I expected the usual 'the end is nigh, the bubble has popped, unicorns are screwed, we're all screwed' article. Instead, I was happy to find that it was about some of the ways that unicorns could or may have to protect employees, founders and early investors from down rounds. Purely as an educational experience, this article is certainly worth a read.
Yeah, it really is interesting to see the situation from multiple perspectives. I still wonder though, is this actually happening? Nothing in the many articles I've read suggests solid evidence that a majority of these companies are struggling. Just sound bytes from VCs pontificating.
"Struggling" is not the same as "no longer able to justify a highly optimistic valuation". Many unicorns could actually be profitable and still never justify a $1B+ valuation.
Because they are private we often can't see the books, and the bits of the books that get out are not entirely reflective of the entire picture (if you know what I mean, nudge nudge great runner sir!)
However, my guess is that most of these companies are not actually profitable, and that most of them have business plans that require significant investments to make them profitable in the future. I think that most of them have a strategy that aims to "win" in the short term by dominating their categories and then to build out a business that capitalizes on their success, reaping profit in the future.
If so they are in trouble in that they are going to need lots more cash before they deliver profits. New providers of cash hold all the cards because if the current shareholders don't get that cash into the business then their stake is worth nothing. If the new providers of cash are the current investors then they need to squeeze hard to justify doubling down on the risk (most of them simply won't do this, but some of the funds with very deep pockets have histories of doing this with some assets)
It's been argued that the deal structure of companies, particularly unicorns, has begun to look like debt[1].
Low interest rates and easy money has created debt. Massive bubbling amount of debt. Crashing debt bubbles is not fun, just ask anyone that lost their shirt in 1929. There is a paper[2] from this past June that goes deep into this, highlighting how and why debt bubbles are so dangerous. TL;DR? At least checkout this Bloomsberg article[3].
I think there will be a number of unicorns that are successful. I don't even think this will only be those that are profitable. Like always, there are companies that are overvalued, and some that are undervalued. I don't think it's a 10/90 split as has been suggested by some, but the next couple years will certainly be interesting.
Have to disagree. They're still preferred equity instruments with unique trigger provisions. Higher up in the capital structure but not debt; you can't credit bid using these instruments in a Chapter 11 scenario and they aren't afforded the same protections in bankruptcy court. What attracts investors to debt instruments are the interest payments. You'd prefer PIK (payment in kind) interest on debt as opposed to cash payments in a low interest rate environment but that doesn't translate to pref equity instruments.
The unique feature of debt vs equity is that debt has a concave investment profile; you know exactly what you should be getting upon maturity (principal + interest payments). Equity has a convex investment profile; you get the residual value after subtracting face value of debt from the enterprise value.
I think the confusion is due to the fact that debt can (and will) be restructured in a downturn, just as equity will lose value. So they're both risky when you make a poor investment.
But, as you note, debt and equity both have distinct risk and payoff profiles that are determined by law.
I agree with it being more debt like and less equity like. And when a new investor re-writes the term sheet such that their liquidation preference is satisfied ahead of everyone else, it is just like having the bond issuer return pennies on the dollar for net negative return. And if you're looking at a $100M write off, that can fund quite a few lawyers prior to leaning back for that hair cut.
I can't really sympathize with startups affected by recent Fed movements. If you picked investors that actually care about a ~1% change in risk-free interest rates, well, I have a pull a Captain Hindsight here ...
1. Early investors overvalue a company at $X+Y
2. Investors give money and get Z preferred shares at valuation $X+Y
3. New investment round, company valued at $X
4. Wealth transferred from founders and employees -> original investors to cover the difference $Y
Yes, that is how 'liquidation preferences' work.[1] I strongly recommend reading/watching Mark Suster, who (in my opinion) does a good job at explaining investors and terms.[2][3]
Just thought I'd point out that the example given doesn't tell us anything about liquidation preferences (though of course you can assume they would be involved, since we're talking VCs here, but they don't matter).
This is almost becoming a self-fulfilling prophecy. Enough articles are written calling for down rounds, now investors are thinking down rounds, employees are sprucing up their resumes, lawyers are preparing for battle...
Can anyone really say if there is any proof to this rhetoric. Are these companies really in such bad shape?
> Can anyone really say if there is any proof to this rhetoric. Are these companies really in such bad shape?
One thing is for sure, you can't look at companies/startups or VC in a vacuum.
