, there are some underlying assumptions made with their valuations. In the past, and I’m vastly simplifying here, a company was valued primarily on its profitability or potential for profitability. This is where the unicorn valuations become a little tricky. Back in 2014 Uber had just gone through a round of funding, valuing them at $17bn. Aswath Damodaran, a finance professor from NYU, then posted a controversial article titled Uber Isn’t Worth $17 Billion. He basically looked at them from a cash flows standpoint and estimated that their real value was between $3.2-$5.9bn. That’s significantly less. The argument for the higher valuation was that Uber’s market would be much bigger than the standard taxi market, which Damodaran used to develop his figures, and in fact, would grow the market for this type of service.

Fast forward to now, Uber is going to IPO sometime in the next week or two (I couldn’t find an exact date) and is going public with an estimated valuation of over $100bn. Many investors think this is an overvaluation, and that the stock will immediately drop in price. While we might not know for certain whether this will happen, it might be prudent to look at a similar example. Lyft recently IPO’d at a price of $78.29 and the market decided that was much too high. Within a day, that price dropped $10 and is now trading at $59.39 a 24% drop.

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Someone’s arithmetic is off here. If you believe the market to be infallible (I certainly don’t) then you’re probably inclined to accept the $59 price point. I would, however, argue that the venture capitalists funding these companies are using equations that aren’t applicable to these situations. Many people look to companies like Facebook and Google and think that initial profitability doesn’t matter, but might miss some critical information.

  1. Facebook and Google both benefitted from natural monopolies and network effects, creating scarce competition.
  2. Both were regulated very lightly, if at all.
  3. Both were able to increase revenue and profitability very quickly.

Many of the unicorns I mentioned aren’t going to have these sorts of benefits. The switching cost between Uber and Lyft is simply having both of the apps downloaded. The period of light regulation is coming to a close. There is already huge pushback against Uber and Lyft from the taxi industry and, as we all know, Facebook is calling for its own regulation.

The revenue/profitability problem is where the real fun begins. I’m quoting a lot here from the Economist article, and they’re talking about 12 of the most valuable unicorns, whose combined valuation is $350bn.

Based on a discounted cashflow model, in aggregate, the dozen firms will need to increase their sales by a compound annual rate of 49% for ten years to justify that valuation. That is the same as the average growth of Amazon, Alphabet, and Facebook in the decades after their IPOs. In other words, these firms have to be as likely to outperform the very best of the previous crop as to underperform them.

But that is not enough. Justifying the valuation means not just staggering increases in sales, but also a very large improvement in margins. In aggregate these would have to increase by 34 percentage points. That would be truly unprecedented. The average for Amazon, Facebook and Google was only 19 percentage points.

There will be many implications if the upcoming IPO’s don’t live up to investors’ expectations, but I would like to focus on two of them: the strategy of “blitzscaling” (growth at all costs) might disappear, the flood of capital to technology startups might begin to dry up.

So far consumers have benefitted greatly from the blitzscaling strategy. We’ve gotten cheaper rides, food delivery, and file storage. This, however, is unsustainable. These companies have subsidized user adoption, making prices artificially lower and leading to huge losses for the companies. This is bound to either disappear or reduce dramatically. No more $10 shared rides to Back Bay.

Capital drying up will have a much more subtle and profound long-term effect. The way I believe this will play out is:

  1. IPO’s don’t go as planned, causing returns on tech to decline and investors to rethink their investment strategy.
  2. Less investment in tech startups means less opportunity for people to work in tech (software specifically).
  3. Both money and interest turn to other avenues of innovation and invention.

While some of you might think this is a bad thing, an argument could easily be made that these companies aren’t providing much in terms of improving peoples’ lives. Here’s a list of current and former unicorns. Honestly, I’d be hard pressed to find one that has really improved my life dramatically. This means that maybe, just maybe, people focus their capital and attention on things that can actually help people and the planet, and to me, that’s something that’s pretty hard to overvalue.

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Obligatory Charlie the Unicorn plug

6 comments

  1. Very interesting post, I always love hearing about unicorns, and the difference between VC analysis and the markets reality. So many VC’s focus heavily on future growth prospects, which makes sense – if a company is not pouring their capital into growing their user base and losing money, then what is the point borrowing money from early stage investors? On the other hand, the quotes you used showed just how highly they are valuing these growth prospects, and that they may not be truly feasible from a cash flow perspective. Even if these companies don’t perform well after an IPO, I’m glad they are around because many of them have had positive impacts on my life (even if it is just from a convenience perspective).

  2. Great post, Matt! As someone who worked for a bank that financed tech companies, I think a lot of these guys are horrifically overvalued. The tech PE ratios these days seem outrageous to me, especially given that a lot of these multi-billion dollar companies have yet to show that they can even turn and sustain a profit, let alone pay out sustained dividends. Tesla’s market cap as of right now is around ~$40 billion. I get that the potential for earnings in the tech sector is enormous, primarily due to scalability, but come on, people. I think we’ll see a correction soon, and a lot of these big tech investors and companies will get a gut check. Who knows.

  3. At the beginning of your post, I was questioning why you were so surprised by the fact that the Lyft stock has been dropping recently. After all, most tech companies start high and then dip upon going public. However, you made really good points about why Lyft is different from other companies (intense competition with no switching costs, increased regulation from governments, etc.). While I think some unicorn companies are true disruptors in their space (AirBnB, Casper, Starry), there are plenty more that have huge valuations for what are basically commodity products. Think about Allbirds, Postmates, Doordash, or Juul. The barrier to entry for these industries is incredibly low and there are basically no networks effects.

    I can see this era playing out like the dotcom boom (call it the unicorn boom). As you said, the bubble will burst and people will find areas to invest where returns are more stable. Everyone is hoping to invest in the next Google or Apple, but I don’t think everyone realizes how rare those entities really are.

    1. Ok when you mentioned Allbirds in a comment about unicorn startups, I thought to myself “no, he can’t be talking about that instagram shoe company…” And after a quick google search I realized this was not a mistake, an instagram shoe company is valued at over a billion within two years of it’s founding. I wonder if the novelty for investors is the cutting out of the middle man for the direct to consumer model. Since we see it work for Casper, maybe investors think this is the key to success (versus the product itself, but a good product certainly helps). I’m not certain a shoe company though can see longevity unless there’s additional investment in creative and design. In particular with how fickle the fashion industry can be. Although I guess one can argue that the company can position itself like the Toms brand, which aren’t so much about style than it is about the philanthropy story.

  4. When I started reading your post, I had terrible flashbacks to Mark Bradshaw’s accounting class, and to finance. But this is a really interesting take on unicorns – I really like your point that while these companies are great (I for one love being able to request an Uber or a Lyft instead of actually calling a taxi), they don’t do anything to actually improve our lives. I am by no means a financial wizard, but I wonder how much of this has to do with the potential longevity of a company, and how much of has to do with the fact that people don’t know any other way to express their excitement about a new, innovative company. But who knows?

  5. Great post. This has been a topic of discussion in all my CSOM classes since I came in as a freshmen. I enjoyed your section on the strategy of “blitzscaling”. I am not sure this would be a bad thing if the amount of this strategy decreases in the coming years. This strategy when scaling a business may cause reckless use of capital and unstable cash burn. All in all I am rooting for these tech IPOs, but a reality that many firms need to focus on is the cautious use of their funding to prevent reckless cash burn.

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