The Unicorn Bubble

November 15, 2018

Unicorns are particularly temperamental creatures. They are supposedly very sensitive to the environment and the conditions surrounding them.

My source here is not Fantastic Beasts and Where to Find Them, but Bloomberg.

Unicorn is one of those made-up names over the last decade that has popped up to provide some new jargon for the tech venture capital sphere. It’s a privately held startup company valued at over a billion dollars. Most are in tech and get ridiculous amounts of funding from VC firms.

There have been a number of interesting trends over the past decade in startup funding and venture capital. The amount of money poured into startups has been increasing, while the time-to-exit (the time it takes for a typical company to IPO or get acquired) has increased. Companies are waiting to get bigger before exiting.

There have been many compelling reasons for companies to stay private. The obvious one is access to capital - lots of VCs want to play every hand, for fear of missing out on the next Uber or AirBnB. If it’s easy to get access to private capital on good terms, why would a company want to expose itself to the hysteria of the market? Elon Musk and Tesla are a prime example of why a company should not go public in today’s environment. If you’re trying to change the world, you don’t want to be juggling the general public’s potpourri of differing opinions, activist investors, and conflicting perspectives. A company out to change the world should have a benevolent dictator (not sure how benevolent Musk is, but you get the point). It used to be the case that if you wanted access to capital, you put your shares out on the open market. Today, if some Saudi sovereign wealth fund or venture capital firm takes your company’s bait on changing the world for the better (and making tons of money while doing it), you’re in the money.

A lot of unicorns are out to change the world. Uber with self driving cars, (previously) Tesla with sustainable self driving cars, and Wealthfront with self driving money. (I work at Wealthfront). There’s a lot of appeal in Uber’s model. It’s sort of encouraging to young startups that there’s a company that can burn billions of dollars a year, a toxic workplace culture, and a 120 billion dollar valuation. (As a side note, I feel like people love selling their startup ideas as “Uber for [blank]”). These companies are out their to achieve some vision, and that vision is more convoluted when public investors tell them to do things. That’s why Musk got stressed out and tweeted about taking Tesla private - there’s so much less scrutiny, and for Musk in particular, less exposure to short sellers.

Over the past decade, interest rates have been extremely low, making it cheap for any bank to do more speculative investment. Venture capital is by definition speculative investing, so it’s been pretty cheap for VCs to pump money into small companies over the past decade. As rates rise, more people have more reason to be skeptical about the unicorns, and it’s less likely that they will have as easy of a time getting funding.

Assigning a value to a company like Uber is particularly difficult, because those companies are hemorrhaging money. Investors have to estimate the net discounted value of future cash flows in order to properly estimate it. For Uber in particular, this is difficult because their pitchbook is dependent on the delivery of one product: the self-driving car. As financial conditions tighten, the net value of future cash flows is discounted accordingly, since a the new future dollar value is worth less than the old future dollar value (interest rate is higher, so the discount rate is higher). Expectations for further rate increases also have an impact on the discount rate.

Another aspect of rate increases is that investors will start to gravitate towards less risky assets. For example, the Fed funds rate generally floats in tandem with yields on the overarching bond market. So if interest rates go up, bonds will give higher yields, and institutional investors will see less incentive to go after risky investments like startup funding.

A number of these companies have defied the physics of traditional valuation models. This stems from the idea that many business models in the software space come at little to no marginal cost - the vast majority of a private company’s valuation is dependent on growth. These growth estimates can come from anywhere - but they always go up and to the right. Some growth curves assume exponential user growth, some depend on regulatory restrictions to be lifted, some are drawn to match the historical growth curves of “similar companies”. Will all these growth projections come to fruition? Probably not. We can only imagine the quality of the pitchbook that Uber uses to draw the funding that it does despite its unprofitability. Perhaps we’re starting see more reasonable valuations as financial conditions tighten. It might be time for VCs to ask why the revenue charts go up and to the right at unreasonable and unsustainable rates.

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