9 investor considerations about unicorns (2/2)

[continued from Monday]

logo6. Private information leaves investors in the dark: No other example could better embody this issue than Rocket Internet. Valued at €6.7bn after a successful IPO in 2014 the company is now worth less than 50% of this amount. The lowered valuation reflects two major investor concerns. First, none of the companies in Rocket Internet has proved profitable yet, despite earlier management commitments to IPO one of its companies by end 2016 – a pledge that has now become a promise to turn at least 3 companies profitable by end 2017. Second, and more importantly, in the absence of benchmark, Rocket Internet can use a lot of discretion when valuing its private investments and the Global Fashion Group case shows that Rocket errs on the very aggressive side of the spectrum. This explains why Rocket Internet currently trades at 1/3 of the value of its companies as reported in April – the market believes there are other exaggerations lying in the dark. Research teams focused on private companies (Pitchbook is one of the most famous) have been proliferating in an attempt to guide prospective investors – but the task proves harder in the absence of official financials.

Share price evolution of Rocket Internet since IPO (in EUR). Source: Yahoo Finance.
Share price evolution of Rocket Internet since IPO (in EUR). Source: Yahoo Finance.

7. Soaring valuations are a rational but meaningless answer to a biased set of incentives: Showcasing the highest possible entreprise valuations, especially greater than the ‘magical’ $1bn, represents an efficient way for stakeholders to get (almost free) publicity in a hypercrowded VC market, but such assumptions make little economic sense. In the extreme, if I invest $1 in any given company to get 0.0001% of its capital, the company will have been implicitly valued at $1bn and could theoretically claim to be a unicorn. In real life, Airbnb used a $30bn valuation to raise $550m, i.e. less than 2% of the pre-money capital. Venture capitalists could thus be incentivised to dilute themselves in order to benefit from a better valuation. For instance, if a VC wants to invest $100m in a company, in the case it gets 12% of the shares the company will reached an implicit equity value of $833m ($100m/12%); but if the VC decides to agree on not 12% but 9% of the shares (which make a limited difference a exit unless the firm becomes the next Facebook), the company is now valued $1,111m  ($100m/9%) and has now entered the unicorn club. Great publicity for the firm, but also for the VC, which will be able to leverage this investment case to attract new investment opportunities and/or investors – in that respect Quanergy or Takeaway.com will certainly offer a good window for its backers. For the company’s existing shareholders, this capital inflow priced at a discount is a godsend – Deliveroo raised a $275m Series E last month with no real growth agenda.

8. In fundraising, quality is at least as important as quantity: A global investor footprint is also crucial, especially when the company is considering international expansion. Raising debt, which implies periodical interest payment and thus some form of cash flow predictability, is also a good indicator of the robustness of a business model – Airbnb raising $1bn of debt is a positive sign in that respect.

9. Glimpses of hope announce a rude awakening: As investors are digesting the first wave of start-up investments, they are showing decreasing tolerance for ‘hockey sticks’ in business plans, and TechCrunch recently noted that required metrics and milestones for Series A fundraising are now closer to the ‘classic’ Series B. The number of new European unicorns reached 10 in 2015, down from 13 in 2014. Fundraising amounts in Europe were down $1bn yoy in H1 2016 to $5.9bn.  Showing a clear path to profitability is a key consideration to raise additional fund and investors are less prone to buy the ‘scalability’ argument. Has the European market slowed down quickly enough? This was at least the viewpoint that the Financial Times was defending before the summer – referring to the fact that there is one new unicorn in Europe every 2.5 months compared with one every 1.7 months last year. On top of a structural regression to the mean, Brexit could harm the financing of UK-based start-ups, although the first post-referendum figures tend to contradict this belief. The adjustment could be tough to make internally: entrepreneurs need to switch from ‘hypergrowth’ to ‘sustainable growth’, a mode that requires different skills, a revised strategic approach and a distinct management style.

andrew-evans“Unicorn valuations, in many cases, are a triumph of hope over reality.”

(Andrew Evans, Equity Value fund manager at Schroders, in the Financial Times)

Any other thoughts? Please feel free to contact me or comment under this article.

9 investor considerations about unicorns (1/2)

‘Unicorn’. No longer than 18 months ago, this word represented a sign of recognition for any start-up founder and a hardly coveted target for venture capitalists, who needed to have at least one specimen of this new species to appear as credible investors. Times have changed and the current environment has triggered 9 remarks I thought worth sharing in this post. As usual, the article ended up being longer than expected, so I will post the first 5 remarks today and the last 4 later this week.

