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Introduction Welcome to Distilling Venture Capital. I am your host, Bill Griesinger Distilling VC is a visionary podcast that provides an insightful and informed view of the key trends affecting the VC and tech startup world. My mission is to cut through and go beyond the hype that tends to dominate the tech landscape. And provide you with information you can use Opening Observations: In Today’s Episode I return to what I have termed Unicorn-mania, building on the subject of my first episode in March. So, it will be a Unicorn-mania Redux. I’m returning to this topic b/c, well, we need to revisit it primarily b/c things seem to be sliding further toward the insane, literally with each passing week. And, I will talk about the continuation of this insanity in the context of some real-life examples: The true poster-kids for “Unicorns are not real”… Specifically, I’ll provide insights into WeWork and Uber, and the unmistakable role played by Softbank’s Vision Fund in helping to fuel the craziness. And, let me say from the outset, how disappointing it is to see the technology press and the data analytics firms like CB Insights and Pitchbook (a Morningstar Co.), continue to engage in this ridiculous charade. I am going to get into some examples of that in a moment. Suffice it to say, that if you have a subscription to one of these firms, my analysis may leave you questioning what value are getting for the money… To begin, let’s quickly review what I covered and highlight a few take-aways from Episode 1 of Unicorn-mania; I outlined and highlighted the hype that characterizes VC and techland today with respect to overvalued, so-called Unicorns – companies alleged to be worth $1B+ I also highlighted the Stanford Univ. Study, Squaring Venture Capital Valuations with Reality, that reveals and proves that so-called Unicorn tech companies are substantially overvalued – and offers a valuation model that really works in valuing theses companies The Study dissects and debunks the use of post-money valuation as nothing short of an illegitimate method for valuing any company, let alone VC-backed private tech companies. Before I go further into the topic, I am going to strongly encourage you to please refer to the Show Notes for this Episode to access links to the following: Link to Stanford University Study: Squaring Venture Capital Valuations with Reality - Downloadable pdf found here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2955455 (Social Science Research Network – SSRN) Link to Video: Presentation at SVOD (Sil. Valley Open Doors Conf.), June 2016 by Ilya Strebulav, author of the Study and Professor, Stanford Univ. Grad. School of Business: https://youtu.be/k4OtGWZ3iYI Original Version of the Study was submitted and published April 19, 2017; However, the findings were presented about a year earlier in June 2016 at SVOD Conf. (Silicon Valley Open Doors) Where Prof. Strebulav was the Keynote Speaker (I encourage you to got to the link and watch it. It’s < 20 minutes) Summary of the Findings – From the Study Abstract: We develop a valuation model for venture capital--backed companies and apply it to 135 US unicorns, that is, private tech companies with reported valuations above $1 billion. We value unicorns using financial terms from legal filings and find that reported unicorn post--money valuations average 48% above fair value, with 14 being more than 100% above. Every Company reviewed and valued, (100% of the Sample) was overvalued to some degree – that means not one company came in at the post-money valuation utilized by the VC industry Values were calculated for each share class, which yields lower valuations because most unicorns gave recent investors major protections such as initial public offering (IPO) return guarantees (15%), vetoes over down-IPOs (24%), or seniority to all other investors (30%). According to the authors, “Overvaluation arises b/c the reported valuations assume all of a company’s shares have the same price as the most recently issued shares.” Even though each new round of funding effectively sucks the value out of prior rounds through seniority and superior rights, among other preferences. Common shares lack all such protections and are 56% overvalued. After adjusting for these valuation-inflating terms of the Preferred rounds, at the time of the Study, almost one-half (65 out of 135) of unicorns lose their unicorn status. Stanford Study Pre-work: In 2016, prior to publishing the Stanford Univ. Study, Strebulav and his team of researchers surveyed, as part of their work, more than 1,000 VCs regarding valuations. It was the first survey of its kind: Result; 92% of respondents of the VCs surveyed agreed unicorns are over-valued; A whopping 75% believe unicorns are significantly over-valued AND, as I noted in Episode I, did you ever notice that the PE industry doesn’t have an equivalent designation (Unicorns) for its $1B+ value companies, even those that are in the tech category? Why this study’s findings are not a wake-up call to the industry is currently a mystery to me. Who Cares? To demonstrate that my concerns and the opinions I’ve expressed, that Unicorn-mania is a total distraction, a waste of time, as I stated in Episode I, are not just some overly-dramatic soap-box issue I am on… Turns out, I am in some pretty impressive company, actually – with respect to my criticisms of the mania. Let’s take a look: All of the examples are from the 4th Quarter of 2015, when some rather prominent and accomplished investors and tech company leaders had begun calling BS on Unicorn valuations, even before the real Mania commenced in earnest over the last several years: Marc Benioff, Chmn and CEO of Salesforce, Dec. 2015 on Bloomberg TV stated, “The unicorn mania that’s going on, that’s dangerous for our Silicon Valley economy," “this is just, you