‘Unicorns’ face up to reality of new dotcom bubble

‘Unicorns’ face up to reality of new dotcom bubble
Mr Drew Houston, co-founder and CEO of Dropbox, shrugs off suggestions that his company is valued too highly. Photo: Reuters

‘Unicorns’ face up to reality of new dotcom bubble

Investors worry as private valuations of tech start-ups are detached from public ones

SAN FRANCISCO — The Bill Graham Civic Auditorium in San Francisco, a venue most often associated with rock concerts and sports events, has more recently been commandeered by Silicon Valley’s biggest names.

In September, Apple put on its glamorous iPhone launch event at the 7,000-capacity building. Social media giant Twitter held Flight, its developer jamboree, there. And last week, as if to establish itself as another of the tech world’s most important players, Internet storage business Dropbox took over the centre for Open, its first major customer conference.

Mr Drew Houston, Dropbox’s 32-year-old co-founder, was flanked on stage by Silicon Valley big shots, including Apple’s Mr Eddy Cue and Hewlett-Packard’s Ms Meg Whitman, as he reeled off a series of statistics aimed at proving critics of his business wrong. It was a rare defensive position for a private tech company, but having attracted a US$10 billion (S$14.25 billion) valuation less than two years ago, analysts are questioning whether that valuation was deserved.

Some pundits have even predicted that Dropbox will be the most high-profile victim of a new kind of dotcom bubble, in which the cheap and easy money that has inflated private valuations runs out, leaving start-ups scrambling to adjust to a new reality.

In 1999, hundreds of tech firms flocked to the public markets, with a rush of investor enthusiasm valuing companies often without any real business model in the hundreds of millions of dollars. When confidence collapsed, so did share prices, with many shareholders losing their life savings and some companies folding.

This year, in comparison, has seen a dearth of floats, but dozens of start-ups achieving “unicorn” status, meaning a private valuation of US$1 billion or more. While e-commerce giant Amazon and web portal Yahoo floated at less than US$500 million in the 1990s, the combination of low interest rates hitting yields from other investments and the prospect of huge returns has fuelled an explosion of capital from private investors. This has allowed companies such as Dropbox, ride-sharing firm Uber and accommodation portal Airbnb to stay off the stock market for far longer than they previously might have. According to venture capital database CB Insights, there are now a record 143 unicorns, with a combined valuation of US$508 billion.

While the mere existence of lots of highly valued companies is no indicator of a bubble, aspects of the environment are worrying some investors. Private valuations have become detached from public ones. While a listed company’s market capitalisation reflects what shareholders value it at, private valuations work differently. Most unicorn investments, rather than consisting of traditional risk-carrying equity, come with heavy insurance policies that allow investors to guarantee a return even if expectations are not met. Late-stage investments come in preferred stock, giving investors special rights to assets if a company fails, as well as prioritised returns when it eventually floats or is bought. “It’s all notional money, Excel spreadsheet money,” said one venture capitalist.

When a start-up is growing rapidly, this phenomenon does not matter too much. But should momentum stall, it can become a problem. Dropbox, which has raised more than US$1.1 billion, grew rapidly after it was founded in 2007. Hundreds of millions of consumers use its software, which is free up to a point, and then costs a monthly fee. The company’s main target has become business customers, which pay a pricier per-employee rate.

Dropbox presents a vision of an effortlessly connected workplace, in which employees replace emails with online collaboration. But it has faced heavy competition from the likes of tech heavyweights Google and Microsoft, which has dramatically driven down the costs of online storage. Analysts have questioned Dropbox’s ability to convert its huge consumer base into paying businesses, and some argue that its key product has become commoditised. Dropbox has been called the “first dead decacorn” (referring to a unicorn with a US$10 billion-plus valuation), and some investors have written down the values of their stakes in recent months.

Mr Houston sought to dispel this scepticism last week. He announced that 150,000 businesses were paying for Dropbox’s corporate product, including big hitters such as social networking king Facebook and News Corp. “This is an incredibly powerful business model,” he said.

Other high-profile tech start-ups are facing questions about their viability. Evernote, an online note-taking app that received a US$2 billion valuation in 2012, recently laid off almost a fifth of its staff. Theranos, a blood-testing biotech start-up with a US$9 billion valuation, has been hit by allegations that its tests do not live up to the hype.

Of course, public companies have their downturns, too. Twitter has endured a tumultuous two years in the public eye as a listed company, for example. And if start-ups have been valued too highly, it only really begins to matter when they need to raise funds again. At this point, though, they run into serious trouble.

On Friday, Square, the online payments company run by Twitter chief Jack Dorsey, set its IPO price range at US$11 to US$13, below the US$15.46 of its last funding round in October. But investors were guaranteed a return of US$18.56 a share.

Deezer, the loss-making French music streaming service, delayed plans to raise €300 million (S$460 million) in an IPO last month, blaming “market conditions”. This is not an isolated case. Tech listings in 2015 have made up the lowest proportion of all floats in the United States for six years. If interest rates go up and dampen demand for floats further, highly valued start-ups could find themselves stuck in a valuation trap. As Square has seen, going public without a valuation significantly above the previous funding round can carry its problems. But raising more money privately also means handing out even more of these preference shares, making an eventual listing harder again.

Mr Houston laughs off suggestions that Dropbox has been valued too highly, and says the company has no need to raise more money.

“This speculation (about private valuations) is like playing fantasy football without any of the statistics,” he says. “It’s just everybody’s opinions about opinions. It doesn’t bother me.”

Investors appear to remain supportive. One venture capital backer says that Dropbox can be a US$100 billion company, pointing out its opportunity to convert its almost half a billion users into massive revenues.

Sceptics have been repeatedly proven wrong about many tech valuations. Facebook’s US$15 billion valuation in 2007 raised eyebrows; last week it passed US$300 billion as a listed company. Five of the world’s seven biggest public companies — Apple, Google parent Alphabet, Microsoft, Facebook and Amazon — are technology groups. It is, perhaps, no wonder that private investors are willing to put unprecedented cash into tech start-ups. For those that pick the winners, the rewards are bigger than ever, but there are likely to be a few dead unicorns along the way.