Tech Startup Bubble Has America's Retirement Funds Chasing Unicorns

Tyler Durden's picture

Last week, we highlighted the not-so-surprising fact that many private tech company valuations are completely made up. To let the VCs who fund these companies tell it, the problem isn’t that Snapchat isn’t worth more than Clorox (as their valuations would suggest), but rather that us simple folk don’t really understand what the word “valuation” means. You see, things like cash flow and operating costs are “less important than you might think”, as long as you’ve got “hockey stick” growth in some metric that you arbitrarily decided matters most for your company. Furthermore, it’s important that you command the market in your industry. Of course in many cases, startups have created entirely new concepts and so there naturally are no competitors and if you can’t command a high market share in a market that you made up, well, you’ve got a real problem. 

But this is all part and parcel of the startup mentality, wherein VCs and founders are more focused on whatever Mark Zuckerberg or Jack Dorsey or Marc Andreessen or [fill in famous tech guru] said recently about how to grow your startup from 10 users to 10 billion rather than on how to generate revenue and profits. The problem with this is that while the Cloroxs of the world generate hundreds of millions in profits every three months, the Snapchats of the world.. well… don’t, and in the final analysis, it doesn’t matter if you have 10 trillion users if you can’t make any money.

Here’s what we said:

Well, now that everyone is jumping on the “there’s no way that app is worth $50 billion” bandwagon, Bloomberg is out with a startling revelation: “Snapchat, the photo-messaging app raising cash at a $15 billion valuation, probably isn't actually worth more than Clorox.” 

 

No, probably not, but it sure is more fun than doing laundry, which is why it absolutely makes sense that the number VCs are putting on the app makes absolutely no sense…

 

So while we thought “valuations” were numbers that indicate how much something is worth, what they actually are are complete shots in the dark which, if necessary, can be “adjusted” later to reflect economic realities. 

Today, Bloomberg is out with another piece that bemoans what very well could turn out to be a giant bubble in late stage tech startup valuations. Here’s more: 

Hedge funds and mutual funds that once shunned venture-style deals are flocking to the market’s hottest corner, paying 15 to 18 times projected sales for the year ahead in recent private-funding rounds, according to three people with knowledge of the matter. That compares with 10 to 12 times five years ago for the priciest companies, one said.

 

While some of the startups may become profitable, others are consuming cash and could fail. The torrid action is spurring talk that 15 years after the collapse of the Internet bubble, the market may be setting itself up for another bruising fall.

 

“Some of the valuations are mind-boggling,” said Sven Weber, investment manager of the Menlo Park, California-based SharesPost 100 Fund, which backs late-stage tech startups.

 

Companies now valued at 16 times future revenue could easily lose a third of their value in a market pullback that Weber and others say may occur in the next three years…

 

Private values also are soaring. Online scrapbooking startup Pinterest Inc. raised $367 million this month, valuing the company at $11 billion. Snapchat, the mobile application for sending disappearing photos, is valued at $15 billion, based on a planned investment by Alibaba, according to people with knowledge of the deal. Uber’s valuation climbed more than 10-fold since the middle of 2013, reaching $40 billion in December.

 

Mutual funds and hedge funds have elbowed into late rounds, both to boost returns and to ensure they can buy blocks of shares in IPOs as competition for tech offerings intensifies. Mutual-fund giants Fidelity Investments, T. Rowe Price Group Inc. and Wellington Management Co. and hedge funds Coatue Management and Tiger Global Management took part in at least 37 pre-IPO funding rounds totaling $5.55 billion from 2012 to 2014, according to Pacific Crest Securities, a Portland, Oregon-based technology investment bank and IPO underwriter.

It’s worth taking a moment here to revisit how these valuations are determined because it’s a highly scientific process that takes into account objective factors such as how much the founder thinks his/her dream is worth. Here’s our take accompanied by two quotes from a previous Bloomberg piece

The reason this makes sense is because these companies often command huge market shares in markets they made up and also because their founders are arrogant. Here’s Bloomberg again: 

 

"Some VCs defend the practice by saying valuations are just a placeholder number, part of an equation fueled by other, more important factors. Those can include market share, growth projections, and a founder's ego." 

 

All of this makes complete sense of course, but it does lead us to wonder how valuations for the next Facebook are determined because ultimately, you’re still left with the annoying task of having to get a funding round done, and even if it’s just a “middling shot,” it’s still a shot you have to take. Fortunately, there’s one completely unbiased party who is always willing to step in and tell you how much the business is really worth: 

 

“The number is typically set by the company…”

“A founder often starts off with a number in mind, based on the startup's last valuation, the valuations of competitors, and, for good measure, the valuation of the company's neighbor down the street.”