You'd be wise to look at financial markets as a whole and all the interdependent factors that __might__ be leading to a situation similar to 2008/9 or worse; another housing bubble, weakness in energy markets, banks exposure to housing and energy, weakness in emerging markets (China, Brazil), tightening monetary policy, sovereign debt crises, geopolitical risk, etc.
If investor and consumer confidence really start to slide, yes, valuations will take a hit.
That's not to say that some unicorns and other companies can't still be wildly successful.
All of it is because investment in Q4 of last year was lower than any Q after 2012.
Which is a ridicules reason given that Q3 was by far the highest ever.
With that being said given the state of the public market (going down + low dividends) startups will still look sexy for a long time. I wouldn't worry about it.
"With that being said given the state of the public market (going down + low dividends) startups will still look sexy for a long time. I wouldn't worry about it."
This is such a ridiculous comment that it needs to be highlighted for just how myopic it really is.
Angel-and-after VC investment has been driven, increasingly, by the effects of ZIRP. "Fuck it, we don't have anywhere else to put our money, we might as well gamble on 23 red" is basically the prime justification for a lot of money that's been put into, say, companies that deliver lunches in San Francisco.
Now that we are moving away from ZIRP, sinking money into glorified AWS-React-Node applications is going to dry up, naturally. There are huge institutional investors who will no longer be willing to take the risk, period.
The "state of the public market" is getting hammered by oil prices, and by China. I don't know how you read that as "startups will still look sexy". The roulette table looks sexy when the bank isn't giving your savings account any return. The moment it does, guess what happens.
Meanwhile, the stock market has been giving returns of 20% per year for the last couple of years. It's been crazy. And corporate bonds typically yield 5%. Savers don't need to care about what the interest rate is. The people who care are the people who lend to invest, for whom low interest rates means increasingly risky stuff is profitable.
> it seems unlikely that interest rates will rise for the foreseeable future
Based on the past two weeks of the stock market? I'm not so sure. A choppy stock market may certainly slow down the Fed's plans for 2016, but Yellen seems hellbent on getting away from ZIRP (and the aforementioned weirdness it creates, like pension funds investing heavily in CRUD apps) before the end of this business cycle. If she doesn't, she's reliant on Congress to prop up the economy whenever it inevitably enters a recession, and given Congress's recent track record I doubt that's a gamble she wants to take.
Are they overvalued? You are worth what someone will pay for you which either is based on what revenue you generate or what they believe you can sell for.
That is true, but with the caveat that there are often terms to what investors pay. If I invest $1,000 for 0.000000000001% of your company, but with a requirement that I am repaid $2,000 in the event of a liquidity event (plus some participation), it's not really much of a risk for me: I'm "guaranteed" a 100% return. The valuation is somewhat meaningless in this situation, except maybe in terms of marketing.
Aka "Preferrence shares", for those unfamiliar with the practice. In the example above, it makes the valuation virtually 100 trillions, except, like all valuations, it's virtual.
we have an increasing amount of evidence that yes, they are overvalued.
Look at two things: long delays IPO-ing, and very poor performance of the 2015 cohort of tech IPOs. It's hard to avoid suspecting that companies would IPO if they could, and a large part of the reason they haven't is having to release to the public audited financial reports conforming to GAAP standards.
If I were a founder who wanted to make sure employees and founders get a better deal, what are my options?
Can I accept money from investors only on the condition that they get paid only after employees and founders get paid a minimum amount, like $1M each?
The stronger version of idea is to not grant stock / stock options to employees (or grant only one share if needed for legal reasons). Instead offer a guarantee that only after they earn some large amount, enough to retire, say $10 million, will any investor receive anything. Employees would never make more than $10 million, but they would maximise the chance of making $10 million. This would make the startup a less risky place for an employee to work, assuming the goal is to maximise the probability of making enough to retire. Then the investors can have whatever liquidation preferences, seniority, ratchets and so on, as they want, and it wouldn't matter to either the founders or the employees.
I'm willing to accept a lower valuation (the certainty of a $100 million company is more important to me than a 20% chance of a billion dollar company).
Does this make sense? Would you suggest a different approach to reduce risk for founders and employees?
The closest I've seen to this in real life is where an investor will purchase common shares meaning they are on equal footing to investors. It's rare, but it does happen.[0]
I'm confused. Employees and founders get a salary. There is no risk to them. If the company fails the investors lose millions of dollars, the founders and employees leave with 1-2-3 years of salary in their pockets and then go get another job.
