In the Age of The Unicorn Bubble, the Real Value of a Business Matters More Than Ever
What’s a business worth? Given the outsized valuations of the so-called “unicorns,” the answer may be “who knows.” Is Uber really worth $75 billion?
These valuations of privately held companies valued at more than a billion dollars -- and public stock prices that have followed -- may excite, but they raise questions for investors, employees, and founders.
It used to be easy to answer the valuation question, especially for a private company. For years, companies were valued as a multiple of their earnings. When I started my first company, that multiple was around ten. So if my company made a $100,000 in a year, I might have been able to sell it for a million.
I say “might have” because, when selling a company, the real value of a business is not determined by the seller. The value is whatever a buyer is willing to pay. Until a buyer sets a price, what a business is worth in monetary terms is just speculation - even if a fair-minded formula was used.
Why Did it Matter
As a private company, my partners and I believed it was important to share ownership with our people. We needed a mechanism to price the stock options we would grant - and to repurchase any shares if a person left the company.
So we devised a fair formula to price the value of options and stock as a multiple of the company’s average profits over a few years. We actually had profits. But we saw no purpose in inflating the value of our stock.
We didn’t want to see our people exercise stock options at too high a price, only to see the value of the stock fall below that price in the future.
What’s Different Today
Many private companies still follow this conservative practice, although some consider revenues as well as profits in setting a valuation. And some fast-growing businesses are valued only as a multiple of revenues.
But in the world of venture capital investing, setting a valuation has entered an orbit of speculation that can be compared to the Dutch tulip bubble of the 17th century. In what became known as “tulipmania,” a rare single tulip bulb was worth 10 times what a skilled craftsman made in a year.
Aggressive valuations today have resulted in almost 200 private companies that carry valuations of over a billion dollars - the unicorns, mostly tech companies. Many of these companies have never shown a profit and eat cash voraciously.
Of course, most companies don’t start out being profitable, but they should at least be able to demonstrate that they will some day.
Valuations are set on expected growth of the number of people using or accessing the technology. Some companies are valued by venture investors who expect an industry player to buy the company.
Who’s Feeding the Bubble?
The unicorn bubble is supported by the large amounts of cash flowing into venture funds from institutions (the likes of schools, hospitals, charitable foundations) and pension funds.
Institutions and pension managers are seeking returns they have not been able to find in traditional financial markets. Mutual funds are also investing in these early-stage companies.Should institutions and pension funds hold such highly speculative assets?
Venture funds attempt to protect their investors in the deals they make: if the stock of a company is sold below a certain price, the venture fund and its investors may get more shares to make up for the “loss.”
But it’s a game for investors who can afford to take risk - not necessarily smaller institutions and pension funds.
And What About Employees
I have never believed a company or its employees are well-served by speculatively high share valuations. It works when you are hiring someone to promote prospects for growth and wealth accumulation, but reality sets in if the stock price falls and employee stockholders find their paper wealth diminished.
Companies often respond to this condition by granting employees more shares and options. When this happens, some publicly held companies -- many of them former unicorns -- won’t reflect the cost of these additional shares in their financial reporting. Outside shareholders don’t like either of these practices.
And the Discipline of Good Management
I also worry about founders who drive for a high company valuations when they have failed to demonstrate they will ever be able to show a profit. Where have the old fashioned idea of profitability and the practice of sound operational disciplines gone?
I know of one founder who refused to show potential investors any financials. He didn’t want to distract investors from his customer growth numbers. In his mind, customer growth was all that was important. This belief is now widely shared.
The Need for Cash
There is, of course, a legitimate argument for the large amounts of cash required to grow certain businesses. Launching Uber was not cheap. To be initially underfinanced can be a painful condition that can lead to the premature failure of a business. So setting a high valuation, in some instances, may be legitimate in order to raise the needed funds.
But beware: too much money can make you dumb.
I have seen many startups spend lavishly and foolishly on costly surroundings and amenities. They have convinced themselves these are required to attract and retain people. When you have a lot of cash, use it wisely. There is a very high cost of running out of money.
What About Shareholders
When a company goes public, initial investors and founders are usually protected because they have acquired their stock at a low cost. It’s new shareholders and employees who assume most of the risk.
For example, six unicorns have gone public in 2017. Two of those, Snap and Blue Apron, were trading on August 18th at 18% and 47%, respectively, below their IPO price. And four mutual funds that had invested in Uber - still privately held - have reduced the value of their interests by as much as 15%.
Sustainability and Profits
Highly inflated valuations serve only those who are able to sell quickly when the need arises. Employees are often restricted from doing that.
Buyers will always be attracted to a company that promises to change the future and will drive up its price. But there is nothing like investing in and working for a company that has demonstrated sustainable growth and solid profits. That company deserves a high valuation.