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SEC Goes Unicorn Hunting: Regulator To Scrutinize How Funds Value Tech Startups
Back in March, we brought you “Tech Startup Bubble Has America's Retirement Funds Chasing Unicorns.” In it, we revisited the “highly scientific” process by which tech startup founders and their VC backers determine “valuations.”
As anyone who follows such things knows, the valuations are all but completely made up. But that’s perfectly ok, because as the VCs who fund these companies will patiently explain to you, the problem is not that Snapchat isn’t worth more than Clorox (and yes that’s a double negative), 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.
As we went on to note, 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.
Of course everyone involved is just waiting for a liquidity event and unless you get a buyout, the VC backers take these companies public at ridiculous valuations. That’s when some poor sucker sitting in his basement hits the “buy” button in his Scottrade account and ends up paying some insane multiple for an unstable startup revenue stream.
That would be bad enough as it is, but as we warned back in March, even if you aren’t the home gamer who bought on IPO day and didn’t realize you were paying an obscene multiple, you may end up owning the shares anyway in your retirement account.
As The New York Times pointed out, “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.”
Now, as more questions are being raised about what look like stratospheric valuations for companies with no operating profits and sometimes no revenue, the SEC is taking a harder look at how mutual funds are valuing these “investments.”

Here’s WSJ with more:
Federal securities regulators are looking more closely at whether U.S. mutual funds have proper procedures in place to accurately price shares of private technology companies amid signs the tech boom is wavering, according to people familiar with the matter.
The Securities and Exchange Commission in recent months has been asking more questions of large fund firms about how they value startups and whether their process ensures an accurate estimate of a company’s worth, the people said.
Startup shares are “not traded on an exchange, so a market quote is not readily available,” said Jay Baris, a partner and chair of the law firm Morrison & Foerster’s investment-management practice. “The question is, how do you put a fair value on it when you’re looking at squishy data?”
Yes, "squishy data", like "managed revenue" and other "metrics" that purport to tell investors something critical about a business that they might not get from looking at "less important" things like actual revenue or (gasp) profit.

Back to WSJ:
Accurate pricing of securities is fundamental to the mutual-fund business, and millions of investors rely on precise valuations to figure out how much their holdings are worth. Fidelity Investments, T. Rowe Price Group Inc. and BlackRock Inc. are among the biggest money managers investing in private tech companies.
The scrutiny comes as big money managers have been loading up on shares of private companies over the past several years, investing in hot startups such as Uber Technologies Inc., Dropbox Inc. and Airbnb Inc. Five of the biggest fund firms participated in funding rounds worth a combined $8.3 billion this year as of Sept. 30, up from $1 billion for the full year of 2011, according to data from venture-capital research firm CB Insights.
Shares of those startups have landed in some of the most popular mutual funds available to small investors, including the $111 billion Fidelity Contrafund and the $15.7 billion T. Rowe Price New Horizons fund.
But mutual-fund firms are struggling to value the startups and frequently report different prices for the same company, The Wall Street Journal reported in a front-page article last month.
Of course valuations aren't the only problem. There are also questions of liquidity. That is, in the event of redemptions, who's going to buy these shares? That's an especially vexing issue considering that when the startup bubble finally bursts, it will be just like what will happen when the HY bubble capitulates - that is, there will be no buyers, no market, no liquidity. Recall what Mark Cuban said earlier this year: "...the only thing worse than a market with collapsing valuations is a market with no valuations and no liquidity. If stock in a company is worth what somebody will pay for it, what is the stock of a company worth when there is no place to sell it?"
Good question. Here's WSJ one more time:
There is growing concern in the technology sector that private shares have become too bloated, and that some recent technology IPOs have been priced at less than the latest private valuation of the companies. In September, Fidelity marked down the estimated value of its stake in Snapchat, the chat startup, by 25%, according to a monthly report from Fidelity.
