Kenneth M. Freeman
The world seems captivated by the growing number of unicorns – private companies theoretically worth more than $1 billion based on their latest round of funding. There are now more than 100 unicorns, led by Uber with a valuation of $66 billion.
If you were an early investor in any of these $billion+ gems, you’re winning big! But what about investors who got in on the latest fundraising rounds? Are the bragging rights of an expensive unicorn deal worth losing money on your investment?
The traditional venture capital investment formula is to select promising ventures early, while valuations are still low. Selecting several young businesses adds diversification and improves the likelihood that one or more will become a success.
While many unicorns have achieved notable marketplace success and will undoubtedly survive and thrive, their current valuations strain credulity, leaving late-round investors vulnerable to substantial losses. How likely is a big win when the venture is already valued at $10 or $20 or even $50 billion?
Uber’s annual revenue run rate is expected to exceed $10 billion by year-end. They retain 20% or $2 billion, which, with many markets left to conquer, is impressive. But do these numbers justify a valuation of $66 billion? Remember, a future value of less than $66 billion for Uber will mean a financial loss for their latest investors.
Airbnb’s 2015 revenues are estimated at $675 million and projected to reach $2 billion by 2020. Their latest investment round puts their worth at $30 billion. 2014 revenues were estimated at $900 million for Square and $600 million for Palantir. These companies aren’t likely to go away. But do these numbers justify valuations of $5 billion for Square and $25 billion for Palantir? Is Snapchat (with still negligible revenues) really worth $22 billion?
Many venture capital investors say traditional valuation methodology – the net present value of projected future discounted cash flows – is impractical for venture capital. They suggest that venture capital valuations rely on perceived potential along with passionate commitment and a dose of hope.
But valuations at early stages appear to implicitly reflect traditional valuation logic. They recognize the riches of potential success, albeit impossible to quantify precisely, while discounting those values sharply to reflect low success odds and inherent risk.
The problem with unicorns’ soaring valuations is that they seem to assume the stars are perfectly aligned and everything will go right. That rarely happens. Yes, it largely did for Microsoft, Google and Facebook, three huge winners over the past 40 years. But how many of those are there? Even Apple had to survive near disaster before its remarkable success.
What if governmental regulations block portions of Uber’s or Airbnb’s planned expansion? What if Uber drivers are ultimately ruled to be employees rather than independent contractors, changing the company’s fundamental economics? The risks are even greater for unicorns with more limited revenues today (and most with large losses).
We at VCapital, are not interested in ventures already valued at $1 billion+, where a return of 10 or 20 times investment is far too unlikely. Gambling in Las Vegas might be a better bet.
We believe in the historical venture capital success formula, focusing on early fundraising rounds – after venture potential is qualified through angel/seed funding but before valuations escalate wildly. For early stage investments in ventures valued at $5 or $10 or $20 million, while most fail, success could mean an exit valuation in the tens or even hundreds of millions of dollars. A few of the ventures we’ve supported over 30 years have even exceeded valuations of $1 billion, but you can’t count on that.
This has worked well for our team over three decades. While the VC industry’s average venture success rate (i.e. achieving any positive return on investment) is about 20%, through rigorous due diligence our success rate has averaged 37%, and our investors’ annualized returns have averaged well above industry norms. Delivering an attractive return to investors requires a few exits at 10, 20 or more times the initial investment to offset the 63% that come in as modest winners or complete loses.
So why are later-stage valuations soaring to stratospheric heights? We think it’s due to FOMO—Fear of Missing Out. Getting in on a unicorn round is great for bragging rights, but for late-stage investors, getting out with a profit may be tough. We’re betting FOMO results in lots of loudly bursting unicorn bubbles.
We’re not concerned about a repeat of 2000’s broad dotcom bubble, which devastated the finances of millions of Americans, since today’s soaring valuations belong to companies that are still private. Their investors are primarily institutions and ultra-wealthy individuals who can weather the risk, so impact will be contained.
We are concerned, though, that a series of loud unicorn bubble bursts could cool the flow of investment dollars feeding life-changing innovation. That would be unfortunate, since conditions for tech-enabled start-ups have never been better. It would also be unfortunate for the 8 million+ accredited investors (defined by the SEC as having net worth of $1 million+ excluding primary residence or ongoing annual income over $200,000), who finally – thanks to the JOBS Act – have access to professionally managed venture capital investing.
We believe that following the historical venture capital success formula will continue to generate attractive returns for investors who stay focused on pursuing strong ROI. In contrast, late-stage investors in pursuit of bragging rights to unicorn deals will increasingly find themselves under water.
Kenneth M. Freeman is the Strategic Marketing Advisor and Member of the Board at VCapital, LLC http://www.vcapital.com/
This article appeared in NEWS FROM HEARTLAND
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