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TechStuff Tidbits: What is a Unicorn?

Published Aug 23, 2023, 5:22 PM

In 2013, venture capitalist Aileen Lee coined the term "unicorn" for startups. What makes a startup a unicorn? How rare are they? And how do investors assign value to a company that might not actually do anything? 

Welcome to Tech Stuff, a production from iHeartRadio. Hey thereon Welcome to Tech Stuff. I'm your host, Jonathan Strickland. I'm an executive producer with iHeartRadio and how the tech are you so. A decade ago, an investor named Aileen Lee, the founder of a venture capital firm called Cowboy Ventures, which, like crap, that's a great name. She coined the term unicorn to describe a startup that has reached the unbelievable milestone of a billion dollar valuation, and since then, tech boffins have used the term unicorn to single out startups that stand out from among the crowd. Every startup founder is hoping for a unicorn. In fact, every investor is hoping that they get in on the ground floor of supporting a unicorn. The end goal for most investors is to sink a decent investment in a startup, see that startup climb and valuation to astronomical heights, and then rake in the wealth when that company inevitably goes public. That's the dream scenario. You see this huge return on your investment. In fact, there are venture capital firms that really count on a few of the companies they pick reaching a level of unicorn status because it pretty much carries the entire company. It'll help carry and balance out all the ones that didn't really reach those levels. What's interesting to me is that there's no point in this journey toward billion dollar valuation where a startup actually needs to make a profit. Startups can reach a billion dollar valuation without making a profit. They could potentially make it without even having a plan to reach profitability, although that's less likely. Typically they will be at a point where they're generating revenue, but they're not making more than what they're spending, so they're still operating at a loss. So as an example of this, I'll give you a unicorn example. The former Twitter now X originally reached a billion dollar valuation back in two thousand and nine, but Twitter didn't turn an annual profit until two thousand and eighteen. Nine years later, it was worth a billion dollars but had not yet made an annual profit. It did make a quarterly profit a couple of times before twenty eighteen, but the first time it made a profit at the end of a year was twenty eighteen. Crazy, So profits are not really a necessity when it comes to achieving unicorn status. It's certainly not a necessity for making a boatload of money off of a company. Now, that was not always the case, right. Once upon a time, investors were much fewer and further between. It was harder to get hold of investment capital. So for a business to really survive, it had to make a profit, or at the very least, it had to break even. Otherwise there was no way to cover the costs of operation, and you would you run yourself out of business. It'd be too expensive to run the business to stay in business, and any hope of becoming an enormous success really hinged upon being profitable. But let's put that aside for a little bit. Let's get back to talking about unicorns. So in twenty thirteen, Aileenlye writes a piece titled Welcome to the Unicorn Club. Learning from billion dollar Startups, and Lee called these billion dollars startups unicorns because of their rarity. They were so incredibly rare. According to her company's research, out of the thousands of companies that had been launched in the previous decade from two thousand and three to twenty thirteen, only point zero seven percent of them reached a billion dollar valuation. I want to say it was like thirty nine companies at the time. So that raises a question, what exactly is valuation? How do analysts determine or really, if we want to be accurate, how do they estimate the value of a startup, especially a startup that may not have a product to sell. Now, with publicly traded companies, one way to measure value is through market capitalization. This is a pretty simple concept, really, So publicly traded companies have shares. Right, you can purchase a share in the company. Each share is worth a certain amount, and that amount is determined by the market. Now, going into all the different forces that play into the the share value of a company would go well beyond my meager ability to explain. If I could explain all of that in great detail, I would be in a different tax bracket. But essentially, for market capitalization, you take the number of shares that are outstanding the ones that exist, in other words, and you multiply that number of shares by the value per share. Then you get the market capitalization of a company. So we'll use an overly simplified hypothetical example. Let's say we've got a company and we're calling it Willie's Widget Wonderland. It's a publicly traded company, and the shares for Willy's Widget Wonderland are trading at ten dollars per share. So for ten American dollars, you can buy yourself a single share in this company. Let's also say that there are only one hundred thousand shares of this company at all, that's all that exists. Well, we would