know, unheard of... It’s become a self-esteem issue for these entrepreneurs.” Benioff states to the SF Bus. Times, also Dec. 2015: “I’m not buying the unicorn theory…" There's no reason [for] these companies who claim to be worth billions of dollars and making billions of dollars to stay in the private markets." Benioff asserted that some billion-dollar valuations are the result of "manipulation" of private tech markets and again called on founders to go public to "rationalize" their worth. Suggesting, by implication, that these values are not rational! Legendary VC John Doerr, who joined Kleiner, Perkins, Caufield in 1980 – [did they even call it venture capital back then?] – In the same 12/7/2015 SF Bus. Times article Doerr pointed out, “Google has acquired one company per week since 2010 but has only five times paid more than a billion dollars for a company,” Doerr said. “There are 150 companies considered unicorns, 93 are in the United States. How does that math work?” Great Q indeed! I suggest it doesn’t, b/c it’s not about the math but rather about the hype. Bill Gurley, another highly respected and accomplished VC veteran from the Valley and Founding partner of Benchmark Capital. In Oct. 2015 at the WSJ Laguna Beach Tech Conf. stated, "All these private valuations are fake. ... It's all on paper, it's all a myth," "Anyone that's raised $400 million is probably spending $100 million a year," he said. "Until you get liquid, you haven't really accomplished anything." And finally, Mark Suster, a voice I respect a lot in the industry. He has been a Managing Partner at Upfront Ventures since 2007. Suster puts out one of the better blogs in venture called “Both Sides of The Table” in which he dispenses and provides excellent, valuable, how-to and other advice for start-up entrepreneurs on a whole range of topics – you should check it out. Well, back in a Sept. 2015 piece that he published on his blog, Mark does not hold back with his sentiments regarding Unicorns stating, “There’s no one sane I know any more who doesn’t privately say that things have gotten out of hand. Few like to say so publicly. And I blame unicorns. Mark is very clear that he’s not referring to what he identifies as “successful” companies themselves but “the entire bullshit culture of swashbuckling startups who define themselves by hitting some magical $1 billion valuation number and the financiers who back them irrespective of metrics that justify it. Unicorn has become part of our lexicon in a sickening way and will no doubt become part of the history we tell about how things got so out of control again. 10 years from now people will be embarrassed to say unicorn.” Well, we are about 5 years out from those highly critical assessments from some really smart people in the industry. Unfortunately, the sane voices of these reputable tech titans from late 2015 have gone under-reported or unreported in recent years. Which, I guess, is a primary symptom or characteristic of a “Mania” itself – delusional thinking…prone to exaggeration, denial and so on, but I’m no doctor…so I’ll leave that diagnosis for others to ascertain. I stated in Episode I in March, It Is a big distraction from what’s really important in evaluating and valuing venture-backed tech companies. We’ve been completely DISTRACTED for nearly 5 consecutive years since the warnings and criticisms of this mania in 2015 by key, reputable industry players in VC and tech. And, that’s despite the publication and dissemination of the most conclusive, comprehensive accurate study ever regarding what the valuations of these companies really are. Here’s the central problem – The $1B+ valuations ascribed to so-called unicorn companies are not true market valuations at all. They all utilize a metric called “post-money valuation” that inflates their value. As stated, the Stanford Univ. Study found 100% of all unicorns are actually over-valued to some degree when applying proper market valuation metrics based upon the terms and conditions found in the Preferred Stock rounds The Post-money valuation methodology is like an alternative universe, or worse, when it comes to valuing private tech companies. This should not be the case. The multitude of preferences, IPO kickers, and other terms and conditions attached to these preferred rounds have no relationship to company fundamentals and performance. Again, I understand why many are being negotiated…b/c of the high risk and probability of failure in the VC model. So what Strebulav and Gornall had to do in building their model was to be able to identify and value all of the disparate Ts & Cs underlying all the different Preferred rounds, each with differing economics, rights and conditions by round. This was a rigorous and complicated undertaking. They have done the industry a great service the development of this model. One of The Study’s major conclusions: “Our results show that equating post-money valuations and fair values is inappropriate.” AND, “Marking unicorns to their most recent round’s price leads some venture capitalists to overstate their funds unrealized value. Unrealized asset values are an important determinant of future fund-raising.” Most LPs revealed to the Study’s authors that most VC funds mark all of their investments to the most recent round’s price. It might be understandable why an unsuspecting public might not get the full risk impact of this, one wonders why major, sophisticated LPs put up with this nonsense… Mutual Fund filings show that almost all of the major mutual funds tend to hold their private VC-backed assets at the post-money valuation. Where are the Real Journalists? On the Media side - There exists an almost a schizophrenic-like behavior exhibited by the technology press in its years-long coverage of unicorns; To be sure, at the beginning there were some real attempts by a handful of outlets to highlight the findings