That is why investors get paid first. Am I missing something? I guess I don't understand where this idea that founders and employees should get paid first. In guessing because the did the work but they seem to be forgetting they also got paid for the work. As a startup it might have been less than some other jobs, in compensation they took some tiny tiny risk that if the company is successful they get a taste. But they risk is orders of magnitude less than the investors.
The ethics of this go deeper than what you describe. If Warren Buffett invests 1m in a company, is he in a riskier position than if a McDonald's clerk were to invest 10k in the same company? The absolute dollar value is not the only way to gauge risk exposure.
Not only is the McD clerk less able to afford loss, she doesn't get the opportunity to diversify risks, as Warren Buffett does by investing in many companies.
except for the fact that Employees and founders salary is generally below market rate while at the same time they are expected to work more than standard hrs( 8 Hrs?? ) and be available 24x7 to fix issues. Equity with promises of big payout is given as a reason to take such such a deal over a job at a Bank.
Now these employees and founders know that these promises are empty and the example provided above is one good way to keep the promise.
Lots of investors expect Founders to take a salary needed to survive and also don't get paid for the sacrifices already made.( its assumed their equity stake makes up for the difference)
I'm probably not seeing the difference but it almost seems like by this logic a busboy (busperson?), the person that cleans up the dishes at a restaurant is owed $$$$$$$ because he could have gotten a higher paying job so he's sacrificing for the rest of us?
Is a fast food worker who goes to company A at $8 a hr but expects to move up into a management position and then gets denied, is he owed money because he could have gone to company B at $10 but without a management position expectation?
Employees and founders get paid. So it's lower than market rate it's still > 0 which means zero risk. They get a tiny piece of the pie. If things fail they still got > 0 whereas investors got < 0. You want the big payoff you have to take the big risk.
We are in full agreement that risk and reward go together. In fact, my suggestion is a way to shift more risk and more reward onto investors.
If I impose the condition that investors get paid only after employees get paid, I expect that I'll get investment at a lower valuation. Which means greater upside for investors if the company becomes a big success.
Alternatively, if each employee's upside is limited, then that leaves more of the money (again if the company succeeds) for investors.
In either case, the goal is to shift more risk AND reward onto investors, not only risk.
Besides, how many fresh-faced twenty something employees at a startup understand the fine print — things like liquidation preferences (optional, participating, stacked and so on), ratchets, valuation caps, and so on?
If people are signing up for something without really understanding the tradeoff, then the argument that they are taking more risk for more reward falls apart. It would be more accurate to say that they are being taken advantage of.
"Can I accept money from investors only on the condition that they get paid only after employees and founders get paid a minimum amount, like $1M each?"
Sure, you can do that, but good luck finding an investor who would be willing to actually give you money under those conditions.
If I were an investor, what incentive would I have to take on this additional risk? There are thousands of founders lining up outside my office who are more than willing to accept my standard terms.
The incentive is more reward, like investing at a lower valuation. Or if each employee's upside is limited, that leaves more money for investors, if the company succeeds.
When I read old case studies like WebVan it is hard for me to believe in a bubble. I do think their valuations are too high, but they certainly aren't zero--more than half of the people I know have taken and Uber or Lyft more than once, for example.
WebVan isn't the right analogy - a real estate bubble is a better one.
In the .com bubble, no one was really sure how things would shake out, so there were lots of companies who wouldn't have succeeded no matter how big they got (the "losing money on every sale but making it up in volume" business plan). When the .com bubble crashed, real estate was seen as a much stronger investment because no matter how low it went, it was real "stuff" that had a sort of intrinsic value - it may go down, but it wouldn't go to 0. A similar thing happened in Tokyo real estate circa early 90s. A Tokyo apartment still has a lot of value - you'd probably think it very expensive - but it's still 80% cheaper than it was at its peak.
The problem with lots of companies now isn't that they won't ever be profitable, or that they don't have realistic business plans, it's just that their valuation is way more than their earning stream will ever support. They are valued at "we'll eventually take over the market" prices, even though they'll only ever reach niche market status.
This is a great explanation. Remember that the value in a stock is that you're owning X% of a business just like if you owned 100% of a coffee shop.
If you buy a coffee shop for 10% @ $100,000 that makes $10k/year you just bought a company for a P/E of 10. The value of a stock in that company is in the growth of that 10k over time that is either paid as a dividend or retained and valued in to the price of the stock. If you don't make money, or make much less than what you could be expected to grow, their value will fall.
