Why insane price tags on “unicorn” tech businesses aren’t justified

By Chris Woodcock 7 October 2015

Are the price tags attached to the likes of Uber completely crazy, asks technology analyst and The Memo's associate finance editor Chris Woodcock.

In ancient mythology the unicorn is a wild and rare creature. Yet in modern times they seem all too common.

At the GP Bullhound Investor Allstars event last week both Farfetch and Blablacar were mentioned as the latest to attain the status, in what is being termed the ‘Year of the Unicorn’.

For the uninitiated, a unicorn in tech is a company that has achieved a $1 billion valuation. Marc Suster of Upfront Ventures has suggested in a rather colourful way that they are so common these days they are turning into something of a pest.

A whole unicorn self-help/get-rich-quick industry has sprung up around the idea. It makes it seem easy to get a $1 billion valuation, yet by focusing on achieving what is essentially no more than a label it subverts the very thing that builds successful businesses: sacrifice and dedication.

Extreme unicorn-hunting

This kind of behaviour is hardly surprising, however. The unicorn has become a thing because of its vivid imagery, and when it was coined a $1 billion valuation was commensurate with success. It was itself a shorthand, a communication short cut. Aspiring to build one is natural.

The entire technology industry is arguably one big efficiency drive, and it is innate to the human spirit to experiment with tools and techniques to ease our daily burden. It is in our nature to find and exploit short cuts.

Taken to the extreme, however, and the unicorn-building mechanism is scarily easy.

Venture capital (VC) investment firms get more investment on the back of their record at producing unicorns, so it benefits all members of a consortium to refinance at a unicorn valuation. More capital flows to VCs and higher pay for the partners. Job done.

However, gaming the system in this way is not the best route to a sustainable business, either for the start-ups or the VCs. To paraphrase Warren Buffett, at some point the swimwear contest will begin.

Going the way of the dodo

For someone spending their life in the public stock market, the idea of the unicorn valuation is a puzzling one. Valuation to us means a ratio of two things: price-to-earnings, enterprise value-to-EBITDA [earnings before interest, taxes, depreciation and amortisation].

With the unicorn, there is only the price.

What is that as a multiple of something real, like sales, profits, or even users? It makes no sense. Google is $150 billion dollar company, so what? How much profit does it make to justify that?

The stock market gets a raw press at times, and with good reason. At the present moment, however, they are looking like the last bastion of valuation discipline in the investment world. It has become a joke within tech that floating a tech firm is the new down round [where new investors buy in at a lower price than existing investors].

In the case of Hortonworks, a US big data company, this was actually the case last December. It will come as no surprise that it is very quiet for technology IPOs at the moment.

A 10x price-to-sales ratio is a rough line in the sand for tech IPO investors, which means if you have a unicorn to offload, it had better have at least $100 million of sales at some point soon.

$100 million of sales sounds like a real business. It almost certainly involved extremely hard work, a long time and a good slice of luck to get there. Make that a target and the chances of keeping a $1 billion valuation will be much higher.

Without it, the way of the dodo is more likely.