then multiply these two numbers together, right, ten dollars per share, one hundred thousand shares. That gives us a million dollars. Boom, that's the market cap for Willie's Widget Wonderland. Now, like valuation, market cap doesn't rely on stuff like profit or revenue, at least not directly. Those factors can play into the value of the company by affecting the company's stock value, and that in turn does affect market capitalization. So market cap tells us what the market, the stock market in this case, values a company at. Often investors will reference marketcap as the size of the company. Now, technically, market cap doesn't indicate if a company is, you know, physically larger or smaller than any other company, but rather the size of its value in the marketplace. However, typically larger cap companies are more established, and usually that means they are also more stable than companies that have a smaller market cap. But you know, to talk about the value of a company beyond just the measure of market cap, you have to talk about all sorts of other stuff, like you might have to take into account how much revenue the business generates, what are its costs of operation, how much does it pay in taxes? You know, how much of the business has depreciated over time, and by how much. This kind of gets us into the dreaded EBITDA or EBITA as I've heard it said that actually it's eb I t DA. It stands for earnings before interest, taxes, depreciation and amortization, And y'all, I have been in meetings where EBEDA is part of the discussion, and every time it happens, I can feel my eyes start to glaze over. I will say that there are critics who have argued that EBEDA has been misused, that companies have leaned on EBEDA to perhaps overstate their profitability because it does take a lot of costs out of that equation, and that it's really just a way for companies to make it seem like they're doing a lot better than perhaps how they are really doing once you take all of these different factors into consideration. But to get into it further would mean we'd need to find another host because I would fall asleep. And anyway, we're not really talking about publicly traded companies, are we We're talking startups. So a startup typically is a privately held company, a corporation. It usually has the goal of becoming a publicly traded company at some point in the future. It's not necessarily its goal, but often that is the understanding among both the startup itself and its investors. So how the heck do you assign value to an entity like that. It's not a business that's established, that has a history, that has actual spreadsheet showing things like costs versus revenue. How do you put a value on a startup that, perhaps in its earliest stage, is very little more than just a good idea, or hopefully a good idea. And that's a really good question. So let's imagine that we have a brand new startup and the founders have, you know, an interesting idea, but at the start, they don't actually have a product to sell. There's no operating income for the business. Maybe they've got a company structure, like maybe they've designated officers for the business who are in charge of specific functions, but as of right now, they're not yet producing something that they can sell. How do you place a value on that kind of operation? But hold on, it gets even more complicated than that. Let's say that this startup is a really new idea, like it's really innovative, something that hasn't seen much or perhaps any representation in the market as of right now. Now, well, that makes it even harder because it means you have very little you can compare that startup against in the market, So that becomes a barrier to valuation. You can't say, oh, well, this other company is valued at such and such, so that's probably the ballpark where we need to look at for this other startup. If the two startups are nothing alike, then there's no reason to port over that value from company A to company B. On top of that, the market changes quickly, which makes it really hard to predict how the startup is going to perform in the future. So will the market continue to support this startups business model and thus lead to enormous growth, which is what all the parties involved want to see. Or will the market itself change and thus the business model then becomes irrelevant. It's not that the business model was bad, it's just it no longer applies because the market itself has changed. Or will it turn out that the market demand for the company's product just isn't there, like you think it's there because it sounds like a great idea, but once you actually get it out there, no one really seems jazzed about it. Here this reminds me kind of of how I see the metaverse right now. Obviously, the metaverse itself is not a startup, but the fact that I often see a lack of enthusiasm in the general public around the concept of the metaverse makes me question the wisdom of investing billions of dollars into that idea. So the truth of the matter is that lots of factors, some of them subjective ones, will come into play to determine a startup's value, and they can include things like investor opinions. If investors are enthusiastic about a startup, that startups valuation typically goes up. But other stuff involves things