When I was in college, we had a term to describe the unattainable girl of our dreams. The beauty is, this was not equivalent to a celebrity crush in that there was no shot in hell, but rather she lived right on the edge of unattainability. This girl was likely someone you knew, or at the very least an acquaintance from a class, club, or the like. Remember Dumb and Dumber’s “so you’re saying there’s a chance?” That girl was the unicorn. The frustrating part about the unicorn was not the likely unattainability, as you always held out hope for that, but rather the risk that something might happen to change your view of her. Perhaps she starts dating someone lower than her, or she says something to take the aura off, or in an apocalyptic scenario, tells you off in some way – removing even the slightest chance of being with her. Herein lies the beauty of calling Silicon Valley darlings unicorns.
The reality of our college unicorns is that they are human beings – complex, imperfect, and flawed – and that reality exists with businesses as well, perhaps more. Just as was the case with the unicorn in college, however, the unicorn status of the various startups lies in the eye of the beholder. Obviously, companies can’t value themselves, otherwise we’d all consider our businesses flawless, but if we’re being honest, the unicorn has less of a hold over its status than it should. This is to say, bluntly, that the system of valuations are inherently flawed.
So how exactly is the system flawed? Two ways: first, they are tied entirely too closely to public markets they have nothing to do with (remember we’re talking about private companies here), and second, the metrics on which they are measured are screwy, at best.
Let’s begin with public market effects. If oil prices are affected by OPEC oversupplying the market, it is logical to assume gas and energy sectors are going to be effected, as we have seen over the past year. And since economic markets are complex systems, there will be ancillary effects to other markets and sectors that may not seem logical, but are affected anyway. Let’s call a spade a spade: commodities markets are behemoths that have incredible top down effects as they move up or down. While acknowledging economic effects of massive market changes, the unicorns are perhaps affected more than others in the private markets. A large reason for this is liquidity, leverage, and positioning of large pre-IPO investors. These investors all have goals of where they want to be, how leveraged, how long, how short, how liquid, and as a result have incentive to adjust their investments as market conditions change. In a bull market, this effect isn’t really seen, as everyone is living high. As soon as a major market, let’s call it commodities, starts to regress, correct, or even go bear, these investors quickly become overexposed in other areas. This is, generally speaking, how markets work, but why should an extremely stable, sustainable business, that hits relevant metrics be hit harder by this, simply because its investors are overexposed?
Enter reason number two, extremely flawed metrics. In a traditional business, analysts look at EBITDA, EPS, and other relevant earnings metrics. This makes a lot of sense for companies that have measurable KPI’s – number of stores, basket size, barrels sold, etc. There is a single difference that exists only in tech, as tech companies could have similar KPI’s. What is the value of a user? Facebook has changed the game, as there is no denying that they have the furthest pure reach of any company on the globe. They have more people in more countries on more devices using their product than any other company in the world. There’s value to that! There is existing value, and there is future value, but is it measurable? Not really. A user in Beverly Hills is likely more valuable than one in Omaha who is more valuable than one in Sri Lanka, depending on what you are selling. Quickly, we can start to see the immense complexity in trying to value this. The only thing we know for certain, there are a damn lot of people. We can then add a layer of complexity and try to discern the value of a paying user versus a free user – the Spotify conundrum. There is a clear value to a paying user – $X per month. Then we can calculate growth against attrition, cost of acquisition, and so on. But again, how much is a free user worth? I think I’ve driven home the point.
The guessing game that we play with the value of a user allows these companies to be much more susceptible to sentiment than more traditional businesses. Twitter’s user base doesn’t grow as much as it did last year, so sentiment falls and investors run. Dropbox only gains X new individual users, so they get marked down. Is this a drastic oversimplification of economics, markets, and the resulting effects? You bet your ass it is. The reality, however, is that following the initial dotcom bust, companies have been able to come up with real business models that bring utility to users and value to investors. But with this new world of actual utility on the internet comes a whole new world of problems. That problem in the world of valuations is how much are you, the user, worth?