Rise of the Paper Unicorns

Getting real on private tech valuations.


You can hardly open a news site these days without reading about the birthing of yet another unicorn — one more private tech company who just raised a round at a valuation over $1 billion (of course sprinkled with chatter about bubbles and being overvalued). As fun as it is to read the unicorn stampede in the press, when it comes to truly useful methods of comparing companies, unicorn valuations seem like more chicanery than true value and appear to be driven by the Silicon Valley equivalent of playground peer pressure (over half of current paper unicorns hail from California).

The doubters and bubble doomsday-ers have a point. A private tech company valued at over $1 billion these days is like being a paper millionaire. You can show it, but you can’t spend it.

Don’t get me wrong, getting a $1 billion valuation in any way, shape or form is pretty cool. But in reality, paper unicorns represent a lot of illusory value. They aren’t nearly as interesting (in terms of generating returns for shareholders) as the fawning of the press would lead us to believe. And they are definitely not the same thing as a genuine unicorn — a company with a fair valued, fundamental-supported worth of $1 billion plus.

@fredwilson speaking on CNBC awhile back said,

“I think the public markets are doing a very good job of valuing companies. I think the private markets are not doing such a good job of valuing companies. And the big problem is that companies can get much better valuations in the private markets than they can in the public markets.”
Fred Wilson, Union Square Ventures

In other words, paper unicorns and the up and comers nipping at their heels are getting higher valuations as pre-IPO private companies than the public markets would give them. Wilson is implying that this is because those responsible for making these private valuations are either up in the night or intentionally manipulating the valuations — either way, the valuations are off.

This isn’t the first the world has seen of wide-scale overvaluations in tech. In the boom and bust of the dot-coms, valuations were decoupled from tried and true fundamentals. False prophets preached that the old metrics were passé and a new valuation era based on web traffic, stickiness, etc. had arrived. We saw how that turned out.

Although there are some similarities — many unicorns are being valued primarily on some measure of their audience rather than their performance — the contemporary transposition between public and private valuations is a condition without historical precedent. That’s one of the things that makes it so intriguing. Benchmark’s @bgurley blogged recently,

Some have argued that each of these [unicorns] would already be public in a prior era. Buying into such a notion is dangerous — dangerous for the entrepreneur and dangerous for the investor. Actually, very few of these companies are at a point where they could or should consider being public. … Understanding these differences is crucial to understanding the true risks in this large private-round phenomenon.
Bill Gurley, Benchmark

Ostensibly, Gurley is saying that many paper unicorns aren’t ready to be public because they would fail to pass muster were they examined with the same disclosures and rigor required of public companies. Like Wilson, Gurley seems to be indicating that the public markets are doing a better job at valuing companies and their risk factors. While that is likely true, I take Wilson’s comment about the public markets “doing a very good job” with a grain of salt.

Why? Because valuations are pretty crazy in the public markets too. There aren’t any great deals in the stock market right now. Indexes are breaking their volume records and there is much talk of the market being seriously overvalued. This has investors looking elsewhere to find investments that generate big returns.

In fact, the public markets are brimming as that cash looks for a place to go. Rett Wallace summed this up nicely in his piece in Forbes,

From a peak in 1997, the number of U.S. publicly-listed companies is down 40%. In the same period the capitalization of U.S. publicly-listed companies is up 144% to $26.3 trillion. No wonder public-market investors are willing to consider alternatives to plowing more capital into a shrinking pool of public names. The money needs somewhere to go.

That’s the big question. What to do? In 2013, @peterthiel presciently commented at SXSW that (see 24:40):

“… nobody knows what to do with the money.”
Peter Thiel, Founders Fund

Some of that money is finding its way into alternative investments — investing in the funds of VCs that place it with private startup companies. There is a scale problem, though. The market at large is much bigger than the VC market.

This is symptomatic of money — SO MUCH MONEY — in the private markets in relation to the number of places to put it. Where did it all come from?

Well, the Fed has kept interest rates at rock bottom since the financial crisis in 2008. As a result, investments tied to treasuries are losers — they’re unable to keep up with inflation (which, though masked, has been significant in recent years). Investors have money, but few places to earn significant returns. In a recent Wall Street Journal article, Gurley quotes the manager of a mutual fund as saying, “You don’t want us to invest in this but the big tech stocks are not delivering enough growth and my competitors are getting into these startups, so what are we supposed to do?”

Recently @davemcclure wrote a pretty awesome piece on how unicorns were going to gobble up all the dinosaurs. With his inimitable flair, he summed up @pmarca’s seminal Why Software is Eating the World. That is, innovative tech companies are solving problems faster and better for consumers — therefore they, the tech unicorns, will eventually eat everybody’s lunch who is less innovative at solving problems.

Well, if unicorns are such a force, why can’t they absorb the appetite for private investment?