like market trends or assumptions about the market in general. So it gets very whibly wobbly. We're going to take a quick break. When we come back, I'm going to talk about some approaches toward assigning value to startups. Okay, we're back. So, as I mentioned, there are a couple of different ways that investors will attempt to assign value to a startup, which will ultimately determine whether a startup reaches Unicorn status. One of those ways is called the market multiple approach. So broadly speaking, this method takes a look at recent acquisitions in whatever sector the startup is in. So if the startup is at all similar to other businesses that are part of these acquisitions, this is a good approach, or at least a viable one. So what you do is you look at the acquisitions that have been made. You also take a look at how much those businesses, those startups that got acquired, how much were they making in sales or how much sales were they actually seeing at the time of acquisition, And then how much of a multiplayer is there for the amount of sales versus the amount that was paid for at acquisition. That gives you your market multiple. So let's talk about our fictional widget company again. Let's imagine the widget company is not publicly traded, it's a startup. And let's say that investors look at how much other companies are paying to acquire hardware companies that are in some way similar to this widget company, and it turns out the acquisition price is about six times greater than the actual sales that these companies are making. That that's the average that you're seeing across these acquisitions six times more. So your market multiple is six and you can use that multiple to kind of estimate your own company's valuation, though obviously you're going to have to tweak that depending upon the status of your own startup. So for example, if you haven't really built out manufacturing facilities yet and you don't actually have anything to sell, well, you can't really multiply anything. If you're at very low scale then and maybe your multiple is much lower because you haven't proven that you can scale the business up yet, and that means that investors are taking on a greater amount of risk when they invest in your company. So your multiple ends up being smaller than the market six times multiple that you're seeing elsewhere. But this can be a way to kind of guide you toward valuation. Obviously, the big hurdle here is that the market multiple approach is dependent upon finding comparable businesses in the market that have been acquired. If your startup is really innovative and really doesn't resemble other stuff that's already on the market, then you don't have anything to compare it against. You don't have any way to derive the multiple in the first place, because there's no one else out there that's like you. So you can't depend upon what's happening in other parts of the market because it may not have any application toward your situation. However, there are other means to assign valuation. So another is called the cost to duplicate. This is pretty self explanatory. How much money would it take to build a duplicate copy of the startup in question. Now, actually coming up with that figure can be a little tricky because it can involve stuff that's a little more ephemeral than just how much do the facilities cost? How much is the business paying its staff, like how much is not just rent but the cost of operations. It can actually include other stuff too, like intellectual property that becomes harder to put an actual, like monetary value to and that gets a bit wishy washy, or things like the value of research and development that's going on within the startup. How do you put a monetary value on that. So the cost to duplicate has a pretty big drawback. It gives a snapshot of a company's current value, but it doesn't necessarily take all of its assets into account because not all of them are so easily reduced to a figure, and it cannot bring into account the potential for the company's success. Right It's looking at a snapshot of why it's valued right now, but it's not telling you what will it be valued six months from now, assuming that everything's working well. So there are assets that just might not be quantifiable, but they are still valuable to the organization, but they're not going to show up on a spreadsheet because he can't reduce it down to that data point. For that reason, the cost to duplicate method can undervalue a startup, sometimes by a significant amount. So you could say, like, all right, well this is the low ball range of the company's valuation. That would be a safer thing to say, because you are acknowledging that this cost to duplicate method does not take all assets into account because it just it's not designed to be able to do that. Next up, we've got the discounted cash flow method, or DCF method, and in some ways it's kind of the opposite of the cost to duplicate approach, because it's all about looking forward as opposed to getting a snapshot of current value. The DCF method requires analysts to predict how much cash flow a startup will have in the future, and then also bring into account the expected return on investment that the startup is going to create, and putting those together tells you how much that cash