Of course none of this really matters because the idea is simply to make it to the liquidity event whether that’s a buyout or, better yet, an IPO. Ideally you want to take the company public because then you can count on the stupidity of retail investors to drive the valuation to ever more insane levels at which point you sell your shares and how the company will make money becomes someone else’s problem, namely the guy who bought his stock at the open on IPO day through his ETrade account on the advice of his broker whose firm underwrote the offering. In that context we guess valuations really don’t matter if you’re the VC or the founders. 

There is however, always the chance that something goes wrong (like your IPO temporarily breaks the market for instance) in which case you may not get the bonanza you were looking for which is why it’s important to ensure that the fine print says you can’t lose. Here’s Bloomberg again: 

Private valuations since then have gotten frothier, at times surpassing IPO values. In the past four months, cloud-storage service Box Inc. and Hortonworks Inc., a data-services provider backed by Yahoo! Inc., went public at valuations lower than their last private-funding rounds.

 

Some late-stage investors have struck deals guaranteeing them a return in an IPO, typically in the form of additional shares they’d get if the offering is priced below what they paid. Known as ratchets, these arrangements water down the gains of other investors who haven’t yet cashed out.

 

When Box’s IPO priced in January at $14 a share, or 30 percent less than Coatue and TPG had paid in July for 7.5 million shares, the firms salvaged a 10 percent unrealized gain owing to a ratchet, according to offering documents.

Better still, even if you aren’t the home gamer who bought on IPO day and didn’t realize he was paying an obscene multiple on revenue the company imagines it may one day make, you may end up owning the shares anyway in your retirement account. Via NY Times:

The retirement accounts of millions of Americans have long contained shares of stalwart companies like General Electric, Ford and Coca-Cola. Today, they are likely to include riskier private stocks from Silicon Valley start-ups like Uber, Airbnb and Pinterest.

 

Big money managers including Fidelity Investments, T. Rowe Price and BlackRock have all struck deals worth billions of dollars to acquire shares of these private companies that are then pooled into mutual funds that go into the 401(k)’s and individual retirement accounts of many Americans. With private tech companies growing faster than companies on the stock market, the money managers are aiming to get a piece of the action.

...and while there are bound to be some killjoys out there like Bentley University's Leonard Rosenthal who think forcing investors into grossly overvalued, profitless tech startups is not necessarily right…

“It’s great for the portfolio manager, but it’s not necessarily in the interest of the shareholders of the fund. If investors are looking for a portfolio of risky securities, there are plenty of stocks to trade in the public market.”

...the good folks at your favorite VC firm will explain to you that this is all about helping the little guy get access to something he wouldn’t be able to own if left to his own devices...

“There’s a huge amount of wealth creation happening, and a very narrow set of people are benefiting from it financially,” said Scott Kupor, who, as a managing partner and chief operating officer at the venture capital firm Andreessen Horowitz.

...which is good because if there’s anything you want your retirement money doing, it’s chasing “unicorns” in a “shadowy market”...

The dilemma for big fund managers is that fast-growing technology companies are so reluctant to sell private stock to the public that there is now a term — “unicorns,” reflecting just how wonderful and magical they are considered to be — for the dozens of private firms worth $1 billion or more…

 

Those lofty valuations, combined with the eagerness investors show in bidding them up, have created a shadowy market for private stock issued to tech companies’ early investors and employees.

*  *  *

Call us old fashioned, but we agree with Prem Watsa who has the following to say about this circus: 

"We’re confident that most of this will end as other speculations have – very badly!"

As a reminder, here are a few examples: 

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Burt Gummer's picture

Why don't those retirment funds chase some /GC or GLD and stand for delivery instead?

https://www.youtube.com/watch?v=i9bHuquTFCs

junction's picture

Those pension funds will get clobbered, of course, when these unicorns fade away in the harsh light of day.  The pension fund managers still get their 2% or so commission on the total pension funds they invest and the placement guys who convince the managers to invest in over-priced unicorns will get their kickbacks.  The only big loser will be the person expecting to collect a good pension from a well-managed pension fund.

RU-GAY2's picture
RU-GAY2 (not verified) junction Mar 23, 2015 10:58 AM

tech companies are in a bubble.  Don't buh tekk!

https://btc-e.com

Antifaschistische's picture

This article is a bunch of bullshit!!

The girl at the Mutual Fund Store told me that the way to get growth in my portfolio was to buy tech stocks/funds!!!  And since she works at the Mutual Fund Store, you KNOW she's more than qualified due to their hyper selective screening process!!

KnuckleDragger-X's picture

I was working in the silicon gulch during the last boom/bust and this one is going to be much, much worse. The Fed has pretty much destroyed the real market and is now leading the herd over the cliff and the band played on......

asteroids's picture

Agreed. Will the QQQ lose 50% of it's current value. Probably. The only question is will it happen over 2 months or 2 years.

cheech_wizard's picture

+1000

I too worked in Silicon Gulch during the first Internet Bubble burst... If pension funds are chasing unicorns, it will be far worse than the last crash. The bear market had just begun and I was reading a book by William J. O'Neil in which he wrote "During a bear market, stocks can lose up to 95% of their value or more..." I called my broker, and sold everything. In hindsight, it was the right choice, as many of the stocks I owned within a year were selling for pennies on the dollar or had gone bankrupt. I was heavily weighted in the tech sector but ended up in all cash and had the broker send me a check. I switched my 401K to bonds and got 5% on my money, which was better than nothing which was what many ended up with.

