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2015-11-26 12:22:27
Some private technology firms are having trouble justifying their lofty
valuations
Nov 28th 2015 | SAN FRANCISCO
WORKERS from technology firms recently gathered at a cinema in downtown San
Francisco to watch a preview of The Big Short , based on the bestselling book
by Michael Lewis. The film, which will be released in December, profiles
several outsiders who successfully bet against the housing market when everyone
else believed it would continue to rise, as it always had. You already know the
ending.
Some viewers in the audience must have seen it as a disturbing reminder of how
dramatically momentum can shift. Technology companies are unlikely to
experience a meltdown as severe as the housing crisis, but an industry that
only yesterday was all promise and optimism is showing signs of cooling.
Valuations for private technology firms are rising at a slower clip than they
were six months ago. On November 24th Jet, an e-commerce competitor to Amazon,
announced that it had raised $350m (valuing the firm at $1.5 billion), a big
sum for a loss-making startup, but a lower one than it had first hoped for.
Recently Airbnb, a fast-growing room-rental firm, raised $100m, but reportedly
stayed at its recent valuation of $25 billion, instead of rising further. Fred
Giuffrida of Horsley Bridge, a firm that invests in private-equity funds,
reckons that the valuations in late-stage rounds of financing have declined by
around 25% in the past six to eight months. These rounds are also taking
slightly longer to complete.
In the last quarter several mutual funds, including Fidelity, have marked down
the value of some of their holdings in unlisted tech firms. Fidelity wrote down
Dropbox, a cloud-storage firm, by 20%; Snapchat, a messaging app, by 25%; and
Zenefits (software) and MongoDB (databases) by around 50% each. All are
unicorns , that is, tech firms which have yet to come to the stockmarket but
are valued at $1 billion-plus. These are seen as having the brightest of
prospects among startups of all kinds. Zenefits, for example, had raised money
at a $4.5 billion valuation in May.
Mutual funds do not comment on the rationale for such markdowns, but it is
believed that these unicorns have not met their growth targets. Stockmarket
volatility may be another reason: investors value unlisted firms by comparing
them with similar listed ones. That can work in private firms favour at times,
but undermines them when stockmarket valuations fall, says Jeremy Philips, a
partner at Spark Capital, a venture-capital firm.
It has become clearer that the high valuations firms achieve in private are not
always maintained when they go public. This month s listing of Square, a
payments company, valued the firm at around $4 billion, around a third less
than in its most recent private round. Other firms have also suffered down
rounds , or devaluations, too (see table). An especially poor performer is
Etsy, an online marketplace for handmade goods, which is 70% below where its
shares traded when it went public in April.
Many investors in unicorns had bet that a new generation of technology firms
would unsettle the old guard, but that has not happened as quickly as they had
predicted. Tech giants like Amazon, Google and Facebook have continued to grow
impressively, especially considering their already large size; and they have
been adept at entering new markets that startups might otherwise have claimed.
For example, Facebook has bought and built messaging apps that compete with
Snapchat, and Dropbox has a rival in Amazon, whose cloud-storage business is
large and growing quickly. Compared with most profitless startups, the big
firms are not outrageously valued. It may become clearer to investors that they
not only overestimated the unicorns but underestimated the incumbent firms
growth prospects.
The mood among some backers of startups has become more cautious. Fewer
specialist technology investors are taking part in new financing rounds.
General investors such as hedge funds, asset-management firms, oligarchs,
princes and sovereign-wealth funds are filling the gap. Fidelity led the most
recent round for Jet, which some specialist tech investors see as a lemon of a
business, as it bleeds money trying to undercut Amazon. In September Baillie
Gifford, a Scottish wealth-management firm few in Silicon Valley have heard of,
led a round of funding for Thumbtack, which helps skilled workers find jobs,
valuing the startup at $1.25 billion.
With investors, until recently, throwing money at them, the unicorns have got
into the habit of burning through their cash in an attempt to buy market share.
Lyft, a taxi-hailing firm that is a rival of Uber, reportedly suffered losses
of nearly $130m in the first half of this year, on less than $50m in revenue.
Instacart, a food-delivery firm, is rumoured to lose around $10 on each order
it fulfils. Such practices are only likely to stop when the funding for these
firms dries up, or investors whip them into shape.
Another ill-advised but common practice among the unicorns is their habit of
pumping up their valuations and giving outsiders a misleading picture of what
they are worth . In an effort to make their supposed valuation go up each time
they raise funds so as to suggest that they are making good progress many firms
are agreeing to investors demands to attach special privileges to the shares
being sold. In theory, if an investor pays $100m for a 10% stake in a firm,
that implies a valuation of $1 billion; but if the investor attaches conditions
to the purchase that guarantee him a return or will give him his money back
first, it means the effective valuation being put on the company might no
longer really be $1 billion. An investor might be happy for the company to talk
as if it has achieved the $1 billion valuation as long as he has his extra
guarantees.
To participate in late-stage financing rounds, many investors are asking for
favourable terms such as liquidation preferences , in which it is promised
that they will get at least their money back and sometimes a guaranteed return
on top. In other cases, investors are offered ratchets , in which they will
receive extra shares in compensation if the firm s valuation is reduced when it
lists on the stockmarket. Late-stage investors in Square were protected with
ratchets, so they are likely to have made a good return even though it went
public at a reduced valuation.
The unicorns employees, whose holdings of common stock are diluted by these
protections, are among the main losers from all this. Firms do their employees
a disservice with their high valuations, says James Park, the boss of Fitbit,
a maker of fitness-tracking devices that went public in June. I don t think a
lot of people realise that once preferred stock and liquidation preferences
come in, their common stock isn t worth much. He also says private firms are
much more cavalier in claiming that they will grow to become $20 billion-30
billion firms. This helps attract employees, but may mislead them.
The tech industry s herd of unicorns contains many beasts that look awfully
similar to each other, or to longer-established firms. Yet many are being
valued in as much as the valuations are believable as if they were guaranteed
to be among the long-term winners in their line of business. In fact, not all
can survive. Weaker firms have been able to keep going because money has been
so easy to raise. And their spendthrift ways have made it harder for stronger
rivals to control their own costs and make a decent profit. If investors are
now becoming more cautious, that should lead to a healthier climate in the tech
industry.
Firms that are still perceived as winners, such as Uber, will not have any
trouble raising new money, no matter how severe the contraction in funding. The
pain of a slowdown will be felt most by firms that have lots of other tech
firms as clients. Food-delivery, catering and taxi-hailing firms get lots of
business in San Francisco and Silicon Valley from tech firms that subsidise
meals and rides for their employees. Firms that offer online monitoring tools
or recruiting services also depend highly on tech companies for business. So do
bigger firms like Twitter and Facebook that have benefited from the boom in
tech firms advertising, says Gil Penchina, an investor, who says he has been
trying to avoid exposure to this breed of firm.
In past downturns healthy and well-capitalised firms have benefited, says
Sander Daniels, a founder of Thumbtack, who points out that Google had its
pick of the litter of top engineers after the dotcom bust over a decade ago.
Those firms that loaded up with cash in good time for the downturn will also do
well. Airbnb, for example, has around $2 billion in cash, and a burn rate of
around $100m a year. If the housing boom-and-bust taught any lessons to Silicon
Valley, it is that the rich tend to bounce back most quickly. This will be true
of the tech industry as well.