Tech startups are drawing bucket loads of investor capital, but prospective returns are plummeting. When reality finally sets in, a crash is inevitable, various observers warn. As Keith Wright, an instructor of accounting and information at the Villanova University School of Business, writes in a commentary for CNBC: "In case you missed it, the peak in the tech unicorn bubble already has been reached. And it's going to be all downhill from here. Massive losses are coming in venture capital-funded start-ups that are, in some cases, as much as 50% overvalued." He adds, ominously, "We are now officially in a tech bubble larger than March of 2000." (For more, see also: Are Tech Startups Overvalued?)

Crashing and Burning

In addition to overvalued tech startups that are still privately-owned, some highly-touted IPOs in recent years have crashed, leaving investors burned. Among the recent high-profile casualties are shares of Fitbit Inc. (FIT), a maker of wearable devices that help users adhere to exercise programs, and social media company Snap Inc. (SNAP). Beyond tech, big losers also include meal kit delivery service Blue Apron Holdings Inc. (APRN) and German-based hotel search engine Trivago NV (TRVG). Through the close on May 25, these stocks are down by 82%, 56%, 69% and 56% from their respective offering prices.

FIT Chart

FIT data by YCharts

The Trouble With Unicorns

The term "unicorn" has been applied in recent years to privately-held startups with valuations of $1 billion or more. These valuations, however, often reflect an overly-optimistic view of their business models and future prospects. Wright cites a recent study by the National Bureau of Economic Research (NBER) which concludes that the average unicorn is overvalued by about 50%, with the result that most unicorns actually have true valuations below $1 billion.

While Birchbox, a subscription seller of beauty products founded in 2010, never reached unicorn status, Wright mentions it as a case study in overvaluation. Once supposedly worth nearly $500 million, hedge fund Viking Global Investors acquired a controlling interest for just $15 million recently, per Recode.net. Birchbox was put up for sale last summer, but a variety of established retailers, including Walmart Inc. (WMT) and QVC Group (QVCA), reportedly were uninterested even at a fire-sale price. Various leading venture capital firms, along with Viking, previously had sunk $90 million into the company, and the others are expected to suffer complete losses, the article says.

Wright is skeptical about ride-hailing service Uber Technologies, the highest-valued private technology company. Despite rapidly-growing revenue that reached $6.5 billion in 2016, he notes that it still lost $2.8 billion. Uber did post a profit, on a technical basis, in the first calendar quarter of 2018, but analysts say it's far from making consistent and solid profits. He is equally doubtful regarding BuzzFeed, Vice Media and Credit Karma, high-profile unicorns that missed their 2017 revenue targets. 

Overvalued IPOs

"When a unicorn is overvalued, it doesn't take long for the market to discover this fact," Wright indicates, citing Trivago as a case in point. Its initial offering in December 2016 raised between 23% and 33% less than expected, due to a combination of a lower offering price and fewer shares bought, Reuters reported. As noted above, the company's shares are now worth less than half their marked-down offering price.

Another indicator of rampant overvaluation among startups in general is that most are going public as unprofitable enterprises, Wright adds. Of the 160 IPOs in 2017, 76% of these companies had failed to turn a profit in the 12 months leading up to their initial offerings, according to research by Jay Ritter, a business professor at the University of Florida who has specialized in studying IPOs for more than 35 years. This presents an ominous parallel with the dotcom bubble years, says Wright: 81% of the IPOs in 2000 were of unprofitable companies.

^SPX Chart

^SPX data by YCharts

Delayed IPOs

Today it takes the average tech startup 11 years to go from inception to IPO, versus 4 years back in 1999, per Wright. Besides venture capital funds being flush with money, the Jumpstart Our Business Startups (JOBS) Act has encouraged hedge funds and mutual funds to become sources of private equity as well, he notes. These new sources of private capital give startups additional time to raise funds before tapping the public securities markets. As a result, the number of IPOs in the U.S. has been declining, from an average of 446 per year in 1999 and 2000, to an average of only 144 per year in the succeeding 17 years, per Statista.

Money for Nothing

Another effect of the JOBS Act, per Wright, is that startups increasingly issue classes of shares that offer investors no voting rights, rights to assets, rights to dividends, or rights to inspect company records. Meanwhile, he cites another research study that found an average overvaluation of 49% in the shares of startups, with the authors concluding that the reason is that older share classes with fewer rights are being ascribed the same values as newer classes that had to offer more rights to entice additional investors.

Snap, which has given no voting rights to shareholders, also is an example of how the outlook for young tech companies can change dramatically, almost overnight. Earlier this year, Snap was being mentioned as a growing competitive threat to social networking leader Facebook Inc. (FB). (For more, see also: Facebook's Growth Threatened By Twitter, Snap.)

'Expect More Dead Unicorns'

"Expect to see more dead unicorns," Wright concludes, adding, "If you intend to invest in a unicorn IPO anytime soon, think twice." He indicates that more than 70% of startups fail after 10 years, and that several financial models predict that up to 80% of today's unicorns will fail within two years. He also counsels investors in mutual funds and hedge funds to investigate how much they may have at risk in privately-held startups.

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