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SKARBECK: High-flying private firms might be about to tumble

November 28, 2015

Ken SkarbeckEarlier this year, we called attention to the growing number of “unicorns,” the term coined for private tech companies with valuations over $1 billion. You are likely familiar with some of the companies: Uber (recent valuation, $51 billion), Airbnb ($25.5 billion), Snapchat ($16 billion), Pinterest ($11 billion) and Dropbox ($10 billion). Heady private valuations, indeed, especially when you consider that Amazon went public in the 1990s at a $500 million valuation.

According to CB Insights, there are 143 unicorns with a combined value of $508 billion. Lately, observers have become concerned there might be a “valuation adjustment” similar to the bursting of the dot-com bubble in these private tech companies. Several of Silicon Valley’s veteran venture capitalists have weighed in, calling the unicorn phenomenon unsustainable.

One reason given for the large number of highly valued private companies is that startup businesses are staying private longer, opting to postpone going public. Delaying an IPO also gives a larger number of venture capital firms the opportunity to invest capital in startups at various stages. As these private-market valuations rise, the venture firms show attractive returns to their investors, even though profits won’t be realized until there is an IPO or sale of the startup. The danger is, a significant correction in these private valuations could turn unrealized profits into realized losses.

One troubling activity is that some late-stage venture money that flows into these private companies comes with a condition called a “ratchet” that essentially guarantees the venture firms a healthy profit.

For example, Square—the company whose technology facilitates payment transactions for small businesses—recently went public in an IPO at $9 per share. Square had six rounds of venture funding while it was a private company. In Square’s last round of financing in October 2014, the venture firms contributed $150 million. These late-stage investors negotiated a ratchet that guaranteed them a 20-percent return on Square’s IPO. So when Square went public a few weeks ago at a reduced valuation, Square had to give them another 10.3 million shares, worth $93 million, to get them their 20 percent profit.

The fact that Square’s IPO value was less than its late-stage private-market value is cited by observers as evidence that private-market values for unicorns are too high. Square is currently valued at six times revenue.

Cracks are starting to appear in the values of other highly touted startups. Dropbox is a company where venture firms are reportedly starting to write-down the value of their investment and is being called the “first dead decacorn,” referring to a firm once valued over $10 billion. LivingSocial, a rival to Groupon, was once privately valued at $4.5 billion and is now struggling to keep the doors open.

In addition, the shine has worn off a few popular publicly held tech companies, including Twitter, GoPro and Fitbit, whose stocks have struggled lately.

Some venture capitalists believe that, with trouble brewing in the private market, more companies will choose to go public in an attempt to cash in while valuations are still high. If unicorns were to rush to IPOs, it’s caveat emptor for public investors. Overpaying for sinking valuations is not a recipe for investment success.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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