Credits: www.p101.it
Credits: www.p101.it
  1. Signs of an overheating market are apparent in the US but more debatable in Europe: In the US the National Venture Capital Association noted that the VC industry deployed more capital in 2015 than any year since 1995. As a result, the US have become the most favourable breeding-ground for unicorns in the making: in 2015 the US gave birth to 30 of these ‘animals’ compared with 10 in Europe and 19 in Asia.
This used to be considered the next Facebook...
This used to be considered the next Facebook…

2. Painful write-downs have already started to take place: Beyond the Rocket Internet case, which results from more than a pure shift in market sentiment (see point 6), established brands, such as Dropbox, have not proven immune to write-downs. More generally tech values are relatively prone to valuation fluctuations, Zynga being a good historical example. In the same vein, Supercell could be the next one? Before the summer Tencent purchased 73% of the maker of Clash of Clans on the basis of a $9bn valuation, equivalent to 10 times trailing EBITDA – reasonable for an asset-light, well established company but more debatable for a company operating in the ‘boom-and-bust’ video game industry. Defunct unicorns have even been given the name of ‘unicorpses’ – Powa and Mode Media are part of the list.

Share price evolution of Zynga since IPO. source: Yahoo Finance.
Share price evolution of Zynga since IPO (in USD). source: Yahoo Finance.

3. The IPO window has become more selective and has left companies stranded: Nothing comparable with the dot-com bubble. The IPO path has consistently represented only c.15% of exit value over the last few years. The average time between first funding and IPO – when it happens – is now 8 years. Even well-established names can struggle to generate enough investor interest to justify an IPO. Deezer was one of the most recent victims, having had to cancel a $300m IPO in October 2015 (based on a c.$1bn valuation), officially because of ‘tough public market conditions’. The fact that the firm was still €27m in the red in 2014 could have contributed to the unease of public markets but did not deter private investors, who injected an additional $109m into the company a quarter later. Today companies IPO to raise relatively low amounts – despite being branded a unicorn Coupa plans to raise only $75m from public markets.

4. Unprofitable strategic decisions have been driven by a shift in key valuation metrics: The days of the ‘EV/eyeballs’ metric used during the 1990s ‘dot-com’ era are hopefully long gone. This does not mean that valuation excesses have disappeared altogether though. For loss-making ventures, using EV/revenues has appeared as the norm despite obvious biases. In that respect, a new unicorn is on average valued at 3x revenues in Europe and 8x revenues in the US – far greater than other more mature companies in the tech sector.

sans-titre
EV/revenues ratios for selected companies. Sources: CapIQ, author research.

Profitability concerns are not (yet) addressed, which explain why so many venture capitalists are funding growth at all costs, even if it means subsidising the sale of products – and therefore fuelling deflation, as explained in one of my earlier posts. The traditional EV/EBITDA ratio is making a powerful comeback this year, in particular when investors are dealing with late-stage ventures – a reason why Uber used ‘accounting magic’ to move the figure into positive territory, see the next point.

“The tech IPO is dead. But great tech companies can – and will – still go public.”

(Ravi Mhatre in TechCrunch)

5. ‘Adjustments’ are plasters on a broken knee: Reaching the break-even point is a big deal for a start-up. Often CFOs will stretch their financials a bit to reach this milestone. Uber announced a positive ‘adjusted net income’ in June this year – although adjustments take out significant cost items such as interest, taxes, employee stock benefits and losses in developing economies such as China.

[to be continued…]

A couple of updates

I have been covering a rather large range of topics over the last few weeks. Some of them made the headlines again more recently. A couple of examples:

  • new-nuclear-build
    Credits: www.edfenergy.com

    Despite all the execution risks involved Theresa May approved the Hinkley point project. As mentioned in my post published in April, she did not have the hardest role, however: EDF (and the French State) will have much more to lose.

  • Ecommerce is forming an increasing share of our daily purchases, with 48% of French people said to have made at least a clothing purchase since the beginning of the year. Traditional retailers such as FNAC, Carrefour, Lecler, Darty etc. account for 8 of the top 15 ecommerce platforms in France. On the other hand, the lack of ecommerce capabilities has been highlighted as one of the main reasons for Primark’s disappointing performance this quarter.

