Unicorns And The Next Venture Capital Crash

by Michael Roth

You can tell the VC industry is hot because there have been a plethora of articles and blog posts discussing the industry. In two parts, I will highlight the impact unicorns have had on the venture capital industry. They have undoubtedly rejuvenated the industry but evidence of excess is becoming more apparent.

To get a sense of where we are now, consider these stories:

  • The 10 largest unicorns have raised $15.6 billion from 137 investors, according to Crunchbase.
  • 71% of companies that went public in 2014 had no earnings.
  • 16 venture-backed companies have raised capital at a $1 billion valuation so far in 2015.
  • Firstmark raised $200 million for Pinterest’s latest round of financing ($11 billion valuation) from seven investors in three days.

And everyone knows Uber. The company is a juggernaut but its ascendance highlights several of venture capital’s issues, including aggressive growth assumptions and return expectations and the prevalence of “me too” companies.

One concern is how later stage investors are valuing the unicorns and what it means for return expectations.

Uber is reportedly valued at $41 billion and has raised $5.9 billion from 43 investors since 2011.

Based on rumors, Uber’s revenue growth has been explosive. It is believed they achieved $667 million in revenues in 2014 and they are projected to achieve $2 billion in revenues in 2015. That would be two successive years of 300% growth. Assuming a 25% EBITDA margin, that would give Uber an EV/EBITDA multiple of 82x based on 2015 projected EBITDA.

For those who invested in the early rounds, Uber has been and will be a great investment. For the later stage investors, like Foundation Capital, NEA and Qatar Investment Authority, how many more years of explosive growth are needed to generate an acceptable return for investors?

Another question some may ask is: How does this compare to public market valuations? Within the transportation industry, Uber’s valuation puts it in the same league as FedEx, which has an enterprise value of $52 billion.

FedEx has:

  • $47 billion in revenues  for the twelve months ended in February 2015.
    • 4.4% y-o-y
    • 3.8% over the last three years
  • $6.75 billion in EBITDA for the twelve months ended in February 2015.
    • 27% growth y-o-y
    • 8.6% over the last three years
  • EV/revenue multiple is 1.1x; EV/EBITDA multiple is 7.7x.
  • Intergrated Shipping & Logistics Industry Averages:
    • EV/EBITDA multiple – 10.6x.
    • EBITDA margin – 9.1%

Clearly, FedEx is a mature company whose growth rates do not come close to Uber’s. Still, the comparison puts a spotlight on how aggressively investors are currently pricing growth. Uber’s revenue and EBITDA are a fraction of FedEx’s but they are closing in on them from an enterprise value standpoint.

Another major concern is how will the unicorns generate liquidity.

This issue is closely tied to the previous concern regarding valuation. At a valuation of more than $1 billion, the unicorns are no longer little tuck-in acquisitions for corporate acquirers. This leaves the public markets as the likely exit route for many of the unicorns. However, late stage venture investors have been aggressively pricing the later rounds so that leaves less upside for public market investors.

If one too many of the unicorns disappoint in the public markets, investor sentiment can quickly turn negative and slam the IPO window shut for the rest of the unicorns.

The abundance of “me too” companies and their ability to receive funding is another symptom of market excess.

Have you heard of GetTaxi or Flywheel? They are mobile taxi apps that have raised $200 million and $35 million, respectively, since 2009.

Eager to have a portfolio company “in the space”, VCs provide more capital than is necessary to more companies than are feasible for an industry. Once the market becomes saturated, the end game for many companies turns into “let’s carve out a niche so one of the market leaders can acquire us” as opposed to “let’s provide innovation in a way that transforms an industry”.

The fierce competition in the mobile taxi app space is a prime example of this. The “Deal of the Day” space (Groupon, LivingSocial, etc.) is another good example as they experienced their boom and bust a few years ago.

Finally, one of the tell-tale signs of an inflated market is that investment discipline becomes less disciplined.

On more than one occasion, industry leaders, like Bill Gurley and Fred Wilson, have questioned the sustainability of the record high burn rates the industry is currently seeing. The answer to this seems to be, give them more capital!

According to the NVCA and PwC MoneyTree, annual venture capital investment exceeded $48 billion in 2014 – the highest amount since 2000. During 2014, there were more than 40 “megadeals” (investments exceeding $100 million) and two deals of more than $1 billion.

To reiterate those points,

  • The amount of capital invested into the industry is at the highest it has been since the last VC crash, and
  • There were more “megadeals” in 2014 than ever before.

A Look Ahead

In Part 2, I will discuss unicorns’ impact on fundraising, show how they result in high fund valuations and highlight the potential issues from an LP’s perspective.