What this means is that if you unknowingly have some unicorns prowling (err wait, we guess unicorns don't "prowl".. let's say "prancing") around in your 401k, not only are they subject to being written down by a quarter out of the clear blue sky, but they are also likely to be impossible to sell in a pinch and unlike HY bonds, there may literally be no market for the shares. As in, no buyers at any price.
So yes SEC, please look into how the most vaunted mutual funds in America are valuing these things, and let us know what you find out, because our guess is, Fidelity, BlackRock, and T. Rowe can't provide any more plausible an explanation for the valuations than the VCs can.
* * *
Oh, and by the way, the cracks are starting to show...
First it was Dropbox.
Two weeks ago we reported that one of the numerous "unicorns" prancing around Silicon Valley was about to have a very rude wake up call when Dropbox was warned by its investment bankers that it would be unable to go public at a valuation anywhere near close to what its last private round (which had most recently risen to $10 billion from $4 billion a year ago) valued it at.
Than it was Jack Dorsey's "other" company, Square.
Last last week: "today another company realized today just how big the second "private" tech bubble, one we profiled first in January of 2014, truly is. That company is Jack Dorsey's Square, which earlier today filed a prospectus in which it said that the "initial public offering price per share of Class A common stock will be between $11.00 and $13.00." Assuming a mid-point price of $12 and applying the 322.9 million shares outstanding after the offering, it means a valuation of $3.9 billion. The problem is that in its last private fundraising round, Square was valued at about $6 billion according to ReCode."
Today, it's the turn of Snapchat, the fourth most highly valued private tech start up.
According to FT, "Snapchat has been marked down by one of its most high-profile investors, raising further questions about the soaring valuations of private technology companies. Fidelity, the only fund manager to have invested in the four-year-old company best known for disappearing photos, wrote down the value of its stake by 25 per cent in the third quarter, according to data from investment research firm Morningstar. It had valued each share at $30.72 at the end of June but dropped the valuation to $22.91 by the end of September."
It is unclear why Fidelity marked down its stake but Snapchat is still searching for a sustainable revenue model.
It is also unclear if other Snapchat investors, such as VC titans Benchmark and Kleiner Perkins, as well as tech companies Alibaba, Tencent and Yahoo have followed Fidelity into what is becoming a widespread realization that not only was there a private tech bubble, but that it has burst.
A bigger question is whether it will be a controlled demolition as unicorns everywhere are demoted to what we first dubbed "zerocorn" status in the coming days. To be sure, the VCs are desperate for a controlled demolition, and hoping the broader market ignores the euphoria that took place in Silicon Valley over the past 3 years, is now over, and that giddy investors overshot by at least 25-35% to the upside in the past several private funding rounds as everyone was rushing to pass the valuation hot potate to ever greater, and richer, fools.
It remains to be seen how successful they will be, and just what the source of capital for hundreds of "$1+ billion"-valued, cash burning companies will be in lieu of generous VCs, and just how viable the second tech bubble will be if these hundreds of companies suddenly are forced to generate cash flow to fund themselves.
One thing we know: there sure are many of them, as this infographic from the WSJ proves:
And here is the stunner: the combined "valuation" of total US unicorns is $486 billion. Their combined profit? $0.
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I thought unicorns were above an 8 hot and below a 4 crazy?
Let's see if anyone gets that...
ACP-
Referring to the father who was a cop and taught his son the X/Y axis chart of women prior to leaving for college. "Unicorns must be captured as they are a rare mythical creature and have never been found before"
Boooom!!! What do I win?
Find unicorn is easy, but only after you are find trail of skittle color feces.
+1 Haha - hot crazy matix!
Trying to get out in front of the Dot Com 2.0 bubble bursting? It's funny if they think this will restore any of their credibility.
One of the most annoying aspects of the Security State is how the segment of the population that eats up all the bullshit always demands "regulation" to save them from their own stupidity. Or do they?
"Please do not throw slinky from window of moving vehicle"
Surely the SEC just wants to understand valuation best practices to be able to apply them to companies that are more conventional, yet still a substantial part of investors portfolios.
Companies should only be allowed to go public when they have a GAAP profit after 3 years of operating history.
