Dark Marks have been flying around recently like it’s the Quidditch World Cup. Here’s a brief selection:
And then there’s the dead unicorns.
What’s a unicorn? In investing parlance, it’s a private start-up company with a $1B valutation. At the moment, there are over 300 such companies around the world. Here’s a fun visual breaking down the unicorn universe:
You may have noticed that Lyft, Pinterest, and Zoom aren’t on there. That’s because they already went public by the time that infographic was put together. Since the infographic, Uber has gone public, in what was possibly the worst IPO in all of history. Unicorn blood everywhere.
Let’s take a look back at the life cycle (end-of-life cycle?) of a unicorn and see what it means when these things start getting slaughtered in the Forbidden Forest of the stock market.
These companies start with basically nothing except an idea, and generally self-fund some prototype or proof of concept or rudimentary app development. They then take their idea and pitch it to early-stage investors called venture capital firms (VC) - exactly like what you see on Shark Tank or Dragon Den: “Here’s our idea, we need $250k to get this up to scale in our market. In exchange, we’ll give you 20% of our company.” Then you have some negotiation around the terms of the deal, but let’s say the company gets $250k for 20%. That gives them a valuation of $1.25M.
Fast forward a bit, they use the $250k to successfully scale up and now want to expand into new markets. They have more of a proven track record at this point, so there are more people willing to listen to the company’s pitch in the next funding round. Still mostly VC firms, but maybe some private equity firms as well. Maybe now they need $2M to expand along the East Coast, and let’s say they get the $2M investment in exchange for 15% of the company. Now they’re valued at $13.3M.
Fast forward a bit more through continued successful growth, and now maybe they want to expand west and need $20M dollars to immediately get scale in, say, Texas and California. Another successful funding round and say they get the $20M in exchange for only 8% of the company. Now they’re sitting on a $250M valuation.
Another successful funding round or two and voila! you have your very own unicorn once you get to a $1B valuation.
Crucially, please note that you aren’t a unicorn because you have billions of dollars in sales, or revenue, or profits. You’re a unicorn because somebody thinks that’s what you’re worth...kind of like stock valuations. To use hyperbole to prove the point, let’s say we started making a gizmo. It’s a mildly entertaining cat toy kind of gizmo, and we get a $100k investment for manufacturing purposes in exchange for 40%. That makes us a $250k company. Then, let’s say there’s a rich old recluse down the street who is mildly off his rocker and also happens to be a crazy cat person. He sees our toy, knows us, knows that we used to cat-sit for him back in the day, and decides to give us $10M for a token 1% in the company so we can entertain all the cats in the world. $10M for 1% gives us a $1B valuation. Boom, unicorn.
It’s unlikely that many of the current unicorns got that way because of crazy cat people. But might a decade of 0% interest rates and an additional $3.5 trillion dollars pumped into the economy have had something to do with it? Absolutely - that’s basic supply and demand.
But back to the unicorn life cycle. Now you’re a well-established, fully-horned unicorn, and you live happily ever after. The End.
Or not. There are several private multi-billion dollar companies out there that will likely continue operating privately happily ever after. Cargill, Koch Industries, Chick-fil-A...these companies all retained control by making money “the old fashioned way”, through growth and acquisition. The reason they’ll stay private is that taking your company public is actually a massive hassle. It’s expensive, you lose a lot of control, and there’s a lot more regulation you have to deal with. In short, probably nobody would do it if they didn’t have to.
But unicorns have to. They didn’t make money through growth and acquisition, they made money because a bunch of different investors gave them money. Threw money at them, really. And eventually, those VC and private equity funds will want to see their money back. That initial $250k investment for 20%? It’s now worth at least $200M. Where are you going to get $200M to repay that investment? You don’t have it just lying around, you’re a finely-oiled business machine! You’re probably not going to take on $200M in debt to cash them out. You’re probably not going to get another private equity firm to buy them out because a) that’s a large chunk of money and b) by this point your future unicorn returns won’t be as attractive as the next pre-unicorn out there (would you rather invest $200M in one company that might grow to $300M in 5 years, or $250k each in 800 different companies, any one - or all! - of which might turn that $250k into $200M in 5 years? Exactly.) That leaves pretty much one option - the public stock market, via IPO (initial public offering).
