Do you believe in unicorns? - Common pitfalls for investors valuing start-ups

15 October 2019

Once a rare phenomenon, unicorns - privately-owned startup companies valued at US$1bn or more - are now a common sight. In the US alone there are over 150 of them galloping towards an IPO. In Europe, the UK leads the way with 72 – including 13 created in the past year.

Many of these unicorns present outstanding investment opportunities, including for mid-size companies eager to fast-track their own digital journeys. But these investments are always complex and often risky.

Why? In an era where technology change is constantly accelerating, companies simply can’t afford to get left behind. But amid the race to act ahead of the competition (often with limited insight), it’s hard to pinpoint the smartest investments in the unicorn (and startup) herd – and pay the right price for them.

As a result, many acquirors and investors are risking big investment dollars. While some unicorns will more than justify their current valuations, achieving unicorn status is not always grounded in hard evidence. Headlines and hype are one thing. But to be reliable, valuations must be based on solid analysis and experienced judgement.

That’s why the unicorn stage should be seen as a milestone on the valuation journey, not an end in itself. To ensure valuations are robust, investors must assess thoroughly where the company is now, where it wants to be, and the risks associated with getting there.

Three valuation pitfalls to watch out for

From our experience of valuing numerous tech start-ups across the world, there are three common dangers that arise at various points in the journey:

1. Misunderstanding past benchmarks

Unicorn valuations are usually based on whatever price the latest investor paid to buy into the company: investor X buys 10% for US$100m, so the business is worth $1bn. But while past funding rounds provide the easiest benchmark, this simplistic approach can lead to unrealistic value expectations.

This is because share classes are more complex than they appear. Different tranches of shares in an early-stage business’s capital structure have different rights attached, giving some investors greater downside protection. Concentration of voting power may raise concerns over governance and dependence upon a “visionary” leader. So grossing up investment in a particular share class to 100% of the business can be misleading and is often wrong.

Benchmarks may also be out of date. At earlier stages of development, many investors rely too heavily on wider market movements rather than on the milestones achieved since the last financing round. Are management really delivering against their objectives?

2. Attaching value to buzzwords

With spectacular valuations of over 10x revenues achieved in recent tech deals, companies sometimes overplay their tech credentials to get access to the higher multiples associated with IoT, AI, machine learning etc. But while management may be passionate about their company’s potential, revenue multiples must be underpinned by fundamentals – not by the latest buzzword.

3. Overhyping the future

Too much reliance is often placed on a single forecast case that isn’t risk adjusted. The market opportunity implied seems limitless; KPIs demonstrating hyper-growth may not drive value if the business model is not sound. Given the 80-90% failure rate for tech start-ups – and less than 1% probability of creating a unicorn – this can lead to management anchoring on an unrealistic valuation. Investors must look at a wider range of scenarios with differing outcomes.

Three lenses to deal with these issues

  1. The past: Challenge your understanding of the business’s capital structure, investigate the rights of each share class, treat fundraising rounds like complex options rather than simple benchmarks, and focus on the milestones achieved since the last investment round.
  2. The present: Compare targets against peers on more specific KPIs, and focus valuations on genuine prospects and fundamental value-drivers rather than corporate branding.
  3. The future: Challenge whether the forecasts you’ve seen really reflect the risk in the business. Do they take account of start-up failure rates? Risk-adjust your forecasts or create multiple cases and weight them for probability.

Tech’s role as a powerful disruptor is indisputable. Companies have no alternative but to embrace it. Unicorns are, on the face of it, some of the most successful disruptors in the market. However, there’s a real concern that some investors and acquirors are buying into early stage businesses without taking the nuances of tech investment into account. Having advised on hundreds of deals in this space, we know how to identify the value-drivers and avoid the pitfalls. To find out more, get in touch…

Simon Harris

Simon Harris | Technology, Media & Telecommunications Director, PwC United Kingdom
Profile | Email | +44 (0)7841 490474

Ralph Dodd | Senior Manager, Valuations, PwC United Kingdom
Profile | Email | +44 (0)20 7213 2413

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