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.

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…]

The 5 economic trends that worry me (1/2)

Normal-Rockwell-Boy-on-High-DiveMany experts agree to say that the current economic environment is something we have never witnessed before. Despite negative interest rates – $10tn in total, now including some high-quality corporate securities – global growth is expected to remain limited – only 2.4% forecast in 2016 according to the latest World Bank report – as well as inflation – for 2016 the OECD forecasts 0.06% in France, 0.43% for Great Britain and 1.07% for the USA despite encouraging unemployment figures. This environment makes the hunt for growth significantly more challenging than in the past and has thus favoured the emergence of behaviours that, taken together, may well threaten the stability of the economy in the medium-term. Although the reader may find many more, I have taken 5 examples which have particularly struck me over the last few months.


  1. Stock markets reaching all-time highs despite weak macro indicators

The weak growth prospects expressed in my introduction have not deterred investors from massively buying stocks. Last week the S&P500 reached a level only 0.5% below its all-time high, lifted by a slight recovery in oil prices and the increased likelihood of a Fed Reserve rate ‘status-quo’ in June. This has come on top of the second longest bull run in the S&P’s history – the longest lasted from 1987 to 2000. And yet it is difficult to identify the ‘hard facts’ that investors base their bullish assessment on.

theres-a-new-most-bearish-strategist-on-wall-street“If you look at U.S. stocks on a global perspective, to be touching or near that high is pretty phenomenal. “Yet when we look forward, we’re struggling to find that next source of growth. Maybe the drag has passed, but where is the growth going to come from?” (Gina Martin Adams, Wells Fargo Securities LLC)

As Benjamin Graham, the famous value investor, claims in his book The Intelligent Investor, we may have switched from an investment strategy, where people believe in the true intrinsic capabilities of the firm they invest in, to a speculative strategy, where people believe that they will be able to sell their shares to someone who puts a higher valuation on them, irrespective of the company’s performance. The former is characteristic of a potential bubble.


2. Unicorns and unicorpses: party like it is 2000

the-18-billion-london-tech-unicorn-thats-struggling-to-pay-its-staff-is-worried-about-going-bustFor those unaware, ‘unicorns’ are companies which have managed to raise equity with an implied valuation exceeding $1bn. Not so long ago, the ‘unicorn’ club was made of a handful of companies with (i) proven business models, (ii) established profitability and (iii) huge opportunities for global growth. Today, the ‘club’ has grown to 150 members or so, all of which cannot claim to tick the three boxes mentioned above.

First, entrepreneurs have realised that being labelled a ‘unicorn’ could turn out to be a real marketing tool and business booster. Some of them decided to enter through the service door by actually raising a relatively limited amount of equity (let us say in the single-digit millions) for an even smaller share of the capital (let us say 0.1%). As a consequence, the firm manages to qualify for the ‘unicorn’ label, even if clearly no investor would be willing to pay close to $1bn for the entirety of the company.

Furthermore, to make up for the lack of revenues, entrepreneurs have come back to the non financial-related KPIs made famous in the late 1990s to support what ended up being the ‘dot-com bubble’: number of users, number of clicks, number of hours of videos uploaded on website etc. Growth is not about top line or EBITDA anymore as taught in corporate finance classes but measured by the notion of ‘increased engagement’ and ‘scale’ instead. Spotify, for example, managed to raise equity last year based on a $8.4bn valuation despite not having made a profit yet. This is easier than in the 2000s given that, as rightly pointed out by Terence Fung, the new ‘Web 2.0’ is mainly about B2C applications rather than B2B software which contributed to the ‘dot-com’ firms’ reputation.

20150210005716!Slack_IconFinally, some startups benefit from potentially inflated growth prospects. Slack has managed to raise $200m of equity based on a $3.6bn valuation in April. The company is nonetheless far from shaking the industry at the moment. It offers a simple chat app and is currently used by 2.7m daily active workplace users, only 800k of which are paying at present. Each paying customer is therefore implicitly valued at $4,500.

2015 witnessed soaring unicorn valuations but 2016 and 2017 may bring those valuations down to earth, a forecast trend that has given birth to the term ‘Unicorpse.

[To be continued on Thursday…]