In my next post I will address ‘unicorns’, the not so rare anymore start-ups valued at $1bn or more. I will focus in particular on the term ‘valuation’; there are interesting thoughts to have in mind when dealing with this dangerously hot topic.

Retailers: stuck between a brick and a hard (market)place

The last few years have seen incumbent ‘brick-and-mortar’ retailers being challenged by new entrants playing the ‘online’ card. In the UK, although 85% of retail sales are still made at ‘offline’ (or ‘store-based’) retailers, according to the Centre for Retail Research, the momentum is clearly in favour of online, which has been enjoying a value growth of 15% in 2015 compared with 2% for the ‘store-based’ market. Given this trend, online should overtake offline by 2026 – and yet the tipping moment may happen earlier.

Online retailers benefit from generally lower prices (inherited from a leaner cost structure and a heavily centralised purchasing strategy), a typically broader assortment and, more importantly, a great knowledge of customers’ preferences which enable targeted marketing operations. Amazon’s recommendation engine is lauded as one of the most efficient, generating an estimated 20-25% sales uplift by either classifying items through their attributes (‘content-based filtering’) or analysing user behaviour (‘collaborative-based filtering’).

Small but tremendously impactful.
Small but tremendously impactful.

Convenience in general, and delivery time in particular, used to represent a major drawback of ecommerce. Massive investments in supply chain (including truck fleets) and the proliferation of pick-up points (such as Amazon lockers or through partnerships with local offline retailers) have shifted the balance of power – ‘next-day delivery’ is increasingly often seen as the ‘new normal’ – and the prospective advent of drones could speed up the circuit even more.

Facilitating mobile payment is also a key consideration to convert the visit into a hard sale. Typing bank card details on a mobile device can be tedious and potentially unsafe. This may explain why although many retailers report that up to 70%-80% of website browsing occurs through customers using mobile devices, only 28.6% of UK online retail sales were made through those devices (as opposed to PCs) in 2015.

On their end, ‘offline’ retailers have been trying to address the customer knowledge gap, historically through loyalty cards which are now complemented by more technologically advanced methods. Several start-ups, such as France-based Openfield, track visitors in shopping malls (up to 40 000 customer journeys per second) to infer their preferences – the visitor can be identified when he uses one of the shopping centre terminals. Gathering offline customer information is also the aim of Index, a Google Wallet-backed company.

‘Offline’ retailers are also trying to turn their weaknesses, namely a numerous workforce and expensive real estate-related expenses, into strengths. Relying on the power of their ecommerce website for ‘casual’ purchases, retailers are now increasingly transforming their stores into showrooms, where in-store staff are here less to ‘sell’ than to ‘advise’ – the relevance and the quality of the interaction could only be reinforced by a more precise knowledge of the customer’s preferences ex-ante. The ‘human factor’ is a clear advantage over online retailers which have been developing machine learning-based bots as ‘humanised’ customer service interfaces.

What we should conclude from this post is that online and offline desperately need each other, and this balance will probably hold for at least the next few years. The combination of offline and online, both in terms of customer knowledge and product offering, will yield the best results – that is at least the bet that many offline retailers, including Walmart and Auchan, have made. The Paris-based Galeries Lafayette have understood the need to work together, not fight, by collaborating with Plug & Play, a Californian incubator, in order to support “around 20 start-ups per year”. Another good example of online-offline symbiosis comes from Instacart, an app (i.e. an online-based tool) which relies on an express check-out system within and a detailed aisle mapping of existing grocery stores to complete deliveries in an hour. Better than Amazon, for now.

Credits: www.reference.com
Credits: www.reference.com

Update (13/09): Talking about customer knowledge, TechCrunch wrote an article today about Breinify, a start-up that not only tries to anticipate what you may fancy, but also adds a time element to the recommendations (e.g. it will endeavour not to recommend pizzas or beer at 9 am).

Want long-term inflation? Raise rates, now

janet_yellen_official_federal_reserve_portrait
Credit: Wikipedia

Central banks across the world have been trying to reignite inflation by injecting a massive amount of liquidity and buying financial instruments, most recently corporate bonds. In theory, a higher supply of money should devalue the currency, thus boosting both exports and domestic demand. In particular, demand translates into more investment, which is a necessary cornerstone for long-term growth. Needless to say, this classic monetary tool has been more than widely used over the last few months. But the target remains out of reach in many countries. Despite more than $1tn of debt now yielding negative interest rates, inflation barely climbed to 0.6% in the UK. The US Fed is considering raising interest rates again although inflation in the US is 2.2% and thus barely exceeds the official 2% target.

