Back in March, we brought you “Tech Startup Bubble Has America's Retirement Funds Chasing Unicorns [7].” 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 [8], “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 [9]:
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 [10]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 [11]: "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 [12], "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 [11]" 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 [13]from the WSJ proves:
[14]
[15]
[16]
And here is the stunner: the combined "valuation" of total US unicorns is $486 billion. Their combined profit? $0.