Period.
GAAP? I think I remember my grand pappy mentioning companies needed to follow that standard a long, long time ago....
The horse escaped the barn a couple of decades ago, so let's investigate for a couple of years and then pretend to do something.....
I'm an Entrepreneur trying to get VC funding and researching their portfolios, it's amazing what they're funding for millions. Pley, which is a Lego Rental Website. Like who the heck, would want to get diseases imported into your home? Fancred helps you capture your favorite moments as a sports fan. They're turning me down, because my concept is not a 'fit', despite being totally useful to millions. Maybe it's because it's not cute enough, not sexy enough or stupid enough.
I'm guessing your problem is that your concept might provide actual utility to people.
I know, that sounds like it ought to be a good thing. But Capitalism has gotten pretty good at placing valuations on actual useful things. If a concept never does provide anything useful to people, then valuation has to be derived from sentiment alone. Snapchat isn't worth anything to me. But my teenaged kids probably think there's a value to it. Their sentiment can't be quantified, so hey, Snapchat could be worth an infinite amount of money. And there's an entire industry devoted to making people think a thing they personally like is enormously valuable.
If the concept they personally like has measurable usefulness, a market price can be established. If it's all sentiment, it can be presented as being worth whatever you want it to be worth, or perhaps more accurately, whatever you think the muppet in your crosshairs has in his pocket.
I like my house a lot. It has enough space to keep all my shit indoors, it stays cool in the summer and warm in the winter, and it's just pleasant to me. However, I can easily enough discover that $200,000 is too low a price for me to sell it, and I'd sell it at the drop of a hat for $300,000. That kind of quantifiability would keep any self-respecting muppet-fleecer (is that an oxymoron? Unfortunately not) disinterested in handling the sale of my house.
I did the begging for VC funding as a CTO of companies back in the 2000's, and it was BS on many different levels.
For a start, the VC's refuse to sign non-disclosure agreements, so you can be sure that they are IN FACT just using your brochures to look for ideas to pilfer - they are just laughing at you while they do it, even.
Patents are only worth the money you have to protect them (hint: you don't have what it takes) and in any case, the greater problem is that there are simply too many ways to stop a good idea from being implemented (through abuses of justice, for example).
So at a deeper level, what's happening is just that TPTB own and operate the VC's, and similarly they have also designed the entire legal and patent system in order for it to block most development (unless you are a mega-corp), and that IN GENERAL, they don't want ANY good ideas that are helpful and enriching for all - they are looking for 'new' penny stock scams to push and other such garbage.
VC funding is a complete waste of time, unless your operation is deeply aligned with TPTB's satanic agendas.
I was in a similiar situation a few years back, though not for a tech company.
And yes, patents are essentially useless nowadays unless you have 10's of millions and a legal branch. I heard the new thing was keeping everything you can a trade secret. With tech companies, I imagine thats probably not possible.
Anyways, most of the patents at these tech companies are laughable i.e. would never ever hold up in court. Its almost like they just have patents to say they have patents. Sometimes the listed prior art is EXACTLY the same.
Best example is that Apple tried to patent the way they list songs in the Ipod: artist then album then song. Thank god a judge had the balls to say that was obvious and not patentable. Its like these companies think that everything they do is original and non-obvious. Im a firm believer that patents no longer help innovation but in fact stymie it. So many patents out there of things never made, never sold only to keep competition out of the markets. Disgusting.
To state the obvious: "Funds do not value start-ups. Banks manage price to benefit insiders who benefit them."
It is a big club that has been around a long time ... and it is better not to be in it.
Amazon is a bad example. They are, bya far, the biggest online retailer. They have a steady stream of revenue that is increasing every year. Bezos is making it clear, by spending huge amounts of capital, that Amazon is going to be the worlds biggest and best retailer/online shopper + web storage and hosting platform. Bezos, unlike Evan Spiegel or whoever made Pinterest, is not only lucky, but smart. He was the first to the game and he is killing all competition. The fact that Amazon has started selling big name clothing brands should tell anyone how serious Bezos is.
