How much is that Unicorn in the window?

What are Unicorn Companies?
Unicorns are defined as startup companies (often private) with values over $1 billion and no profits (often with deep losses).
You may think why such lofty companies have no profits?
In Silicon Valley, investors don’t expect their portfolio companies to be profitable. Because it should be too far less concerned with profitability than a market opportunity.
Ecommerce giant Amazon once in 2019 kept its backers waiting almost four years after its flotation before posting a small, $5m profit. Its losses had grown to $3bn at that point but that didn’t hold back its shares. Today, Amazon is the world’s third-largest company by market value and can make that profit in less than four hours. They may have high valuations in private markets with their founders becoming instant celebrities but they also generate hefty losses.

But how does one justify these mighty valuations?

A unicorn’s value depends on the most on its cash flow, which in turn depends on its profit or return on capital.

We can analyze a situation where profit and revenue a company would have to generate $1 billion. There can be two cases to this:

1. If a company is potential enough to generate $200 million from operating profits before tax in the coming 10 years with an enterprise value multiple of 15 times, it would be worth $3 billion in 10 years. Further assuming cash flows, then and now, net out to be zero and discounting the $3 billion to today @ 10% you get $1.15 billion.

2.For a similar company, to be worth $10 billion let’s ay would have to generate $2 billion of operating profit in 10 years. Assuming a generous 20% profit margin, the company would need to generate $10 billion in revenues with profit margin and also achieve a sustainable enterprise multiple of 15, that’s difficult! Unless we gave a monopoly-size return on capital.

Most firms use the Discounted Cash Flow method to estimate these valuations. This method includes making periodic projections of the financial statements for a certain period and then discounting the value of the company based on the last future projection, post certain adjustments. The firm projects its financial health on a future date and calculates the present value of that health.

Case Study: Hike and ShopClues

The hike was founded in 2012, it became a unicorn in 2016 — in merely 4 years into operation in 2017, with no dearth of funds although, the CEOs father owns the third-largest telecom and a Unicorn tag, loses Rs. 400 crore to earn Rs. 50.8 lakhs from its core services. If in 2016 the company calculated the $1 billion valuations based on this method, the due diligence could not have projected a Rs 400 crore loss and Rs 50.8 lakhs in organic revenue for FY18. But that is exactly what happened

Now adding to one more such case of Shopclues also shows the ambiguity of what it means to be a Unicorn. The company just shut down operations by handling pick slips to over 200 people after failed acquisition talks with major e-commerce companies. A company that started in 2011, became a Unicorn in 2016 and would be shutting shop in 2019. When GIC leads the Series E round in the company which took the valuation to $1.1 billion; did the projections, in any way figured in the possibility of the company going down? No.

This solidifies the fact that the trending practice and methods of calculating these mighty valuations, and associating these tags with startups, unless financially justifiable, are pointless activities and toxic to the startup ecosystem.

Losses and expenses decreased because the company didn’t have enough money to spend on things that needed investment. Forget investment, the company did not have enough funds to pay off its vendors, or even its employees. And, at the same time, this money was being invested in non-current and financial assets — money market, mutual funds, etc to make up for the revenues that its core model failed to generate. This non-current investment went up from Rs 1.28 crore to Rs 8.81 crore. Where the company had brought Rs 33,639 worth of financial assets in FY17, the investment had increased to Rs 9.69 crore in FY18.

On the other hand, ShopClues was writing off its fixed assets. In FY17 the company-owned Rs 4.03 crore worth of PPE, the value came down to Rs 2.11 crore in the next fiscal. FY16 saw this figure stands at Rs 6.84 crore.

There are several trends in the startup ecosystem around valuations that go on to devalue the claims that these unicorns and their investors have been making for a long time. And it calls for a serious reality check.

Disinvestment by a firm to bring in money for the working capital needs is a glaring anti-growth sign that goes on to reflect prevailing financial mismanagement.

But nowadays, Unicorn has become a financial myth as there is no denying that in the past couple of years, turning a billion-dollar worth startup and coveting the so-called prestigious Unicorn status has resulted in a cutthroat rat race where entrepreneurs, investors, as well as the media and the audience, all are equally obsessed with the tag. In this long game of risk, exactly how much is worth this risk?

Nevertheless, the mystique of the unicorn is bound to persist and so is the media attention and public interest around them.