Still possible for Uber to be overvalued though. Fedex, a proven business, has an EV of $39BN and FCF of ~$700MM. Uber has a $63BN valuation and loses money. Uber could take over the world. Or it might not. A lot of assumptions baked into that $63BN number. Will be interesting
Things are different than the webvan bubble: many of these companies have substantial revenues, selling into a market of 10 to 20 times as many internet users, much cheaper infrastructure, etc.
Webvan had $178.5 million of revenue in 2000, selling in only a few markets, and it had semi-coherent plans for growing its revenue quite a lot farther by penetrating existing markets more deeply and adding new ones.
Trouble was, Webvan's way of doing business bled cash at a horrific rate. The bigger it got, the more money it lost. Investors got tired of throwing more cash into the company because the cash-bleed problem couldn't be fixed.
I don't think Webvan is the last company ever to suffer from such problems -- or to be unable to save itself if/when investors go on strike.
I don't think you are viewing this through the right lense. Valuations are a point in time vs. thinking about a company as a long-term investment - you should more think about which of these businesses has the best long-term potential to become the winner in a massive market, with a strong "moat" that makes it hard to compete, as well as extraordinary margins.
Based on that criteria, Uber & AirBnB should be on top of this list, followed by Palantir and Stripe. Zenefits has not really shown the type of defensible traction that Uber / AirBnB have (right now they are simply a rapidly growing insurance agent with a difficult-to-scale direct sales model). I would not add Spotify to this list - bad margins, and hard to defend against Google / Apple.
I'm not going to speak to their ability to become winners in massive markets, but I don't see how Uber or AirBnB have a strong moat that makes it hard to compete. Both seem extraordinarily easy to switch away from to a competitor. Many drivers already drive for both Uber and Lyft at the same time, and it's very easy for consumers to use both apps. I haven't used AirBnB, but it seems like it would be easy to list your apartment/house on multiple marketplaces.
Both of these businesses have what are called supply-side network effects (https://en.wikipedia.org/wiki/Network_effect), which are not as strong as demand-side effects, but can still lead to dominant market positions. In more concrete terms this means that for you as a consumer, there is no DIRECT additional value of someone else joining the service (you don't care if your friend joins Uber), but the value of the service does go up with every additional supplier that joins the network (for Uber, this would mean shorter wait times when you want a car, etc.) The defensibility of these types of services is created through their supplier network, and their ability to create more value for those suppliers (and consequently consumers as well) that the competition. Uber / AirBnB can then use the revenue from their leading market position to innovate faster than their competition, create more services for consumers, pay for distribution / new customer acquisition, spend money on marketing and awareness, etc. all of which leads to them creating a massive moat around their market that makes it nearly impossible for anyone to compete with them.
Spotify is not like Netflix. Spotify is solely dependent on content creators who know exactly how profitable Spotify is at any time, and therefore how far they can be squeezed for royalties.
Netflix has two major advantages: (1) consumers are far more likely to accept a limited video catalog than they are a limited music catalog, and (2) Netflix has spent a lot of money developing their own content. Could Spotify do the same? Possibly, but probably more difficult to do so.
I think Spotify will in the future generate consistent low profits, much like a utility, and their valuation will likely reflect that.
Another poster suggested Zenefits would be hit hardest as many small/growing businesses fail and most will slow growth. On the flip side, maybe they've reached a sufficient size/revenue that they can "weather the storm".
With the stream of articles like this in the past few days I have been thinking the same thing. I have a feeling that it's already obvious to anyone doing real research — but I'm not paying close enough attention.
Ah, it would be great to drum a list! I.e. analyze each company, their rhetoric, metrics, and current trending performance, irrespective of perceived valuations.
I almost suspect someone is in the process of doing so right now.
I wish I understood what it is about Evernote that makes it worth $2 billion, Dropbox $10 billion, or Nextdoor $1 billion. There aren't many companies on that list that have valuations I can understand.
In the most literal sense, "being a unicorn" means nothing more than in the last funding round, they sold X% of the company for $Y, and (100/X)*Y >= 1,000,000,000
For example, if DizruptrCo Inc, sold a 15% equity stake for 200 million, they are a unicorn "valued" at $1.333 billion.
How they come up values for X and Y are part of the VC fundraising black magic. What's being reported here and a lot of other places recently, however, is that VC investors are actually willing to put an abnormally high value on Y in late rounds, because liquidation preferences mean they are very unlikely to lose money. Founders also love this, because it means they get to join the Unicorn Club, hopefully on their way to the Three Comma Club.