flow itself is worth, and that ends up allowing you to place a valuation on the company. To me this method comes across a lot like telling fortunes. You're making the best guess you can based upon the information that's currently available, but knowing how things can change quickly means that at some level you really have to acknowledge that this approach is far from bulletproof. The last method can sometimes feel the most arbitrary of them all. It's called the valuation by stage method, So this method assigns value based upon how far along the startup is as it develops to become a real boy. Wait, I'm sorry, No, I'm sorry, that's pinocchio. I mean when the startup is becoming, you know, its own standalone, real company that can exist without regular injections of investment cash. Obviously, the earlier the startup is on the journey, the lower its valuation is going to be. And only if the startup is able to hold together and continue to develop and reach certain milestones like finding the right leadership team that's a milestone, or forming strong allegiances in partnerships with other companies that's another milestone. Hitting these milestones tells the investor community, Oh, you have reached the next kind of level in your growth, and thus your valuation has increased because you are more stable and you're on a better footing for reaching profitability or eventually going public. As we said, profitability kind of doesn't matter, it's kind of crazy, but profitability in the view of investors, as in they're getting a return on their investment. So that can also include things like if you're able to show that you have a really strong path toward generating revenue and scaling up the business, that is incredibly valuable, enormously valuable, and a lot of startups fail to ever reach that because scaling is hard. Now, the goal of the investor is pretty simple, to get a return on their investment, preferably a nice, big, fat return. The goal of the startup that depends. There are a few potential outcomes for startups, and depending upon what the founders want, some of them may be desirable and some of them may not be. All of them, assuming everything turns out well, means that they will be very, very wealthy. We're going to talk about those potential outcomes after we take another quick break. All right. Before the break, I mentioned that there are a few different potential outcomes that are hoped for among startups in general and unicorns in particular, and they're pretty easy to understand. One, as I've mentioned before, is for the company to ultimately go public, to become a publicly traded company. Usually this is managed by having an initial public offering or IPO. There's a whole process involved in that, and obviously it's not just for the tech sector. It's for any company that's going public. But the goal here is to offer shares of the company, shares of ownership up for sale on the stock market, and this will end up creating a big in jecttion of capital which the business can then use toward, you know, increasing the size of the business, expanding business in various ways, business e business stuff. So it's all about growth really. It does, however, mean also that the leadership and the investors are seeding some control of this business to the shareholders. Like when you own a share in a company, you also technically have a say in how that company is run. Now, obviously, if you only have a share and there are millions of shares out there, your voice is a tiny one and it's only through big collections that you can really make any kind of movement. But there are groups that form together to do just that. And they're also like activist investors who will invest very heavily in a company so that they have you know, a significant ownership, maybe not you know, enough to rank a whole percent even, but significant enough for them to be a voice that is impossible to ignore. And that means that you know, you're not making all of your own decisions. Some of those decisions are subject to the whim of the shareholders. It gets a little more complicated than that, but you get the basic idea, But there's no rule that says a startup, even a unicorn, has to go public. It doesn't, It could remain a private company. The issue with that, however, is that private companies don't have a way to generate this enormous influx of capital the way a publicly traded company does with an IPO, So it is very difficult to get the capital together to do things like expand the business and to scale up, and it might mean having to get more investments, which you know that can end up being a law term challenge, or relying upon the company's own profitability where you're pouring the profits back into the company itself, or to grow the business. But that can be much much much slower than holding an IPO. Even in publicly traded companies, growth isn't always enough. It's not enough for a company to grow from quarter to quarter. The rate of growth becomes important. Shareholders want to see a company grow faster this quarter than it grew last quarter, So the rate of growth is important, not just that the company grew, but how fast did it grow. It's wild to me that it could be a case where you might say, oh, this company didn't grow as much as we hoped it would, and therefore