The Unicorn's 'Van Wilder' moment

Van Wilder's Party Liaison is not a good film. It holds a 19 per cent rating on Rotten Tomatoes. Don't go out of your way to watch it.

(Warning: this trailer is not safe for work.)

But if you really want to know, the story goes like this: Van Wilder is a student in his seventh year at Coolidge College. Thanks to a rich father who subsidises his lifestyle, he spends his time careering around in a golf cart, organising parties and being a general bro. Graduation is a mere afterthought.

One day, Van Wilder's father unexpectedly visits and, in disgust at his son's wantonness, cuts off his funding. Van Wilder now must face reality: earn enough to live, and graduate, or drop out as a penniless laughing stock.

Something similar is happening in the Bay Area.

In 2019 the market expects some of the so-called “unicorns” — loosely defined as $1bn private companies with a technological component — to IPO. In other words, it's time for these businesses to grow up, and face the real world.

“Seven years, no degree”

When money is loose, bad behaviour sets in. For Van Wilder, it was the joyful sins of college lifestyle, absent the moderating pressure of academics. For the unicorns, it's a history of enormous revenue and market share growth, with no immediate need to make profits.

Take Lyft, the ride-sharing company which controls 39 per cent of the US market, as of December. Its last valuation came at a cool $14.5bn. The company filed for its IPO with the SEC a fortnight ago, revealing its fully audited accounts for the first time.

Here's its income statement for the past three financial years:

Revenues grew 528 per cent over two years to $2.2bn. At the same time, losses deepened 33 per cent, to $911m.

Similar patterns repeat across other unicorns. Lyft's rival Uber — which some expect to be valued at close to $100bn when it IPOs this year — recorded net revenues of $11.3bn in 2018, its losses, in adjusted-ebitda terms, were $1.8bn.

Or how about WeWork, the shared-office space business. It made a loss of $1.2bn in the first nine months of last year as its revenues almost doubled. Last valuation? $47bn, and rumours of an IPO are never far way.

Like Van Wilder's lifestyle, these unicorn losses have been underwritten for the best part of a decade by a benevolent force: venture capitalists willing to bet that, at some point in the future, revenue growth will eventually overcome costs, and profits will flow.

These bets have been made in size. Since 2008 the total invested is a whopping $674.2bn according to PitchBook data. And venture capitalists are showing no sign of slowing up. In 2018, the industry invested $130.9bn across 8,948 deals. Tellingly, this was the first time since the peak of the dotcom bubble in 2000 that this figure eclipsed the $100bn mark.

With big bets come bigger expectations. Just as Van Wilder's dad underwrote his son's college life in the misplaced hope he would eventually graduate, the venture capitalists, and their institutional investors, are expecting a multifold return on their capital.

But with money so abundant, why the seeming rush to the public markets?

“But I've done a lot in seven years”

The cash-burning Unicorn phenomenon, as economist-venture capitalist (and Alphachat guest) Bill Janeway explains in his book “Doing Capitalism”, can be explained by three interlocking factors: the macro backdrop, proven tech successes, and shifting dynamics in the economics of technology companies.

Janeway's macro argument is worth exploring in further detail. He argues that the sustained level of low interest rates, implemented by central banks to stabilise the financial system after the crisis, has caused a wave of institutional money to shift out of safe assets, and up the risk curve in search of higher yields.

Venture capital, sitting at the very apex of this curve, has been greatest the beneficiary. And this money has found a natural home in the unicorns, who promise giant market shares of even larger total addressable markets, or “TAMs”.

Lyft, for instance, in its IPO documents states:

Our market opportunity today includes transportation spend in the United States and Canada. In the United States alone, consumer expenditures on transportation were approximately $1.2 trillion in 2017.

If Janeway's thesis holds, however, then the reverse is also true. As the Fed starts to normalise monetary policy, the appetite for venture's riskier returns will roll-off, back towards safer assets like high-yield bonds and public equities.

Despite a record year for fundraising, there's a few early signs that the appetite for backing the largest of the unicorns is running out. For instance, Softbank's totemic $97bn Vision Fund — which holds stakes in Uber and WeWork — has come under scrutiny from its investors for the high valuations it's paid for its investments, according to a WSJ article from February.

Softbank's leader, Masayoshi Son, has also reined back plans for a second Vision Fund in the near future.

It seems likely, that if the Fed continues to hike rates, that these pressures will only increase. But that's not the unicorns only problem.

“You should have graduated twice by now”

Venture capital is known for its patience, but even patience has its limits, as Van Wilder found out to near ruinous effect.

Funds raised by venture capitalists tend to have a 10 year duration — investors put their money in, and expect a much larger amount back in a decade — and each investment needs its value realised by a liquidity event, so cash can be returned. With the unicorns now approaching relatively mature ages — Lyft is 7 this year, Uber 10 — there will be several venture capital funds, who invested at a business's early stage, looking to cash in their equity.

Traditionally this would take the form of a sale to a bigger company — such as Github's $7.5bn sale to Microsoft last year — or an initial public offering, like Spotify's listing in April.

So far, some of the unicorns early investors have found other means to pull their equity out a company. In 2017, Benchmark, one of the most storied venture funds, sold 14.5 per cent of its stake in Uber to SoftBank, realising $900m in the process, according to Recode. But finding another buyer with the capital, and willing, on the secondary market is not something an investor can bank on.

The public markets, or a buyout, beckon then. However the frequency of liquidity events — also known as exits — has gradually declined in number over the past four years, according to PitchBook:

Although the size of the exits has remained high, with the median money raised from IPOs last year coming in at $348.4m, the highest in a decade. So those lucky enough to exit, are raising in size, perhaps hastening others to follow suit.

So money needs to be unlocked, and the window within which to do so is slowly shutting. Just as Van Wilder needed to knuckle down and graduate once access to the Bank of Mum & Dad was denied, so the unicorns' investors need to find someone will pay for its equity ideally at higher price, before the limited partners demand their cash back.

To boot, gyrating public markets haven't helped matters.

“What if I'm avoiding graduation, because I'm scared?”

During the fourth quarter of 2018, the Nasdaq — the premier index for US technology companies — entered a bear market (a 20 per cent peak-to-trough drop), before bouncing back this year.

December fears of a total tech meltdown have proved unfounded, but volatility within some of tech's largest names may add further scrutiny to upcoming IPOs, particularly those with such lofty private market valuations.

Consider the mixed returns of some of the most-hyped tech IPOs in the past few years. Pinduoduo, a Chinese e-commerce business which raised $1.6bn last summer, is up 37 per cent. Cloud storage business Dropbox, which raised $756m last year, has returned a rather less impressive 5 per cent. Spotify is up 6 per cent since its April listing.

On the downside, Blue Apron, the provider of delivered ready-to-cook meals, has collapsed 90 per cent since the summer of 2017. Listed in spring of the same year, Snap, the parent company of Snapchat, is down 34 per cent. (All data via Bloomberg.)

Such comparisons will be weighing on investors' minds when it comes to pricing the unicorns' shares. Like Van Wilder promising his father he just needed one more year to graduate, investors may decide future returns have already been realised, or overpriced, and decide not to be so generous with their cash.

“I'm proud of you Van, graduation or no graduation”

Van Wilder has a happy ending. Once the punchbowl has been taken away, he steps up his entrepreneurial activity (read: throws more parties featuring soft nudity, it was the noughties OK?), graduates, and gets the girl.

Whether the unicorn IPOs have such a Hollywood ending, remains to be seen.

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