Chasing Unicorns

These days, it’s almost impossible to read an article about tech companies without hearing the word Unicorn. The term has come to define a moment in time, when nearly 150 private tech companies, many of them started in the last few years, are valued in excess of a billion dollars. To put that number in perspective, there are less than 50 public tech companies since the dawn of the Internet with valuations high enough to make the same claim.

So how is it possible that over the past few years so many private companies have come to achieve values that are so lofty? The answer is obvious – growth.

Unicorns on average are growing really fast and investors are infatuated with investing in growth; especially when interest rates are so low because the vast majority of their portfolio is barely earning a return, so they need to compensate by investing in high growth assets.

Typically, high growth = high risk and high risk = high yield. So when you have a bunch of assets earning next to nothing, you need to find risk, which in turn generates yield. As a result, you either need to find companies that are growing or find companies that are troubled and willing to pay a premium for investment. It makes sense.

What doesn’t make sense is that investors seem to be chasing growth in irrational ways.

Let’s start with private company values relative to their public company peers. There are four Unicorns that touch local commerce in some way – Blue Apron, Instacart, Eventbrite and Thumbtack. If we take their combined value (assuming the media is right which I realize can be dangerous), these companies are collectively valued at about $7 billion. Again, based on articles, they have collective revenues of about $600 million and are losing about as much annually. If you compare them against the four local commerce public companies (GrubHub, Groupon, OpenTable, and Yelp), their enterprise value is about the same at $7 billion. But, collectively, the four public companies generate about $4.5 billion in revenue and produce about $600 million in EBITDA.

How can that be? Clearly the answer is growth. The four public companies are growing about 20% in the aggregate, and the four private companies are growing at about 100% a year. Again, on the surface it makes sense.

But when you dig deeper, the math doesn’t add up. As we all know, small things grow faster on a percentage basis than large things. In other words, it’s easier to grow at 100% a year when you’re revenues are a hundred dollars then when your revenues are a hundred million dollars. Growth rates slow with size and scale.

As a result, let’s say those four private companies that are growing 100% a year decelerate by 20% a year – from 100% to 80% to 60% to 40% to 20% where they level off just like their public company peers. And let’s also assume the four public companies, as a group, continue to grow at 20% a year. Where will both be in five years?

In 2020, the private guys would be generating about $6 billion in sales in the aggregate, and the public companies would be at about $11 billion. But that’s only half the story.

The real dilemma for investors lies not in revenue growth, but in EBITDA growth that is depressed by marketing and SG&A investments.

Growth in e-commerce doesn’t fall from the trees. Unicorns are investing heavily in growth, which is why they’re losing so much money. To get those 100%+ growth rates, they’re incurring losses by investing in marketing, sales and price discounts. They’re fueling their growth by over-investing at this stage in their life cycle; presumably because the underlying economics of their cohorts tells them they should.

But at some point, they’re going to have to make money and generate cash. And at that point, they will have to detox from those investments as their growth rates suffer.

When Groupon was investing over $700 million a year in marketing, we were growing really fast. When we dialed that down to $200 million a year, our growth rate slowed.

Finding the right balance is tricky, but overpaying for growth when it’s largely fueled by hyperactive investments that can’t be sustained in perpetuity is even trickier.

Now I’m not saying all Unicorns are overvalued. To the contrary, there are a ton of great Unicorns. And when a Unicorn is growing really fast without over-investing in marketing – when the growth is largely organic – it can be incredibly lucrative to invest even at a high valuation.

But you have to understand the underlying impetus driving growth.

Cash can be an inorganic over-stimulant to growth. As long as you can keep pouring cash into the top of the funnel, growth comes out the bottom. But as soon as you are forced to be rational and not over-invest, which is inevitable unless companies can endlessly raise money at increasingly higher valuations, the music has to stop and the party has to end.

It’s at that point that growth investors may wish they had bought a good old fashioned horse instead of chasing Unicorns.