Insights on a unicorn valuation

Unicorn valuation – Uber, Lyft and Wework

In this blog, we shall provide insights on unicorn valuation. Then we analyze the recent IPO’s of Uber and Lyft along with latest updates on We Work that filed for IPO this year.
We shall identify the key underlying business drivers that are common across all these companies – Huge market size, its success in scaling up revenues accompanied by huge losses.
As the scope of this article is limited to unicorns filing for IPOs, we shall also analyse how VC firms price startups and whether the market uses these same metrics when they file for IPOs.

Unicorn valuation factor 1 – Huge potential in Total Addressable Market

• Startups and early stage companies are generally optimistic and inflate how their service offerings will help their Total addressable market.
• All the unicorns that have filed for IPOs this year have described themselves very differently in their prospectus. For instance Lyft, which is primarily a ridesharing service company described themselves as Transportation company.Uber refined it further classifying them as Personal mobility company. We work, essentially a real estate leasing firm has described itself as a Community company in its prospectus, when it filed for IPO this year.
• Let us look at the TAM – Total Addressable Market size that is shared by these firms in their prospectus.Uber TAM is $5.7 trillion spread across 175 countries.They have arrived at this TAM by adding all the passenger vehicle and public transport spending.We Work has shared its TAM as $3 trillion in office space opportunities.
• Such a huge TAM size shared by these companies seems to be an exaggeration of what the real definition of TAM is.While it is easier for these companies to expand to new markets and add new customers, their concept of defining TAM makes their business case weaker and less credible.

Unicorn valuation factor 2 -Scaling Revenues aggressively

• All the unicorns that have filed for IPO or have gone public share one thing in common – These firms were able to scale up very fast, showing aggressive growth in revenues.The key metric that these companies have boasted is the growth in their revenue units (Uber riders, We work members etc.)
• As these companies are platform based, they rely on network effects to scale in order to generate more revenues.
• Successful user based companies like Facebook and Amazon prime have shown how large user base can help in building new products to generate more revenues.
• However many of the recent unicorns are adding users using badly constructed business models and pricing their products/services at a very low prices in order to attract more users to their platform.Their strategy is that they will raise the prices once they have built the sizable user base.Inspite of the huge losses reported, they are still able to attract money from VC firms.

Unicorn valuation factor 3 -Vague Business models and doubtful earnings measures

• Almost all the unicorns who have filed for IPO this year have suffered huge losses and still have negative earnings even after excluding the customer acquisition expenses.
• In this era, investors continue to have investments in these firms because of their huge potential to grow.These companies exhibit a common negative characteristic which should be a warning signal to the investors.

Profitability in unicorn valuation

• None of these unicorns have any plans on how to address the vulnerabilities in their current business models to get back to state of positive cash flows.
• With Uber and Lyft, the companies did not have a plan on transition of their drivers from independent contractors to employees.
• With We Work, the firm did not have any plan with strong duration mismatch in the long term leases that We Work is locking itself with real estate companies against the shorter subleasing contracts that We Work is having with the startups and enterprises.

Earnings Adjustments in unicorn valuation

• All the unicorns adjust their EBITDA numbers by adding back stock based compensation and other operating expenses.
• Adding back expenses to EBITDA is not a good practice as these expenses form a regular part of business operations.
• In case of We Work, the company adds back most of its operating expenses arguing that these expenses are community.They arrive at metric called Community EBITDA which actually is misleading the investors.

Unicorn valuation issues – Corporate Governance

• Traditionally most public companies were run by quid pro quo method where investors who provided capital to companies were given the right to vote for selecting the board in return. This gave the investors a chance to make substantive changes to the way company is run and to its corporate charter.
• More lately with new companies, there seems to be a paradigm shift with new CEOs looking to exert more control through super voting right shares.Most of these IPOs have the common characteristics:

Unicorn valuation issues -Shares with different voting classes

• With exception of Uber, most of the high profile IPOs have different classes of shares, with shares having least voting power issued to public while the owners retained shares with higher voting rights.
• In the case of Uber, the founder was not the CEO at the time of the IPO.The founder Travis Kalanick was forced to relinquish his position in the aftermath of personal scandals.

Unicorn valuation issues – Boards lacking oversight

• The role of the board is to protect the interest of the investors.Unfortunately, in many of these firms covered, the board seems to be in collusion with the CEO inspite of it’s high qualifications and credentials.
• A glaring example would be WeWork where the board was lacking in its oversight of its CEO – Adam Neumann.

Unicorn valuation – The Venture Capitalists Game

• All unicorns that have filed for IPOs this year were able to raise huge capital from Venture Capitalists. Due to the huge backing from VC firms, these unicorns were able to scale quickly growing revenues and subscriber base.
• Issuing shares with different voting rights by these companies indicates that VC firms encouraged this approach and rewarded them.
• In other words, the VC firms preferred scaling success over sound business models and Corporate dictatorship over Corporate governance.
• The IPO estimate for all unicorns were based on the pricing offered in its last VC round.For instance Uber and We Works were priced at $66 billion and $47 billion respectively by Softbank.
• The argument by the bankers for the same IPO pricing is that VC firms are smart and would have done their valuation/due diligence properly. It should be noted that VC firms price companies and do not value them, hence if there is a shift in the momentum, the pricing will come down.

Final comments on Unicorn valuation

• The biggest insights from all unicorn valuation IPOs filed this year is that all unicorns follow the pricing game which explains the large numbers attached to these firms.The pricing game is not only at the IPO stage but also at the VC rounds.
• Most of the unicorns that have filed for IPOs this year have negative earnings.It is not the losses that is a primary concern but a lack of a tangible plan to get back to profits.
• The unicorns look at equity markets to raise capital where as their founders look at it to cash out their investments.These firms are not interested to stick to the rules of Corporate governance on how the companies should be run.