The Game of Valuations: A Case of Unicorns
What are Unicorn Companies?
Unicorns are defined as startup companies (often private) with values over $1 billion and no profits (often with deep losses).
You may think, why do such lofty companies have no profits?
In Silicon Valley, investors don’t expect their portfolio companies to be profitable, as it is too far less concerned with profitability than a market opportunity.
Ecommerce giant Amazon once in 2019 kept its backers waiting almost four years after its flotation before posting a small, $5m profit. Its losses had grown to $3bn at that point and still didn’t hold back its shares. Today, it is the third-largest company by market value and can raise that much profit in less than four hours. They may have high valuations in private markets with their founders becoming instant celebrities but, they also generate hefty losses.
But how does one justify these mighty valuations?
A Unicorn’s value depends most on its cash flow, which in turn depends on its profit or return on capital.
We can analyze a situation where profit and revenue a company would have to generate $1 billion. There can be two cases to this:
1. If a company is potential enough to generate $200 million from operating profits before tax in the coming 10 years with an enterprise value multiple of 15 times, it would be worth $3 billion in 10 years. Further assuming cash flows, then and now, net out to be zero and discounting the $3 billion to today @ 10% you get $1.15 billion.
2. For a similar company to be worth $10 billion, let’s say have to generate $2 billion of operating profit in 10 years. Assuming a generous 20% profit margin, the company would need to generate $10 billion in revenues with a profit margin and achieve a sustainable enterprise multiple of 15, which seems impossible! Unless we gave a monopoly-size return on capital.
Most firms use the Discounted Cash Flow method to estimate these valuations. This method includes making periodic projections of the financial statements for a certain period and then discounting the value of the company based on the last future projection, post certain adjustments. The firm projects its financial health on a future date and calculates the present value of that health.
Case Study: Hike
The hike was founded in 2012, it became a unicorn in 2016 — in merely 4 years into operation in 2017, with no dearth of funds as the CEO’s father owns the third-largest telecom and a Unicorn tag, loses INR Rs. 400 crore to earn Rs. 50.8 lakhs from its core services. If in 2016 the company calculated the $1 billion valuations based on this method, the due diligence could not have projected a Rs 400 crore loss and Rs 50.8 lakhs in organic revenue for FY18. But that is exactly what happened.
There are many more cases to add to the evidence and solidifies the fact that the trending practice and methods of calculating these mighty valuations, and associating these tags with startups, unless financially justifiable, are pointless activities and toxic to the startup ecosystem.
Nowadays, Unicorn has become a financial myth. There is no denying that in the past couple of years, turning into a billion-dollar worth startup and coveting the so-called prestigious Unicorn status has resulted in a cutthroat rat race where entrepreneurs, investors, the media, and the audience, all are equally obsessed with the tag.
In this long game of risk, exactly how much is worth this risk?
Nevertheless, the mystique of the Unicorn is bound to persist and so is the media attention and public interest around them.