There are two reasons why VC and private equity firms want their money back. One, to pay off their investors. Two, because they think there is better opportunity elsewhere...which means your company has either reached a growth plateau or a public demand plateau. Let’s be crystal clear about this: companies IPO in order to lock-in returns for their early-stage investors. And nothing screams “caution” like a bunch of these really sophisticated early-stage investors deciding they need to get their money out all at the same time.
So now comes the IPO. IPOs are all about telling stories. You want to drive up demand in the public market so that people will want to buy your stock when it opens. The more people that want to buy it, the more the price will go up. The company releases a prospectus, some slick marketing materials, and then literally does something called a “roadshow” to try and generate demand in the market ahead of the IPO. The price of the IPO is a delicate balance between maximizing cash for the company and making a good public impression. Sure, maybe you could get $45 per share and just have the stock trade there all day; but would it be better if the stock opened at $35 and immediately jumped up to $45 to show a 30% gain on day 1? It’s all about the marketing.
A successful IPO is one in which the shares start trading and go up. If an IPO is priced too high or there’s not a lot of demand, the shares will drop. The companies managing the IPO will generally “support” the IPO by buying shares at the IPO price so that the stock doesn’t show a loss on the first trading day, but that’s bad optics.
Here are some notable recent IPOs:
Lyft - Initial suggested IPO range was $62-$68. Actually IPO’d at $72. Lots of shadiness around the IPO, with accusations of short-selling against the IPO by the same firm that was managing it. Lyft initially opened about 20% higher, then faded. Mediocre-to-disappointing/confusing IPO. (Lyft shares fell below the IPO price on day 2 of trading and still haven’t recovered).
Pinterest - Initial suggested range was $15-$17. Actually IPO’d at $19 and jumped up to $24 on day 1. It peaked at $30 and has since tailed off back down to $25. Pretty successful IPO.
Zoom - Initial suggested range was $33-$35. Actually IPO’d at $36 and closed day one at $62. Since then, it has gone up to $79. Great IPO.
Uber - Initial suggested IPO range was $44-$50. Actually IPO’d at $45, yet opened at $42 and has yet to trade above $45. Ever. Unbelievably terrible IPO.
No other company has been as large, well-known, anticipated, and yet IPO’d as poorly as Uber. Facebook was the biggest flop of the last decade, but it at least opened up 25% or so before needing a lot of support to hold the IPO price by the end of the day. Note that those other three companies IPO’d above the anticipated range. Uber IPO’d at the bottom end of the range. Not a great start, that. But to make matters infinitely worse, the opening price was almost 7% below the IPO price! That’s...almost unheard of. Uber used to be valued at upwards of $120B. After that IPO, it’s worth less than $70B. Fun fact: that means that over 80% of the money invested in Uber is underwater now.
Realistically, Uber (and Lyft) should probably be worth...absolutely nothing at the moment. Companies have to give potential investors a look at their financials before the IPO. Add Uber and Lyft to the list of companies that don’t make money. In 2017, Lyft had $1.1B in revenue but a net loss of about $700M. In 2018, they had $2.2B in revenue but a net loss of over $900M. Lyft just reported their first quarterly earnings as a public company and expects in 2019 to generate $3.3B revenue but a net loss of over $1.1B. Uber, before the IPO, told investors that it may never actually make a profit. In 2018 Uber had $11B in revenue...but a net operating loss of over $3B. And for the first quarter of this year, they lost over $1B on $3B of revenue.
Question: How much would you pay to own a company that loses literally billions of dollars a year?
Answer: Objectively, nothing. Subjectively, anything that is slightly less than someone else is willing to pay in the future.
And that’s the problem here. The entire point of the IPO process these days is to stir up a bunch of those “willing to pay more in the future” people with a lot of hype and smoke and mirrors. All of these large, well-known IPOs are not a positive economic signal, it’s a sign that future growth prospects are diminishing and your VC/private equity firms are trying to cash out at the top. When there’s not even enough demand to open at a low IPO price for a well-known and fairly popular company, that’s a pretty good indication that the top for valuations may be in the rearview mirror.
Unicorns have been the darlings of the investment world for the last decade. It’s not a good sign when they start dying in front of you.
It may or may not also mean that He-Who-Shall-Not-Be-Named is about to return, so brush up on your expelliarmus this summer. Or, better yet, learn some real fighting magic because the premise that expelliarmus is good enough to stand up to the Unforgivable Curses is absurd.
About the Blog:
Here lives our collection of newsletters, articles, and some occasional guest posts by outside authors (where indicated) who have quoted us. If you're interested, feel free to browse through the archives here.