we've lost confidence in it. It's crazy to me that that's a thing, because the company still grew, it just maybe didn't grow as fast as you liked. So like sometimes you'll see headlines about a company reporting a decline in growth but still growing. It's just not growing as quickly as it was previously, and yet that can be seen as this terrible sign. And I think personally this focus on growth has been incredibly unhealthy for companies in general and for society as a whole. I just don't think it's the right philosophy. It's very difficult to sustain, and it drives a lot of bad decisions. I would say, but that's again I'm getting off topic. I apologize so anyway that even with public companies or private companies, growth is always a concern, and it's harder to do when you're a private company. Sometimes there is a third option. You don't have to go public, and you don't have to stay private. The third option is he finds yourself a sugar daddy. By that, I mean you find a bigger company that wants to acquire your startup. This is kind of it almost became a joke that people were going out and founding startups just in the hopes that a bigger company would come along and spend a ridiculous amount of money to acquire the startup. And you don't have to worry about whether or not your business is profitable, like that never even becomes a concern. All you have to do is create an organization that seems desirable for some reason and then sign on the deadline and accept the big old checks. And you didn't have to do something as complicated as running a business and making it successful. There's a bit of there's a bit of truth to that, but that's obviously an oversimplification and almost a parody of what's actually happening. So what is going on here, Well, maybe the bigger company is looking at the startup as a potential rival further in the future, and so the bigger company wants to buy the smaller company before the smaller company a company becomes a competitor. You can look at Meta slash Facebook. That company has done this a lot, purchasing companies that either we're already starting to compete with Facebook's attempt to dominate online attention, or we're rising up rapidly, and then Meta swoops in purchases the company for some ridiculously high cost and then may or may not end up doing anything with it. Maybe the bigger company sees that there are bits and pieces of the startup that could be useful in the bigger company's own products, Like it's not that the startup itself represents something that the company wants, but rather the assets that the startup has. Some of those look really valuable, and maybe you incorporate those into your own stuff, and then maybe later on you even discontinue that stuff. I'm looking at you, Google, Google does this all the time. But it remains that sometimes the startup team is really just hoping to drive valuation up as quickly as possible and get some offers from bigger companies that can lead to a huge opportunity to cash out. This can go different ways, too, right Like, there are stories about startup founders who turned down fairly big offers to buy out their company because they say, oh, now this is undervaluing what we're going to do. And sure maybe right now, like as of right now, you know your your fifty million dollar offer is more than enough to cover all the assets that we currently own, but it doesn't cover the potential, and we would rather bank on our potential than cash out for fifty million. There are plenty of stories like that, but again, unicorns are rare, or at least they're supposed to be. Remember, like in twenty thirteen, when Aileen Lee first coined the term unicorn, her company estimated that there were fewer than forty companies that would merit unicorn status from two thousand and three. Within that decade, there were like thirty nine companies. But according to say CB Insights, as of July twenty twenty three, there were over twelve hundred unicorns in the world. And then not only that, you had variations that were even more kind of grandiose than unicorn. There's the deccacorn, that's a startup that hits a ten billion dollar valuation, or the Hectocorn, which is a hundred billion that's a lot of money. If you're wondering what companies were hitting more than one hundred billion in valuation, SpaceX would be one. Byte Edance, the parent company of TikTok is another. But yeah, there are lots of companies out there that are in the unicorn decacorn status a lot more than there were back in twenty thirteen, so it's not nearly as rare as it used to be. I mean, it's still not like, if you go out there and launch a startup today, you've got a real good chance of having a unicorn on your hands. It is not that common, right, It's still pretty darn rare. It's just way less rare than it was when Alienly coined the phrase back in twenty thirteen. Okay, that's it. That's what a unicorn is in the world of business, and the tech world in particular is known for these, So that's why I thought I would cover it. I hope you are all well, and I'll talk to you again really soon. Tech Stuff is an iHeartRadio production. For more podcasts from iHeartRadio, visit the iHeartRadio app, Apple Podcasts, or wherever you listen to your favorite shows.

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