This summer I binge watched the entire two seasons of HBO’s Silicon Valley. I must admit, I found it pretty entertaining.
For those who don’t know the show, it is an HBO comedy series based on a group of young Silicon Valley entrepreneurs trying to make in the cut throat world of California’s tech community. Although it is a little over the top with stereo types, most of the reviews I have read allude many of the crazy events are more based in fact than the Valley would like to reveal.
At the start of the second season, the Pied Piper employees (that is the name of the group’s tech startup), are working on raising money from various Venture Capitalists. Hilarity ensues as the show’s goofball realizes the ruder he behaves, the more the VCs want to invest in his company because, to be so arrogant, they figure he must be really good.
As the Pied Piper pitch men are ruder and ruder to the VCs, their valuation keeps rising. But eventually the show’s lead character realizes a down round is the worst thing that can happen to a private tech company. To guard against the next round being a disappointment, he instead lowers the price of the current financing round.
Obviously the plot is ridiculous. But it does highlight an important point about the necessity of ever increasing valuations.
This whole Silicon Valley boom has been fuelled by easy money, with private company tech valuations carefully walked higher by the Venture Capitalists. The fact so many of these growing tech companies stayed private made their job all the easier. No longer did the company’s backers need to deal with the vagaries of the stock market. Instead they simply made sure each round was done at a higher price than the last. No more worrying about the daily ticks on the stock exchange.
And there is no doubt they have played this game well. Have a look at the number of “Unicorns” (private companies with a value of greater than $1 billion dollars) created during this cycle:
Does that look sustainable? Does that seem healthy? I don’t know about you, but it certainly feels frothy to me.
In case you feel differently, have a look at the kind of crap that is getting funded these days.
Now apart from being a little pissed these millennials seem to be way more, how should I say this… liberated? than when I was in university, I think these kinds of ridiculous investments are a sign of way too much money chasing too few good ideas. This absurdity is what you see at the end of the cycle, not the beginning.
But more important than my grousing about the habits of millennials are two important recent developments that should be highlighted.
Important point #1 – negative gross margins
The first came to my attention in a terrific blog by Fred Wilson, a great VC who writes everyday on his site AVC.com. In a recent article titled “Negative Gross Margins”, he laid it all out on the table:
There’s been a lot of talk coming out of silicon valley lately about fast growing companies with high valuations that are going to face problems in the coming year(s).
Bill Gurley said this recently:
“I do think you’ll see some dead unicorns this year”
Mike Moritz said this recently:
“There are a considerable number of unicorns that will become extinct.”
Instead of just making a prediction of imminent doom, Fred explains exactly why the boom is unsustainable.
But how is this going to happen?
The most likely scenario is the thing that has been driving growth (and valuations) for these companies ultimately comes home to roost. And that is negative gross margins.
We have seen a tremendous number of high growth companies raising money this year with negative gross margins. Which means they sell something for less than it costs them to make it.
It can be an “on-demand” service provider that subsidizes the cost of the workers on its platform so that the service seems like it costs less than it actually does. Why would an on-demand startup take this approach? To build demand for the service, of course. The idea is get users hooked on a home cleaning service, a ridesharing service, a food delivery service, or a gym roaming service by bringing it to market at a price point that is highly attractive and then, once the users are truly hooked, take the price up.
It can be a service provided to startups, like the ability to ship via an API, or the ability to process payments via an API, or the ability to pay your employees or give them benefits. All of these examples have a real cost component to them. They are not pure software. And there are providers in the market who are not passing through the true cost, in effect subsidizing the cost of the service, to gain market share. This results in fast growth but negative gross margins. Again, the companies that are doing this are hoping that once they get to scale and users are “locked in”, they can raise prices.
Yet Fred does not think the road to profitability will be smooth:
The thing that is wrong with this strategy is that taking prices up, or using your volume to drive costs down, in order to get to positive gross margins is a lot harder than most people think. If there are other startups competing with you and offering a similar service, you aren’t going to be able to take prices up without losing customers to a similar competitor, unless your service truly has “lock in.” And most don’t. Using volume to drive costs down can work, but if there are similar services out there, the provider who is being asked to take a cut by you might just move their supply over to another competitor offering a higher price.