This is whats meant by unicorn valuations being "inflated". As always, the people who get screwed the hardest if things go south is the employees. People are starting to figure out, however, that a down round, or really anything short of a spectacular exit, for an inflated unicorn means their options and equity are probably going to end up worthless. This could lead to all the best talent running for the door as fast as they can, death spiral, etc.
Profitability depends on a network of flowing capital. When the input (e.g. of venture funding) dry up, profits will vanish in a shockwave.
That is dramatically true for companies whose business model is to provide services and products for either other companies in the network...
...but also for those catering to their employees.
IMHO a lot of 'problems' which seemed to cry out for an 'app' solution are going to turn out to be first world problems no longer pressing when the economy turns.
Then there's the fact that there are a lot of ugly weather patterns nationally and globally brewing...
Er, what? If they're profitable, the further capital and financing becomes a nice-to-have, not a need-to-have. It's no longer a business killer when it goes away.
Exactly, and this is especially true for companies that are disrupting existing players by being more efficient (e.g., I would expect more travelers to turn to AirBnB during a recession as a cheaper alternative to a hotel, even if overall travel goes down).
Might want to start writing the book on the 2016 unicorn dehornification, since it seems the powers that be are pretty determined to make it happen (or at least getting all the media outlets to make people think it's about to happen).
You're getting downvoted, but there's lots of value in your statement. Language is important, and the choice of words will frame narratives and reveal hidden truths and agendas.
The press and HN/etc DOES talk a ton about unicorns. It's the only grade that has its own name. There's no word for a $10-25m startup, or a $100-500m startup. No, only $1B-unicorns. They have their own name and we're obsessed with them. This either highlights or promotes the notion that investors (and entrepreneurs?) are only interested in billion-dollar companies.
I'd really enjoy "wizard" to be the graduated rank, like when you're officially huge and profitable. Then, iOS/Android dispute becomes a wizard battle.
It's not surprising, considering the current standards for startup employee equity: apart from the perilous, uncertain route of becoming a founder, joining a unicorn early is the only way for rank-and-file startup employees to get any opportunity of substantive wealth creation.
I wonder if that has led to some of these very-VC favorable deals with large liquidation preferences. Rather than take an investment that has lower valuation, a founder takes an investment in which a lower percentage goes to the VC, and thus the total valuation is higher, because getting into "the unicorn club" has value all its own: press, cachet, employee retention.
What's really amusing is the skepticism built into the name. Unicorns are mythical creatures and historical accounts of unicorns are either hoaxes or cases of mistaken identity. The metaphor is obvious.
Having had a front row seat to the popping bubble in 2000: I can't think of a single instance where wash-outs (which is really what is being described in the article) led to a wonderful outcome for employees.
Most companies got hit hard, but the ones that survived have all thrived since then. It was definitely an extinction-level event for 90%+ startups it not more, and I think something similar will occur in 2016.
It will be interested to see how many of the YC companies survive 2016.
All the more reason to go public and have some liquidity in your shares.
I remember being at Intel in 1999 when the share price was 72. six months later it was down around 18. There was one smart senior engineer there that had put options as insurance against all his shares. The rest in that group had to rethink retirement.
Haven't we been 'expecting' this since 2012, yet the biggest, most successful unicorns keep going up in value.
For all the hype and doom about Square stock, the price is back to where it was when it began trading a month ago, although it has fallen 20% in recent weeks.
But this is a good opportunity for employees to understand the risks of stock options, but it's not like the world is coming to an end. Such risks have always existed.
It would be interesting to see if more founders take money off the table in high value rounds as a hedge against down rounds. It's not mentioned but while the founders may lose value in their common shares a lot of them have been able to cash out in the good rounds giving them a nicer cushion compared to straight employees
Sometime fake valuations. "I give you a boatload of money for a small piece of your company" Doesnt mean the market or the prowess of the company will scale way up beyond that small piece. Reminds me how they pumped IPOs in the late 1990s.
META: Am I mad or has the term "Unicorn" suddenly blown up and now every news outlet has to somehow shoehorn it into all their articles when dicussing anything startup related?
I really don't recall the phrase before maybe a few months ago?
I expected the usual 'the end is nigh, the bubble has popped, unicorns are screwed, we're all screwed' article. Instead, I was happy to find that it was about some of the ways that unicorns could or may have to protect employees, founders and early investors from down rounds. Purely as an educational experience, this article is certainly worth a read.