The Valuation Drivers of Silicon Valley Unicorns

We all stopped believing in Santa Claus long ago but thanks to the unicorns[1] of Silicon Valley, many a founders’ faith in the mythical prevails.  It is hard to fault them at times with headlines about billion dollar valuations or stories in trade magazines quoting the purchase of that younger competitor, with little revenue and market penetration going for $20 or $30 million, off a sub-$2 million revenue base.  For those keeping score at home, that is more than a 10-15x revenue multiple.[2] 

The natural inclination for many business owners is to do a comparable analysis believing that the transitive property applies to valuing their business.  These outlier cases, or unicorns if you will, fail to translate due to a lack of understanding (i) valuation methods and (ii) the underpinnings of those high flying valuations the unicorns receive.

Leaving the mechanics of various valuation methods to another day, let us focus on the underpinnings of unicorn valuations coming out of the venture space, so that you can better understand them in relation to your business and its probable market value.

High Risk = High Reward

Venture capital investments are made on the backs of the higher the risk, the higher the reward axiom.  According to the Wall Street Journal, venture capital firms make their money off of roughly 20% of their investments.  This is not surprising given that just 35% of start-ups make it to their 10 year anniversary[3].  The result of this is a community constantly seeking a high grade multiple.

 “It wasn’t worth fighting that much over the valuation… What really matters is the multiple.  So how many times my original investment am I going to get back when this company ultimately exits.  So I may deeply believe in your company.  But if I invest at a $50 million dollar valuation and your most optimistic outcome for what this could be is a $100 million dollar outcome, then considering the risk of investing in a start-up, a 2x or a two times my money back probably isn’t worth that math.  So the challenge for us at a $10 million price….do we preserve the potential for a 10x multiple or greater.”

 –Chris Sacca of Lowercase Capital on Episode Six of StartUp

High Multiples Need a Rational Foundation

When an investment fails, then the high flying multiple may seem crazy in hindsight.  However, investors typically invest based off a set of what they thought were logical reasons at the time.  Investors paying high multiples tend to require at least one, if not a selection of the following, to be present in the company they are investing:

1.       Rapid growth: Honest Co., the maker of non-toxic household supplies, nearly tripled year-over-year sales in 2014 to $170 million.  This kind of hockey stick growth has given an 8.2x sales multiple to its initial funding, at a current price tag of $1 billion dollars[4].  However, on a forward multiple basis that multiple would presumably come way down assuming the high growth trajectory continues.

2.       Forward runway for high growth: Uber’s $41 plus billion dollar headline valuation[5] has primarily been fuelled by their growth potential.  In the early days, it was the potential user base of their platform and now many articles talk about the real value driver being last mile delivery[6].

3.       Intellectual property:  Oculus VR’s Kickstarter fan base was not enough to support a $2 billion dollar cash and stock valuation that Facebook paid.  What Facebook bought was the intellectual property and the team that developed it.[7]

4.       Competitive threat to purchaser’s core business: Facebook tried to buy Snapchat, with its estimated 26 million user base, for $3 billion in 2013.  What Facebook was doing was trying to maintain its market relevance with users by expanding its control over alternative photo sharing platforms.  This is why they were willing to pay over $115 per user without any supporting revenue.[8]  These types of purchases are more about preserving the value of the acquiring company’s business than anything else.

5.       Early Mover Advantage Exists: Uber was able to gain scale quickly and take large market share.  This has allowed them to dissuade many would be competitors from entering the market and has at the very least marginalized existing competition.  This has helped drive up the company’s valuation as oligopolies are traditionally attractive to investors / shareholders.

The Market Is Not Always Rational

Venture investing has proven lucrative in the past decade, which in turn increased the number of venture investors and corresponding dollars.  This means more investors are chasing the same pool of businesses, looking for outlier returns.  Simple economics tells us that this bids up the valuation of companies in the short run.  Sound like a movie you have seen before?  The beginnings of an asset bubble perhaps?

