The latest term doing the rounds is Unicorns – startups with $ 1Billion valuation. There is great excitement that India has 8 of the worlds 107 Unicorns. Every emerging startup looks at these companies with reverence. Their founders are the darlings of the media. But lurking in the shadows is a sinking feeling – is this for real ? Are these companies going to be game changers for the economy or are we on the threshold of the next IT bubble burst?
First let us understand valuation basics . If a company has a $ 1 Billion valuation it does not mean that it has a profit of $ 1 Bn, or even a projected revenue of $1 Bn, not even that they have received funding of $ 1 Bn. All it means is that some investors have invested a sum of money ( say $ 100 Mn) and have got a 10 % of the ownership of the company which gives the company a notional value $1 Bn. This valuation stays notional till another investor buys into the story and is willing to give say $200 Mn for the 10% stake , at which time the valuation of the company rises to $ 2Bn.
Every investor hopes that the next guy will raise the valuation story by another notch so that he can get out without getting singed. For this the company as well as the existing shareholders go along with one hoopla after another by way of press meets, publicity binges, customer acquisition campaigns etc. The objective of all these is to blow the valuation bubble to bigger and bigger proportions. The end game for all this is the IPO , where the company is sold to millions of uninformed retail investors , who are probably guided to buy these stocks by the same investment bankers who are the original investors in the company.
The facts as they are:
Given in the table below is the actual funding received by Unicorns and the corresponding valuation
As can be seen the actual equity received is only a fraction of the perceived value. If you take our Indian Unicorns the story is not very different. Flipkart valued at around $ 11 Bn has got actual funding of about $1.5 Bn. InMobi has received funding of around $220 Mn and is valued at $ 1Bn.
With each subsequent round of funding the valuation goes up by a multiple of five to ten. So by the time these companies reach IPO the above values could treble or quadruple. One can only imagine how much revenue, profits and cash these companies would have to provideCommensurate returns to its future shareholders.
Where does the money go ?
Normally in any new round of funding over 50 % of the funding could go to early investors by way of share dilution. Some of the money gets used to fuel the growth engine- new hires, office space, technology etc. A large percentage is also used to build a customer base through deep discounts on products, cash back offers, referral bonuses and the like. This is the fuel that drives the company to the next level of valuation
The net effect of all this is that the company become a vehicle to make a few initial investors extremely rich. The new set of investors are also looking for exit and have to drive growth, profitable or not (more often “not” than profitable) to be able to recover their investment. This quest for greater and greater valuation with each successive round of funding results in many of the principles of good business being given the go-buy. Long term strategy has no meaning in a set up where the exit time window is the tenure of the fund investing in the company.
What about real value?
The concept of real value is the same for all companies irrespective of type – and has been so since the emergence of business enterprises. Companies make money for its shareholders if they can create and sell a product or service to a customer at a profit. The greater the per unit profit, and larger the number of customers, the greater is the intrinsic value of a company.
Because businesses make profits over time, value has to be computed in the context of the long term – say 10 years. So in traditional companies, which are running businesses, profits are projected over time with reasonable assumptions. This profit (or cash ) is then “discounted” for present value and the sum of such future period cash flows gives a present value of the enterprise. This is the DCF method, the gold standard for valuation.
But how does one value a company that has no past and no tangible future plan for revenue generation?
This is where the concept of notional value comes in . As there is no past ,nor a very clear idea of the future it becomes necessary to make conjectures of the future and project cash flows. These “narratives” of the future get converted to expected cash flows to fit into the DCF math. But neither the current or future investors are too concerned with questioning the narrative. Their time frame is short – limited to the next round. The only question that is asked is if the company would be able to demonstrate enough milestones to be able to attract the next round of funding.
Take the case of a Unicorn called Pinterest, a photo scrapbook service on the net. They have not billed a Dollar till date but is valued at around $ 11 Bn. Its call to fame is that it has over 70 Million users who use its services and that this would enable them to sell advertising on their site at high prices. Analysts say they may get advertisement revenues of $500 Mn by 2016. Though this is still a pie in the sky, its valuation jumped up from $ 5BN to $11 Bn in their latest round of funding. But, you may ask how is anyone to know if these revenue projections will ever happen- why would anyone pay good money for a “maybe”. You are right – and this is notional valuation for you.
Let us take the case of Facebook, and Snapchat, and Twitter and Pinterest and ten other such companies including our India’s InMobi. All ( including existing giants like Google, Amazon etc.) are chasing the same digital advertising spend. If you add up all the expected digital advertising budgets of the world (estimated at around $100 Bn – which after all can only be a percentage of product revenues) , it would perhaps justify these valuations for one or two of the above companies. What happens to all the others and the investors who have put other people’s pension money into these firms. This is the frightening truth.
What is true of the social networking businesses is equally true of e-commerce businesses like Amazon, SnapDeal, FlipKart as well. After all these companies are only vehicles to deliver products of the real econom . They cannot grow at multiple times of the growth of the economy they ride on. These hefty valuations, therefore, would justify at best one or two such companies – not fifty!
The tragedy is that no body in the chain is interested in real cash flows. A key element of the entrepreneur’s pitch to the potential investor is the exit strategy. This is totally bizarre. Can you imagine Warren Buffet investing in a company where the investor entices him saying that an exit is possible in 3 years with a 10X return ? Buffet would have asked- it the business is so good that another guy is willing to give me a 10X return, why should I exit?
Who wins and who loses
Clearly this trend is making a few initial investors extremely rich. The VC fund managers also gain as they are able to entice HNIs and pension funds to put in money showcasing spectacular gains. These funds carry a management fee of 2 to 3 % and a success fee of 20%. Even if they are not able to collect success fee (~ 20% of cases ) , the fund size being large, the management fee itself becomes a sizeable sum.
The losers are the late stage investors and finally the retail investor who will get to hold the lemon. He will dismiss it as yet another investment and go on to buy into the next unicorn.
Of course the real loser is innovation the economy. Bright minds who would otherwise have worked to build great companies get diverted to making the quick and easy buck. It is a rare Elon Musk who would invest the first $100Mn earned in building relevant businesses like Tesla and SpaceX. Most others would take the easy way out , become serial investors and make even more money by investing in questionable startups and perpetuate this deadly game of Unicorns
 Times of India, May 16 th 2015