I was originally thinking of using this story for my Tidbits in the News weekly entry, but I decided otherwise, namely because it feels to me this is a symptom of a much larger, more fundamental problem. What’s more troubling is that this was one of the first problems I pointed out early when I “pivoted” this blog from a fiction blog to a business one. But, before we get there, I should start off by talking details.
Dropbox IPO Cuts Valuation
First, Dropbox is to IPO sometime within the next few months. That’s nothing new. What is new is that we’re starting to hear more about the pricing of said IPO. The firm is reported to be seeking $648M in financing from the IPO, while selling about 36,000,000 shares, effectively pricing each share at between $16 to $18 a pop. This values the company at between $7B and $8B after factoring in RSUs and the like.
Unfortunately for us, that was the easy bit.
I say it’s the easy bit, because we have concrete numbers to work with. $16-$18 a share, 36M shares + all shares currently already issued, and we get the effective market cap. Trouble is, this is actually below the $10B valuation the company garnered for its latest funding round in 2014. Combine that with the time value of money, and comparable purchases, and you can see that the company has actually “shrunk” in terms of valuation metrics.
To make matters worse, the company’s financial picture is also rather complex. The company is on a clear growth trajectory in terms of revenue. In fact, it reported a $1.1B revenue for the fiscal year 2017. This is nearly double what it reported in 2015, when it reported $604M in sales. But, it’s not profitable. In fact, it’s highly unprofitable, reporting a loss of $112M for 2017, when they made over $1B in sales.
Is this a part of a larger trend? It’s hard to claim definitively one way or another, but I do see this as indicative of a larger trend, and a weakness in the market that needs addressing before it gets too late. But I don’t, however, see it as a bubble — not yet.
What do I mean by a larger trend? Take Snap, Uber, even Twitter. What do they have in common? They’re all struggling to be profitable. In fact, you can check out this article from 2015, with a shortlist of unprofitable, billion dollar startups. You can see this isn’t just isolated to Silicon Valley, or even the US. It’s worldwide.
Another sign that this is part of a larger trend is the latest developments with big names, especially concerning their market caps. Twitter stock is trading below its IPO in 2013, so is Blue Apron, and Snap. Uber recently held a secondary buyout for its employees and investors, devaluing the company by a hefty margin. Gilt sold to HBC below its peak valuation, and Etsy only recently recovered its IPO price.
To the undiscerning eye, this may not mean anything. It may just mean the companies are underperforming. It may just mean the companies aren’t profitable. It may just mean the companies markets are shrinking in general.
And, while all that may be true, there’s a more fundamental reason than that — stakeholders from the stock market, and stakeholders during the venture phase of a business fundamentally demand different things. Venture capitalists know what this game entails. They know that the road to profitability is a long one, often riddled with pivots and failures. Most of them have been through the journey before, many of them as entrepreneurs themselves. Stock market investors are different, however. They’re not interested in the long run. They’re interested in the now — is the company doing well now? Or is this company struggling?
That’s why profitability is so important.
But in recent years, stock market investors have shown that they’re willing to compromise. If the company could show that it had a long term plan, a long term profitability plan, the market would be willing to wait. That was the reason for success with Facebook and Amazon, even Tesla. It communicated its plans for success clearly and effectively, and executed on those promises.
Snap isn’t communicating its plans to the market, if it even has one. Neither is Blue Apron. When Gilt sold to HBC, it wasn’t able to communicate to HBC that its previous valuation was an undervaluation, and that it would be growing quicker under the giant. Even Uber hasn’t been able to give a clear answer to overcome allegations of sexual harassment, and the resulting brand image hit.
Bubble or Not?
Once again, I don’t quite see this as a bubble yet. I understand the concerns over startup valuations, especially when considering their profits and assets. I understand that the DCF model of valuation, even the First Chicago Method, value these startups at far under their current valuations. But, in that case, no one should have invested in Amazon when it first went public. No one should have even listened to Mark Zuckerberg when he was raising venture financing in the valley. No one should have given Elon Musk the capital to create money losing companies end on end.
But the thing is, the financial markets have fundamentally changed. The market is interested in how a company is looking to grow, even post IPO. It’s looking to see whether it has a clear idea of what its identity is, and how it will, eventually, become massively profitable.
If the market was investing in something they didn’t know what to expect from, unable to set KPIs and metrics, that would be the sign of a bubble. Take 2008, for example, when institutional investors invested in mortgage derivatives, not knowing what to expect from them. Or, even the dot com bubble, when investors of all sorts were unable to properly hold these companies accountable, because they didn’t understand the fundamental basics of how these companies worked. Crypto, to an extent, is a bubble.
This? This isn’t a bubble. Not yet.
In fact, this might be a paradigm shift we’re experiencing — a market correction where founders with a fundamental vision ultimately survive, and investors who don’t know how to discern those with a plan, from those who don’t, are pushed out of the market.
If there are more shrewd investors in the market than those who aren’t, then the bubble will be a mild overheating, and it’ll end without a fuss. If there are fewer shrewd investors, then we’ll see this grow into a bubble, perhaps one rivaling the pre 2008 crisis, or even one surpassing it.
Startup Valuation in a Non-DCF World
P/E ratios, DCF valuations, PEG ratios — all these valuation methods might no longer be applicable for startups post series A. In fact, it might even be useless in valuing startups going public. Valuing these later stage startups is looking more and more like the seed and pre-seed stages, where you invest in an idea and a team; except this time, we have to focus on the management team in particular, and the fundamental values and plans they operate upon.
Dropbox, in that sense, is rather interesting. Their fundamental values and management team look promising. They even have a strong corporate identity that they rarely venture out of. But, in terms of their plans for the future, it’s a giant question mark. The company has shown that it’s able to grow the business quickly, and effectively, including increasing its number of paid accounts. Where it falls rather short is on how to turn those revenues into profits. That picture will become clearer, once we’re able to analyze their costs structures and cash flows, but right now, that’s the one area they’re lacking in.
It’s seems to be a dawn of a new era for people playing the late stage venture game. It’s becoming more a marketing and PR game than a finance one. Perhaps VC is finally ready to step out of the shadows of its older, much more mature, sibling, PE. Maybe this is the start of a fundamental shift for the industry. If that’s the case, it’ll be interesting to see which startups and investors end up surviving.