of the Stanford Study, which were astounding; e.g. - CB Insights CEO, Anand Sanwal, opined in an August 2019 piece that it (unicorn status) is often used as a scheme to attract top talent in a very tight hiring market for key tech talent… PitchBook Weekend Pitch from Nov. 3, 2019: “For a long while in and around Silicon Valley, unprofitability was what every startup hoped to achieve. And if losing hundreds of millions of VC dollars was cool, then Adam Neumann was Miles Davis.” Really? Are you kidding me? This is your expert analysis that PitchBook is charging for? PitchBook continues, “But these days, in the wake of WeWork’s sudden fall from grace, investors are feeling differently. All those years of red ink are finally adding up.” The only redeeming thing I could take from such a ridiculous statement is that the writer even knows who Miles Davis is. But then I realize, the whole thing is an insult to Miles Davis and our intelligence. Miles Davis was a musical/jazz genius, a master artist. Adam Neumann was a fraud. And the VCs in the WeWork deal should have known this through their diligence. So, my criticism is reserved for the adults that allow this nonsense to continue, followed closely by some of the more youthful folks who are in senior roles at the data analytics companies (CB Insights, PitchBook) and write the articles for TechCrunch, Wired, Crunchbase, et. al. Whether you realize it or not, you are on a path to making yourselves irrelevant, in my opinion. Your so-called analysis is not widely recognized as providing rigorous, meaningful, and dependable insights and analytics regarding what’s really going on in tech. It’s more like click-bait tactics to get noticed and get “likes” than demonstrating some actual skill and expertise as to how firms should be evaluated and valued by those making the investment or managerial decisions…What are your subscribers actually paying for anyway? Further, as stated in Episode 1, It’s a Consumer Protection Issue: Definitely NOT a soap box issue! A number of the largest US mutual fund companies (Fidelity, JH, T. Rowe Price and Vanguard) have invested directly in private co. unicorns In 2015, Fidelity > $1.3B into unicorns! That’s more than any single US-based VC fund invested, in total, that year. Including $235M in WeWork, $129M in Zenefits – A company that hired too many people, grew too fast, and the company culture spiraled out of control, and $118M in Blue Apron, the food delivery startup that IPO’d in June 2017 and is now looking for a buyer… The common thread on all these investments by major mutual fund companies? Use of the meaningless post-money valuation to value these private tech company assets in their portfolios. It’s Mind-boggling to think that this is the valuation methodology used… Incredibly, they have accepted and used these meaningless valuations to mark their holdings of these private tech companies w/o further analysis – a completely irresponsible methodology. It surely doesn’t inspire confidence in their ability to perform proper valuation analytics Where’s the adherence to the fiduciary responsibility of these investment firms to their clients? There are real financial implications for any retail investor in a mutual fund (401k or directly) related to this high-risk category. How about institutions? Univ. endowments, public pension funds, etc.? Are mutual fund companies fully disclosing real risk of this asset class to their retail investors? Accurately? How so, if at all? (e.g. – Fidelity had to recently write down its WeWork holdings to reflect the difficulties the company has “reported” after the cancelation of its IPO.) Where are the Regulators? The SEC… Sagas of WeWork and Uber They represent some of the many Poster-Kids for, Unicorns aren’t real I want to take a look at Uber first then we’ll talk about WeWork. Uber went public in May of 2019, so a little over a year ago. It priced its shares at $45 upon IPO The IPO was billed as the largest of 2019 as Uber sought to go out at greater than $100B with $120B even suggested by some of the I-Banks underwriting the deal. However, what’s intriguing is to evaluate, are the Uber valuations in the years leading up to its IPO – In fact, Strebulav Stanford Study authors, posted to Linkedin in early 2018 that they extended their analysis to re-value Uber after a deal it closed at the time with SoftBank – we are in Jan. of 2018, more than a year before Uber’s IPO. Basically, a consortium led by SoftBank and prior investors, they were purchasing about $8B worth of Uber Common and some early preferred shares in a tender offer for about $34/share AND; An additional $1.25B consideration for some Series G-1 shares for $49/share. Based on the deal terms and details analyzed, it was determined that the Series G-1 shares I just mentioned, being purchased at $49/share, had no special features or terms making them worth more than Common shares. So, why the 42% mark-up as part of this transaction? Conclusion: My Recommendation/proposal: All private tech company valuations should be run through the Stanford Univ. Study Model prior to any kind of exit or any time the value of a private tech company needs to be certified for audit or other purposes. These companies owe it to their employees who are provided, in many cases, with near worthless Common stock or options for common. In the interest of time and also to provide a proper analysis, I prefer to save WeWork’s story and saga for my next Episode. Thank you for joining me for this edition of DVC. I hope you found the topic interesting and useful. I am currently working on the DVC website. In the meantime, Please send questions and your comments regarding today’s episode to: bill@ccs.capital Stay tuned for my next Episode, in a few days, where I will pick back up with discussing and analyzing WeWork’s saga, … Thank you for joining me for this episode of DVC…