I will leave you to your own devices to settle the question of whether or not VC investing is reaching a bubble or not.[9]  However, I will share this story of a Kentucky-based high net worth money manager.  He recently created a venture fund that invests in companies that pitch to angel groups or work out of incubators, and graduate from accelerators in Kentucky.  Kentucky is far from a Raleigh Durham, Mountain View, or even a Kansas City[10].  To me this is an anecdotal sign that there are too many venture dollars in the space, similar to that of teachers becoming real estate speculators during the housing boom.

The Sunday Punch of It All

So what does this all mean when calibrating your valuation expectations?  To answer this, compare your business to the drivers of valuation listed above.  In other words:

  • Does your business offer a high risk / high reward type investor scenario?
  • Does your business show solid historic compound annual growth?
  • Does your business have sufficient runway to grow at high rates and a plan to capture that growth?
  • Does your business have valuable intellectual property?
  • Does your business pose a long term competitive threat to large established competitors or other companies in adjacent markets?
  • Is your business a monopoly or oligopoly; or does it control significant market share?

If the answer is yes to a few of these questions, then congratulations, your business has sound reasons for a higher than industry average multiple.  However, I point you back to fact that the market is not always rational, so no matter how great you think your business is, it is only worth what a willing and able buyer pays for it. 

As of last month (that is February 2015), the total list of billion dollar venture backed unicorns totaled 78.[11]  These companies, heavily concentrated in the technology sector, represent a rare group of survivors from the start-up community.  Lesser unicorns exist as well.  Often these are small revenue companies selling for tens of millions of dollars often with obscene multiples.  I am talking about the kind of multiple that requires two if not three X’s after the turn to make it clear just how outrageous the valuation is.

I offer one piece of parting advice.  Do not set your (or your client's) valuation expectations off of either of these two groups of outliers.  Doing so typically results in heartbreak that is akin to a seven year old’s when their older cousin lets it slip that Santa is not real.  It also makes for a more difficult deal process for you, your business partners, and transaction advisors.  Would be buyers often get turned off by Porsche prices for Toyota quality.  Do yourself a favor and listen to an objective professional on what a typical business like yours fetches.  Chances are your business is closer to the common but still valuable Quarter Horse then the mythical and majestic unicorn’s that populate the headlines out of Silicon Valley.

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[1] In 2013, in a TechCrunch article, a venture capitalist referred to businesses that have achieved valuations of $1 billion or more as “unicorns” and the reference stuck.  See http://fortune.com/unicorns/ and http://www.wsj.com/articles/how-unicorns-became-silicon-valley-companies-1426861606.    

[2] Sometimes companies tend to trade off of revenue multiples (rather than earnings multiples) when they are in growth mode, due to their future potential and earnings that have not caught up to the growth on account of profits being reinvested to fund the growth.

[3] http://www.wsj.com/articles/SB10000872396390443720204578004980476429190.

[4] http://graphics.wsj.com/billion-dollar-club/?co=Honest%20Co.

[5] Financial structuring can inflate the value based up on the mix of the underlying securities that make up that implied enterprise value (e.g., preferences or preferred returns).  Or in layman’s speak, all that glitters is not necessary gold because of financial engineering.

[6] http://graphics.wsj.com/billion-dollar-club/?co=Uber.

[7] http://time.com/39271/oculus-facebook-kickstarter-backlash/.

[8] http://www.forbes.com/sites/jeffbercovici/2013/11/13/facebook-wouldve-bought-snapchat-for-3-billion-in-cash-heres-why/.

[9] For more perspective on where current VC valuations are and the potential for a VC bubble read: https://www.pehub.com/2014/09/andreessen-goes-on-epic-tweet-storm-advises-tech-community-to-worry/,  http://fortune.com/2015/03/15/bill-gurley-predicts-dead-unicorns-in-startup-land-this-year/, and https://www.pehub.com/2015/03/greycrofts-sigalow-talks-bubbles-term-sheets-and-moving-the-needle/.    

[10] Kansas City has cultivated a tech start-up scene thanks in part to Google Fiber.

[11] http://graphics.wsj.com/billion-dollar-club/.