Credit: Getty Images
Credit: Getty Images

I have already highlighted in this blog the importance of confidence in driving the decision of individuals. When people are confident about the future (i.e. they can predict with relative certainty the future state of the economy and the implication for their personal wealth) they do not hesitate to invest part of their income in ‘non-vital goods and services’ such as domestic appliances, automotive etc. The same logic applies to companies – this is what we call investment. Today’s environment largely lacks visibility. Geopolitical concerns (elections in the US, France and Germany, Brexit in the UK, tensions in the Middle East) make economic decisions even harder to predict. As a consequence, despite the affordability of debt, households and companies prefer to save today in case the situation gets tougher tomorrow. The resulting drop in demand has been widely pointed out as a cause for low inflation or potentially deflation in some areas (e.g. food in the UK).

Not only are hyper-low interest rates inefficient, they are counterproductive, and central banks should raise interest rates as early as feasible. Let me explain. The excessive amount of non-invested liquidity has led individuals and companies to invest in financial assets such as bonds or funds. Venture capital funds have been particularly in demand given their risk-reward profile; they tend to be more risky than ‘plain LBO’ funds and according to theory should yield better expected returns. Unsurprisingly E&Y in its latest global venture capital trends report states that venture capital deal activity increased by 54% in 2015 to reach $148bn.

Flooded with liquidity venture capitalists are begging for start-up ideas to invest their money – given that the worst scenario for an asset manager is to show his investors that their commitments are sleeping at the bank. The number of start-ups has been logically soaring in all developed economies as a result, sometimes giving birth to incubators, the most famous certainly being Rocket Internet, and a few have been raising tens or even hundreds of millions of dollars to boost their development.

In the 2.0 economy, where marginal costs are almost non-existent and barriers to entry are low, ‘customer acquisition’ and ‘network effect’ are the new mantras. Rather than investing in expensive marketing campaigns, start-ups have decided to invest in prices, most often selling their services at a loss to ensure maximal penetration. Uber is a good example. Rides in London are on average 30% cheaper than a black cab. The company is present in more than 500 cities and has been valued at $68bn in its latest fundraising round completed last year. And yet, Uber reported $1.2bn in losses in H1 2016 – this raises a broader debate about the criteria for start-up valuation, which we will address in a later post.

Credits: bpplan.com
Credits: bpplan.com

Private investors have shown patience so far, hoping that the ‘hockey stick’ will materialise. And if it does not, investors often believe that it is simply due to a lack of scale and that further investment is required to ensure the user base is large enough to prove profitable. The stock market, conversely, has been indifferent to this thesis and very few start-ups have succeeded to make a strong enough profit to reach the IPO stage – a feature that differs from the 2000 ‘dot-com’ bubble.

Exit of VC deals: IPO vs. M&A (value in $bn). Source: E&Y.
Exit of VC deals: IPO vs. M&A (value in $bn). Source: E&Y.

My point is that for months now many aspects of our daily life have been ‘subsidised’ by increasingly risk-seeking venture capitalists and that behaviour has largely been driven by the abnormally high amounts of liquidity made available by Central Banks. Paradoxically, these start-ups have most often been bringing down prices and ultimately favouring deflation, pushing Central Banks further away from their initial objective. I am not saying that price cuts are always bad. But in this case price cuts have only come at the cost of corporate losses – simply put: value destruction.

The argument about the ‘hunt for worldwide scale’ is dubious. Although this hunt is legitimate in a limited number of cases (social networks represent the most typical examples), entering new markets brings limited benefits to most start-ups. When Uber decides to enter Santiago, it cannot rely on network effect: the taxi drivers operating in Santiago are different from the ones in Singapore and the customer base is also very distinct. Given the very lean cost base, the only synergy it can expect is the brand power – which may not justify hundreds of millions of dollars of losses. And, even if you do so, you cannot prevent an aggressive competitor to emerge with even lower prices – only the depth of the investors’ pockets will make the difference.

My recommandation to Central Bank governors is thus simple: raise interest rates and clean up the mess. We will not find growth by artificially subsidising value-destructing activities. The fear of the next crisis and the willingness to avoid recession at all costs are leaving everyone in doubt. Take the hit, start from a fresh and economically sane breeding-ground and build again from there.

flower
Credit: www.ericnguyen23.com