The bottom line is the primary way this strategy works is if you obtain a monopoly position in your market and you are the only game in town for your customers and suppliers. But given the massive amount of startup capital that is out there and the endless number of entrepreneurs starting businesses similar to each other these days, I think it will be hard for most companies to achieve monopoly position (which is somewhat in conflict with what I wrote here the other day).
Yes, there will be a few that succeed with this strategy. Getting a huge lead on your competitors, raising a ton of money to operate a scorched earth strategy and force your competitors out of the market, will work for some. But not nearly as many as the capital markets seem to think.
And so most of the companies out there who are growing like weeds using a negative gross margin strategy are going to find that the capital markets will ultimately lose patience with this strategy and force them to get to positive gross margins, which will in turn cut into growth and what we will be left with is a ton of flatlined zero gross margin businesses carrying billion dollar plus valuations. And that is what Gurley and Moritz see when they look out into next year and the year beyond. They aren’t alone.
Fred’s piece on negative gross margins demonstrates the late stage of the current tech cycle. Strong fundamentals are no longer the driving force of this bull run. Instead we are rising because we have been rising…
Have a look at this chart of the stages of a market, and ask yourself at what stage do you think the private tech startup cycle is at:
I don’t know if we are still at delusional, or new paradigm… But I think there is a good chance we have already rolled over and are bumping along at the denial phase.
Important point #2 – prices are no longer rising
Which brings me to my second important point. Last week I wrote about Fidelity’s marking down of its Dropbox holding. Now we learn that Fidelity has also reduced the value of probably the most famous Unicorn out there. The big dog announced they have also written down the value of their investment in SnapChat by 25%.
This might not seem like a big deal, but this game was predicated on ever increasing prices. That is what made the private market so appealing – the VCs could control it. However it increasingly looks like the game is over.
It is obvious that Fidelity was not a good actor to bring into this markup game. They don’t have the same ability to control the pricing like the VCs. Fidelity’s money isn’t locked up. The tech companies should have never let them invest.
That is what happens at the top. You need new investors. The game can’t continue forever.
But new investors in the private market have dried up, and the tech companies are now forced to head out to the public market. The problem is that the public markets are not assigning the same valuation to these Unicorns.
Square announced plans on Friday morning to price its IPO at $11 to $13 a share, meaning an IPO in that range would value the company at much less than the valuation it secured in its last round of private financing.
If the company prices at $13, Square would carry a value of about $4.2 billion based on the approximately 323 million shares it says will be outstanding. Square, Jack Dorsey’s payments company, was valued by private investors at about $6 billion in its last round of private financing, according to insiders.
I am convinced we have now rolled over and are about to enter the distribution phase of this cycle. There will be rallies, but the top is in for these stocks. From here on in, these private company Unicorn stocks will go from strong hands into weak ones.
[ I am looking for ways to short the Unicorn club. I am aware of GSV Capital, but it is trading at a wicked discount to NAV. If anyone knows any other closed end funds that hold positions in the Unicorns, please pass them along. ]
Platinum/Gold ratio vs. US Treasuries
One of the strange spreads I like to follow is the platinum/gold ratio versus the yield on US treasuries. Over the past half dozen years it has shown a surprising high degree of correlation.
Yet during the past couple of months there has been a large divergence. I have plotted out the regression analysis to get a feel of how stretched the spread has become.
Over the past few days, it has hit a level where it has rebounded in the past.
I don’t know if that means you should be buying platinum and shorting gold, or buying US treasuries, or maybe even doing both.
But I am weary of leaning short against the US treasury market, and I will keep my eye on the platinum/gold ratio for signs of a bounce. I have found every time I think this relationship is due to fall apart, it finds a way to come back together…
Thanks for reading,