To me, many of the people that state how wnderful this market is (namely because they have never seen a down market) are in for a huge awakening/shock when it all comes tumbling down around them.

 

KnuckleDragger-X's picture

Yeah, about six months before it popped I reached maximum paranoia when everybody told me it would go on forever. I made a nice little pile out of it....

weburke's picture

pension managers will short these companies if they are listed, and pillage from their victims funds, which they control, on the way down. 

KnuckleDragger-X's picture

The tech IPO's will come pre-pillaged to save time......

JRobby's picture

Movie trailer: Starts out with the usual: "IN A WORLD"

(scene: crowds of people being jostled, beaten, forced to board blue buses by security forces)

(Cut to opulent conference room on the 80th floor somewhere: $750,000 conference table, men in suits)

Dialog:

"Let's clean 'em out a second time."

"Come on, they aren't going to fall for that a second time are they?"

"By the time they figure out that they won't be alive for retirement they will be on a bus to the processing plant"

Colonel Klink's picture

Shearing the sheep by the million$!

But you can bet the matzah mafia gets their vig.

F0ster's picture

I've been running 'real' businesses around these tech start ups for years. Its painful and amusing to watch these smug socially disfunctional programmers and young bearded tech wantreprenuers tell me how the world works when they can't produce a bean of profit in anything they do as I produce millions in revenue on my slightly less sexy businesses. Reality (cycles) always kick these morons out of the business world every few years. 

JRobby's picture

Wow! Satellite internet on the 180ft yacht and everything?

Shizzmoney's picture

BUT....BUT...NO RISK IN TECH BUBBLE…NO SYSTEMIC RISK…MANY OF THESE TECH COMPANIES MAKING MONEY

Fucking fools, the whole lot of them.  

Kreditanstalt's picture

"Retirement funds"??  Not real "money" anyway...never was.

 

May these craven desperately lose their shirts!

The_Small_Lebowski's picture

those puke launching unicorns are the best thing ever!

joego1's picture

Most of these app companies are based on future advertising revenue from a shrinking middle class. That dog don't hunt.

Chuck Knoblauch's picture

1998 HOT TUB TIME MACHINE

Kaiser Sousa's picture

buy the dip...

we all be getting rich!!!!!!

BITCHES...........

 

disclaimer: i only invest in the only 2 forms of real money.

Seasmoke's picture

You can pay me now or DON'T pay me later.

bahaar's picture

A few months ago, weren't they all saying that this time it's different.  because all these tech startups don't IPO until they have billions of dollars in revenue (who needs profits).  That it's not retail investors but savvy VCs and hedge funds who are investing in them?  What changed?

J Pancreas's picture

Xiaomi is the only company on that list that has any profitability potential. Uber's business model is easily replicated. That list is a pile of garbage company wise. If you want to invest in trash, buy WM.

Chuck Knoblauch's picture

Stealth austerity through income inequality can still work, Stanley.

Mister Delicious's picture
Mister Delicious (not verified) Mar 23, 2015 11:50 AM

invest in ball bearingsa, fellas.

 

It's all ball bearings these days!

Monetas's picture

I miss Do Chen Roller Bearing .... did Sendero Luminoso get him for ransom .... he made me feel good .... about my racism issues .... if I found out that he got disgusted with all the left wing gibberish around here .... you'll be hearing from me .... meanwhile, Do Chen call home !

Buckaroo Banzai's picture

Maybe you boys need a refresher course!

yogibear's picture

Fund managers are begging Market Makers to issue more IPOs.

Plenty of private companies to offer IPOs.

Private companies can go from being broke to being multimillionaires through stock IPOs.

 

Jstanley011's picture

"While some of the startups may become profitable, others are consuming cash and could fail."

Could fail? Could?? COULD??? Tyepical mealy-mouthed Bloomberg bull crap. The vast majority of these outfits WILL FAIL, and they know it too.

RaceToTheBottom's picture

A hockeystick in every Retirement plan!!!!

At least the remaining middle class ones...

orangegeek's picture

are these the unicorn kind that shit skittles and talk to care bears?

Monetas's picture
Monetas (not verified) orangegeek Mar 23, 2015 1:25 PM

Sometimes people shit Skittles .... after they've been shot !

motorollin's picture

SpaceX, Square and Stripe are the only companies on that list that will be around in a decade.

Hohum's picture

I prefer grilled cheese trucks.  Is that tech?