End of the fairytale?

October 2016  | FEATURE  |  FINANCE & INVESTMENT

Financier Worldwide Magazine

October 2016 Issue

October 2016 Issue


‘Unicorns’ – primarily tech start-ups with a value of $1bn and above – have been highly sought after investment vehicles for many years. The typical unicorn company has a very high valuation, typically supported by somewhat questionable fundamental financing.

Though unicorns in the traditional sense are animals rarely seen by man, in the financial world they have become more commonplace. According to some estimates there are more than 100 unicorn start-ups roaming free around the financial plains. Unicorns that rise in popularity within subsectors of the broader tech space typically end up in a monopoly. Facebook, Amazon, Netflix and Google, among others, all ‘won’ their markets and became profitable in the process.

The ubiquity of such brands has helped to drive investor interest in start-ups that could one day follow in their footsteps. Compelled by a desire to not miss out on the ‘next big thing’, investors, including corporates, have collectively taken multibillion dollar bets on insurgent start-ups. Accordingly, the valuation attached to these unicorns is largely a function of growth, irrespective of business economics and market structure.

Venture capital, hedge, private equity and sovereign wealth funds have all looked to cash in on unicorns. With the number of companies valued at $1bn floating around the market, it would appear that the tech industry has been in the midst of a stunning boom, unseen since the dotcom days of the late 1990s and early 2000s.

Valuations have come under pressure in 2016 following a number of disappointing tech IPOs.

Walmart, the world’s biggest retailer, recently joined the throng of companies enthusiastic about unicorns. In August, it agreed a $3.3bn deal to acquire the unprofitable unicorn Jet.com – a company which is believed to lose around 30 cents for every dollar of sales it makes as a result of the lower prices it offers compared to competitors. Walmart intends to integrate Jet’s real-time pricing algorithm into its own online store, a move cheaper than trying to develop a similar programme independently.

Dollar Shave Club, a start-up that disrupted the shaving industry, agreed in July to sell itself to Unilever for around $1bn. Though not technically a unicorn, Dollar Shave Club had raised over $160m in venture capital funding, most recently last November at a $539m valuation. Its seed round of funding was led by Forerunner Ventures, while its Series A and B rounds were led by Venrock. Technology Crossover Ventures led its two subsequent rounds.

But comparisons with the dotcom era have led some commentators to suggest that the current market may be too good to be true. They ask whether another bubble has formed, one that is on the brink of bursting. Indeed, a number of venture capital and public market investors have started to balk at the sky-high valuations of certain tech start-ups. Only seven unicorns were funded in the second quarter of 2016, a notable drop from the 25 firms that won funding in the third quarter of 2015.

So is the unicorn fairytale coming to an end? One of the biggest issues facing unicorns is the question of profitability. Many have struggled to generate profits and yet have rushed to an initial public offering, in some cases forgoing pre-IPO auditing and regulation in order to issue massive funding rounds based on their balance sheets. Measuring the value of a company based solely on the strength of its user base, rather than actual revenue generated, focuses too much on the perceived potential of a company instead of looking at what those businesses have managed to realise.

Many commentators have urged investors to apply caution when it comes to investing in tech unicorns. Valuations have come under pressure in 2016 following a number of disappointing tech IPOs. According to Pitchbook, the median valuation of unicorn companies hit $1.5bn at the beginning of August 2016, a considerable drop from $2.5bn in 2011. Global economic challenges have also contributed to the decline in enthusiasm. Furthermore, it is perhaps easier than ever to launch a company, particularly in the tech space, thanks to open source frameworks and mobile app stores for distribution.

The lack of available exits for venture capital investors is also an issue. Data from CB Insights suggests that out of the 21 acquisitions of private technology companies worth more than $1bn completed this year, only two transactions involved the sale of venture capital-backed unicorns.

The prominence of companies that ‘won’ their particular sector will also impact the progress and profitability of unicorns entering those markets today. Facebook, Amazon and others have been joined by a new breed of tech mega powers, such as Uber and Snapchat. Once these new kids on the block gain enough power and financial clout, incumbents will often absorb them quickly, perhaps to prise away a key member of staff or a new piece of software.

Suggestions that a new tech bubble is forming has caused regulators to cast a worried eye over unicorns. Earlier this year, Mary Jo White, chairwoman of the SEC, said the Commission was worried about the “eye-popping” valuations of some unlisted start-ups. The once soaring popularity of unicorns may be coming to an end.

© Financier Worldwide


BY

Richard Summerfield


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