by Investing Daily, Investing Daily
— this post authored by Linda McDonough
Investing Daily Article of the Week
Anyone following the progress of ride-hailing service Uber, short-term office space lessor WeWork, or vacation rental service Airbnb likely knows the term “unicorn.” It describes a private company sporting a valuation of $1 billion or higher. They’re usually on the cusp of going public, enriching those who get in on the ground floor.
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In Lewis Carroll’s Alice’s Adventures in Wonderland, the words of the Cheshire Cat aptly describe excessive investor hopes for corporate unicorns: “I’m not crazy. My reality is just different than yours.”
Corporate unicorns once were rare. No longer. “Blessings” of them now roam the world. (For those of you unfamiliar with some of the terms for animals that move in groups, a blessing is a group of many unicorns.) But these unicorns are a mixed blessing.
According to industry source CB Insights, there are more than 260 unicorns worldwide as of this month. Year to date, private companies received almost $60 billion in venture capital investments.
This mountain of cash dwarfs prior years and is on track to reach $100 billion, the highest amount invested annually since the height of the dot-com craze (see chart):
Private companies are all the rage. Typically in the past, private companies wishing to raise capital followed a reasonably predictable timeline. They would go through several rounds of private funding while in their early stages. The early rounds of investors took on the most risk but were usually in the position to reap the most reward due to the low valuations bestowed on young, unproven companies.
As these young’uns matured and needed more cash to fund expansion or product launches, additional rounds of private financing occurred. Usually, the valuation of the private company increased with each incremental round of funding.
The private valuation is calculated by dividing the percentage of equity provided to an investor by the dollars used to buy the stake in the company.
For example, if a VC spent $4 million for a 5% stake in a company, the value of that private company would equal $80 million. As investors fight for access to growing private companies, they will often come in gaining less equity for the same dollars invested by someone in the early rounds. The entrance of new investors is the trigger for a new valuation of a private company.
A unicorn would usually follow this path to an eventual initial public offering (IPO). But without any prospect of profits and the need for a lot more funding, many choose to remain private.
Private equity and venture capital funds are so hungry for new deals that they have taken to overfeeding the Cheshire cats. This is the dynamic described by two professors at UC Berkeley and UC Davis who recently published a paper entitled Unicorns, Cheshire Cats, and the New Dilemmas of Entrepreneurial Finance?
In their paper, the authors lament that these companies are fed more and more capital without ever turning a profit. Unlike public companies which must answer to shareholders (some short-term holders, some longer-term) on a quarterly basis, these private companies may never become independent and growing companies.
The study notes that Cheshire cats are those that remain private but get too much cash. They are not under the scrutiny of the public eye, which means they can keep gorging on cash.
These fat cats find it easy to raise money, often without a clear path to profitability. As anyone following the stock market knows, concepts and hopes are born easily, but the execution of a business plan is difficult.
The devilish details haunting the implementation of a plan can wreck a company. Look no further than the mayhem surrounding Tesla (NSDQ: TSLA) as it tries to carry out its promised production schedule.
Like the infamous fat cat sitting in the Wonderland tree, these pampered private companies threaten to disappear with all but a toothy grin remaining.
I prefer publicly traded companies. I can rate management on how closely they’ve delivered on their stated goals and can formulate valuations easily. If a plan doesn’t look like it will come to fruition, I have an easy exit: sell in a liquid, public market.
Linda McDonough is chief investment strategist of Profit Catalyst Alert.