The truth is, there aren’t nearly enough of them. Despite the excellence of tech companies, they still account for only a fraction of the market. Part of the reason paper unicorns have high valuations is simple supply and demand — there isn’t enough supply in relation to the demand. What’s the result? An increase in price.

In an interview for Fortune with @danprimack, @pmarca describes this proportion (and lays out how even if software is eating the world, it’s doing so one tiny bite at a time):

… tech is really small. From a macro standpoint, tech is really tiny. So all of venture capital is $20 to 30 billion a year. All private tech investing right now is $50 billion a year, and there’s a lot of these bubble articles that talk about, “Oh, my God, $50 billion a year, how can you possibly put that much money into new companies?”
So against that, the S&P 500, just the top 500 companies in the country, will give back $1 trillion in the next 12 months in the form of dividends and buybacks. And so, total private tech investing is 1/20th of just dividends and buybacks out of the S&P 500. …
Just again put it in context. The big mutual funds like — my friend Will at Fidelity that does a lot of this… that’s a $120 billion fund. Right? It’s like the total amount across all of tech investment is less than that this year. And so it’s just a very, very, very small amount of money.

The leveraging effect of this ratio makes even a small shift in the public market, looking to private companies for better returns, enough to swamp the private market with cash. And it’s not free — with that money comes performance pressure. It’s awesome that a16z raised $1.5 Billion, but it’s a tremendous undertaking to generate 20% IRR on that kind of money, especially in an industry where most investments fail.

How do they hedge against the risks and still deploy all that cash? Bet on the winners.

Despite playing in the risky end of the pool, VCs are still necessarily risk averse. How do they hedge against the risks and still deploy all that cash? Bet on the winners and justify those bets with corresponding valuations. This is driving up valuations for the paper unicorns as early investors watch for opportunities to make large follow-on investments and ultimately orchestrate the best exits for themselves, investment banks and founders. That means orchestrating exits at valuations that represent the maximum the market will bear.

Market cap, when you don’t have the public market reminding you every minute what the overall market is willing to pay, is full of room for manipulation. The reason is the number of buyers. The more buyers you have that substantiate your value, the more real it is. Public companies are exposed to the maximum number of buyers, while private companies can be valued based on whatever the last guy paid. Why are public companies typically worth more? Because they offer liquidity. Why do they offer liquidity? Because there are lots of buyers in the public markets.

So, what does it all mean? Are paper unicorns bad companies? Not by a long shot.

What’s interesting is that both McClure and Andreesen shared their opinions against a backdrop of questions about a bubble. Is there a tech bubble? Is there a startup bubble? Is there a unicorn bubble?

There’s just a lot of talk about bubbles.

Bubbles happen when there is a disconnect and unicorn valuations are based on a disconnect. Neither customers, nor shareholders are the beneficiaries of sky high valuations — those that are based on simply trends/growth, far distant cash flows (think DCF/NPV), or phantom potential. Who does benefit? Investment bankers, angel investors, VCs, and founders. The truest form of valuation is what a buyer actually pays. So, if the early players can find a buyer, who’s to say they don’t have the valuation pegged?

The problem is that the company’s ability to generate revenue and earnings from customer-funded transactions ultimately forces a correction in the valuation. And the shareholder, an individual public investor, or more likely an investor who is one drop in the ocean of institutional investor-managed funds, ends up taking it in the shorts when the market corrects for the disconnect.

I wish the news would shift away from the blips — if you want to show that your company is more than paper, more than a toddling unicorn foal, do it with something of substance, something truly rare. Show me you are a genuine grown-up unicorn with $1B in revenue.

Why should it matter? Because the froth in the current market has audacious investment bankers running around full of today’s version of the 2001’s irrational exuberance. If you can get your customers to show the same exuberance, then you have something real — something that isn’t just playing roulette with the timing of an inevitable market correction.

Blueprint to a Billion, showed us the recipe for authentic unicorns.

If @JimCollins showed us the recipe for enduring greatness, David Thompson, in his underrated Blueprint to a Billion, showed us the recipe for authentic unicorns.

At the end of the day, the most important question in valuation is not whether a company is overvalued or undervalued. Such broad brush indicators are hardly useful since greater-than or less-than encompasses a whole spectrum of generalization. No, the most important question is, what is a company’s valuation when it is fair-valued? What is it truly worth supported by its underlying fundamentals. Understanding a financial world populated by paper unicorns starts by understanding that like their namesake, there’s a lot of fantasy involved and when the corrections come, there’s going to be some ugly carnage in startup land.

That’s kind of a downer, so I’m not going to end there. The good news is that with all the extra cash looking for startup companies to invest in, and the accessibility of great advice on starting and running good companies, plus the enthusiasm for tackling big challenges, I think we are in for a decade like we haven’t seen in awhile. I think conditions are ripe for innovation and big strides in solving the world’s problems. If you have a great idea, there’s never been a better time to launch it. There have never been more examples of entrepreneurs who took the leap, who swung for the fences, and strove for greatness. Show your heart. Be one of them.