The age of the unicorn might be coming to an end. Silicon Valley startups valuations, which had risen to fantastic figures in recent times, are being brought down to earth. Media reports and investor talk has brought down entrepreneur egos and pushed entrepreneurs to review their strategies.

Here are the reasons for an uptick in valuations and recent warning signs in the market.

Why Did Startup Valuations Rise In Silicon Valley?

There are two main reasons why startup valuations rose in Silicon Valley.

First, the entry of corporate players and financial services firms multiplied funding choices for entrepreneurs and inflated valuations. This is because corporate investors, such as Google Ventures, Alibaba, and Comcast, invest in startups to gain strategic advantage in emerging technologies (such as artificial intelligence) or gain market share in a new industry. Enthused by the response of the stock market to technology IPOs and the lack of high growth returns in a dismal global economy, mutual funds, hedge funds, and, even, sovereign funds are buying shares of privately-held startups “since they will need to own stock once it's (the startup) public."

But, their entry has prolonged the investment time horizons and led to fiscal indiscipline and complacency in startups. In an interview, Bill Gurley, a venture capitalist at Benchmark Partners, said that Silicon Valley and venture-backed businesses have moved into a world that is both "speculative and unsustainable." Gurley says a high valuation has become the end game for complacent entrepreneurs. "They (valuations) are not a reward for what you have accomplished in the past," he said.

The entry of corporate investors has had another side effect: revenue is not factored into valuations as user traction will ensure that they become prime acquisition targets.

The second reason is related to the public market expectations from technology companies. The spectacular growth and public market valuations for tech conglomerates, such as Amazon, Google, and Facebook, in a relatively short period, has boosted the industry's prospects and led to high future earnings discounts for unicorns. A high valuation ensures a buzz around the unicorn; this could yield a price pop on its opening day when it makes its IPO debut.

This is good news for investors, who are increasingly demanding senior liquidation preferences (which guarantees that they will be the first to get a payout if a startup fails) and ratchets (which grants additional shares to them, if a startup makes its IPO debut below the asking price) to recoup their investments.

Warning Signals In The Unicorn Market

According to CBInsights, a research firm, the number of private unicorns (or startups valued at a billion dollars or more) has more than doubled from 30 to 80 in the last 18 months. The unicorn frenzy began in 2013 when Uber exploded, and startups with barely any revenues received a rapturous reception from public markets.

Then, social media platform Twitter listed on NYSE at a valuation that was 50 times its earnings even though it barely had any revenues and its service was (and is) yet to gain mainstream traction. The company's user growth has stalled in recent times, and its stock fell by 13% following its latest earnings call. (For more, see What's Plaguing Twitter and Yelp?)

The valuation correction is happening in private markets as well as investors raise questions about sales figures and technologies used by the startups.  

Questions are already being asked of Snapchat, a hot startup with zero revenues and a valuation of more than $15 billion. A recent story in The Wall Street Journal illustrates the case of used car startup Beepi, which sought a $2 billion-plus valuation earlier this year (equal to a sixth of the public market's valuation for Carmax, California's largest used car dealer), even though it's sales were a mere 17% of Carmax's quarterly sales. Eventually, it had to settle for a valuation of $500 million. More damagingly, the Journal wrote a series of articles critical of Theranos, a startup valued at more than $9 billion, and its technology. In response, the Food and Drug Administration cracked down on the startup. (For more, see: $9 Billion Startup Theranos Gets Disrupted.)

Several prominent Silicon Valley startups have joined a chorus of startup skeptics. For example, venture capitalist, Mark Suster, is unequivocal when he "mourned" the loss of rational behavior and stated that the privately-held technology market was clearly in a bubble. Similarly, legendary investor Michael Moritz (who was an early investor in Google) wrote about the emergence of "subprime" unicorns, based on the “illusory” valuations and “flimsiest of edifices.”

The Bottom Line

The last couple of years have been a party for Silicon Valley startups with zero revenues and high valuations. It was only a matter of time before the veil fell and a valuation correction occurred. The startups that survive this bust will be the winners in tomorrow's markets. 

 

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