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.