Editor’s Morning Note: 500 Startups’ Dave McClure’s thoughts on Unicorns vs. The World are worth a moment of our time.
Happy Monday. I trust that you survived the weekend in at least decent shape. We’re going slow this morning in case your coffee has yet to set in. I promise.
Recently Dave McClure, an active technology investor, wrote a piece entitled “The Unicorn Hedge,” which has a few themes that we need to explore. McClure piece is mandatory reading.
Let’s gist his argument down, and then unpack a few core points to see what we can learn.
Sifting through McClure’s piece again, here’s the best summary I can do for you this morning:
- The media likes to shout “bubble” very loudly before bracing for an earthquake that may happen either sooner, or later, or never at all.
- Movie reference.
- Over the next few decades, public companies that aren’t innovative will lose value as younger, nimbler companies disrupt their business.
- The valuations multiples at which public companies currently trade—PEs between 15 and 25 are silly and should instead fall between 5 and 10—are too high and ripe for a whacking.
- Some companies today worth tens of billions will go to zero. [Implied point that those big companies would have gotten away with it too, if it wasn’t for these meddling unicorns!]
- Since unicorns are doin’ the disrupting, legacy big companies are going to implement “The Unicorn Hedge” by buying a unicorn or two.
- Graph showing that tech companies are buying fewer unicorns, while non-tech companies are ramping up their purchase rate.
- Point that even big tech companies are buying unicorns! [Cut scene to Twitter crying in the corner.]
- “So what do you think is more overvalued? The average unicorn or tech IPO? Or the average non-tech public company that hasn’t innovated in over a decade?”
- Digression on investing during market downturns.
- Note that most private valuations don’t make sense: “As it turns out, most unicorns and many tech IPOs are perhaps overvalued[.]”
- Note that not all of them are: “[B]ut a few of them are actually UNDER-valued as well.”
- In fact: “SOME unicorns are NOT overvalued and NOT over-funded — a few are the real deal, growing like crazy, and scaring the bejeezus out of CEOs at non-tech public companies they’re competing with.”
- So now everyone wants a piece of the action. Non-traditional players are working to get into unicorns and unicorn-ish companies earlier.
- Return to the discussion of fundamentals: “The private market unicorn is the new IPO. Whether or not valuations make sense, demand for access to this new ‘stage’ of capital is huge & growing.”
- Everyone wants to build their own Silicon Valley.
The piece is essentially an argument that technology companies will continue to attack incumbent interests through rapid-fire innovation, something that the structure of Silicon Valley abets by placing bets.
Large companies that fall behind will be consumed and destroyed, and the upstarts will take up the incumbent mantle and die as well, a cycle or two later, if they fail to buy what’s next before it kills them.
The Unicorn Hedge.
Hedge Back From The Ledge
What’s fascinating about McClure’s post is its hybrid dose of optimism and pessimism.
On one hand, McClure argues that the current startup and private technology company landscape will create hundreds of billions of dollars in value over the next decade. (His use of Facebook’s IPO and pre-IPO cap table make that point.)
But at the same time, McClure isn’t impressed by much else. Current public companies are merely accreted wealth strapped to faltering cash flows, and huge swaths of tech companies that are private or looking to go public are overvalued.
McClure wants to say that the “REAL twist is thousands of public companies hemorrhaging billions in losses and value over the next ten years,” while it also being true that “most unicorns and many tech IPOs are perhaps overvalued.”
It appears that McClure is arguing that future value creation will be largely constrained to small set of unicorns, which has the feel of a winner-takes-all market to it. Can we square all of the above?
Lies, Damned Lies, And Profit-Valuation Multiples
Keep in mind that part of McClure’s argument concerning the impending value destruction at large public companies is predicated on their current price-earnings ratio (PE).
Quoting historical norms, the investor says that “[t]he REAL twist is Wall Street finance getting disrupted by Silicon Valley tech (and, by NYC and LA tech too). The REAL twist is the S&P 500 not realizing their avg P/E multiple should be ~5-10 instead of ~15-25.”
We should not read that sentence as McClure saying that technology companies should trade as low as 5 times profits—current SaaS multiples aside. Instead, I’d guess that McClure thinks that technology companies, with higher average innovation cadences and resulting faster revenue growth, will command a premium.
That’s largely reasonable, but we need to understand that the sort of PE shift that McClure is advocating for will not occur in a vacuum. Instead, it’ll also whack the value of the very companies that he expects to create value in the face of falling multiples for so-called “NON-tech public company dinosaurs.”
For fun, let’s examine Alphabet. Alphabet isn’t afraid of buying things and growing the daylights out of them. Heck, the company isn’t even too worried about dropping a few billion on a major initiative. Alphabet is a Unicorn Hedging machine.
And according to Yahoo Finance, Alphabet has a trailing PE of 29.87, higher than McClure’s decried range. Looking at its forward PE ratio, Alphabet trades a smudge under 20 times earnings. That’s likely still too high for McClure.
At the moment, you are complaining that we are comparing Apples and Exxons. That’s a good observation. However, we are not saying that Alphabet’s PE ratio should be in sync with the Very Boring Companies that will trade for 5 times earnings. Instead, we are saying that the expected premium that Alphabet would have to command to stay as high as it is over the 5-times trailing earnings companies is too vast a ∆ to be reasonable.
And Alphabet pays no dividend, stripping it of yield that other stocks—the same stocks that McClure thinks will either evaporate or dive in value, likely at least temporarily spiking their effective yield—offer. Alphabet could pay a dividend, of course, but that would change the calculus behind its ability to invest in its longer bets, efforts that cost hundreds of millions of dollars in losses each quarter. It’s in-house Unicorn Hedge factory (or whatever you want to call that tortured terminus of the concept).
And Alphabet is a company at risk of the very sort of unicorn attack that McClure warns against. Therefore, it should trade at a valuation discount for that reason as well; not as severe as other incumbent companies given its in-house investments, but one all the same.
That means that Alphabet has to trade at a discount from its valuation today due to McClure’s shifting PE norms, a discount from upper-end ratios due to its size and therefore disruptability, and a final time for having no yield. The first two discounts are top-down, and the last bottom-up, making this all the more fun.
And if Alphabet is due for a correction, then damn, who isn’t?
And that feels like a bubble.
If that got a bit confusing, let’s be simple and sum from both McClure and our own work:
- The stock market is at all-time highs. It will lose some oxygen, compressing multiples for all public companies.
- Adding to that, there are huge companies that will suffer steeper-than-average losses, as technology shops riding secular shifts come at them full-speed.
- There’s lots of slop in private companies; some unicorns will be deleted, some will do ok, some will sell, some will go public.
- Big companies worried about dying are going to buy some unicorns in an attempt to prevent their own demise to those same unicorns.
So expect some more M&A on top of the rest of what you already knew. That’s not very scary, is it?
Disclosure: According to Mattermark, 500 Startups is an investor in Mattermark. As always, Mattermark’s editorial operation operates independently from both internal and external parties.