Snapchat and Pinterest. They dont even come up on Amazon's radar. In 10 years, no one will even give a shit about Pinterest or Snapchat, they will go down from multi-billion dollar valulations to 300-400 million. Remember Groupon? Yeah I dont either. But I do remember Google trying to buy it for an insane amount.
Selling the dream to investors is always easier than getting them to perform their own due diligence.
Unicorn Meat... an excellent source of sparkles.
(Some Amazon comments are almost as good as ZH)
While they're at it they can look into unicorn valuations on FB and Amazon. Amazon trading at 900 times earnings, will eventually have to make $20 a share to at current prices trade only at 33 times earning. Good luck with that. A company that's basically a middle man for UPS, Fed-Ex, makes a tablet no one buys, and has servers.
Then there's Facebook which as far as I can tell sells "likes", has no real product and has a market cap of $300,000,000,000.00. Yep one 1/3 of a trillion dollars for a company that makes absolutely nothing other than " apps".
In Facebook's defense, according to the Terms of Service they own the largest collection of human personal information in the history of the world.
So they've got that going for them, which must be worth something.
That's true, knowing everything about everyone does have its advantages. That's what DC is built on.
"Yep one 1/3 of a trillion dollars for a company that makes absolutely nothing other than " apps"."
You overestimate what they do. They don't actually develop the apps, they're just a marketplace for them. Grabbing a cut of the app spend + advertising is literally their entire revenue model.
What's to understand? Pump-and-dump has been understood for a long, long time.
LOL!!! Honest valuations require honest PRICE DISCOVERY!!!
Sorry, that has not existed for quite a while.
Pre-revenue is what you have to aim for...
https://m.youtube.com/watch?v=BzAdXyPYKQo
They are also putting in new laws around crowdfunding: http://www.sec.gov/news/pressrelease/2015-249.html
Those assholes are the most unhelpful, worthless group of bureaucrats in our bloated 'government'.
Hypeability is the only factor.
Which part of "All valuation is subjective" is so hard to understand here?
Also, WTF is the point of funding Uber with $7.4B? What could they possibly need it for, if their business was really a business? Looks more like a legal fund, to me.
The good thing is that the SEC is completely ignoring the price-fixing in the Gold and Silver markets. Of course when the price-fixing is being done under the express consent of Federal Govt, I guess you can't do much about it.
it goes something like this: see this pile of cow manure? That's now e-cow manure and it's worth $40 million.
Maybe I can take a course in vowel placement at my local community college.
Turdollars!
Make you own too! Just eat more.
How to value a unicorn?
Mark me well, I will tell you, sir:
The way to value a unicorn?
Is to love her...simply love her...
Merely love her...love her...love her."
https://www.youtube.com/watch?v=U55m_TzM7jw&t=1m14s
"Cat and rats and elephants
but sure as you're born;
you're never gonna see no unicorn."
https://www.youtube.com/watch?v=TG_RA_IKO6g
So who is going to live and what to buy?
This is off the top of my head, I didn't study the numbers yet, but I would buy these guys at a huge discount (Maybe 80%):
Dropbox, Palantir, Square Credit Karma?
Any others?
Draftkings and Fandual are already dead men walking, Florida is going to be next to ban them case is coming up before judge I understand soon.
If you like the names you mentioned at 80% off peak prices, then you'll LOVE FCX, BTU, X, CLF and a host of others
trading at 90-95% off peak prices.
You know, with BTU, energy policy reguarding coal can turn on a dime if the political wind changes
The others I don't know, "A miner is a lyer standing next to a hold in the ground" lolz
Maybe X, but that could languish for years as out grinding recession continues.
Just read in the paper today that Tindr is valued at $3bn - yet another unicorn.
Now I get the value in enabling 2 humans to meet up to fuck, but I don't get how the hell they're going to monetise. If they require subscriptions, people will jump platform to any number of 'me-toos'. Ad revenue? Jump platform.
Just unicorn shit.