The Death of Manufactured Unicorns?

Jeremy G. Philips, a partner at Spark Capital, wrote an op-ed for the New York Times, The Rise and Fall of the Unicorn:

For a moment, there was no more prestigious endorsement for a technology start-up than joining the so-called Unicorn Club, consisting of more than 150 private technology companies valued at a billion dollars or more. Now, with valuations deflating, it’s often viewed as more of a scarlet letter.

However, because the only membership criterion is valuation, the members of this club have about as much in common with each other as a gram of gold has with a barrel of oil.

Some private market valuations got ahead of themselves, requiring adjustment. But that’s hardly remarkable; this happens frequently in public markets, too. The issue is that many unicorns are not sustainable; they have a shiny veneer of revenue growth, without a sufficiently durable competitive advantage to create substantial, long-term value.

The rise of the unicorns was fed by an almost universally accepted theory that, as the commentator Om Malik recently wrote, “Most competition in Silicon Valley now heads toward there being one monopolistic winner.” Because “winner take all” markets tend to be highly profitable, this idea stoked investor enthusiasm to find leaders in any category, leading to a multibillion-dollar experiment to treat valuation as largely a function of growth, irrespective of business economics and market structure.

Several well-known Internet companies, particularly the so-called FANG stocks — Facebook, Amazon, Netflix and Google, now a unit of Alphabet — have built powerful positions. The market recognized this by adding more than $250 billion in market cap to this group over the last 12 months — even while the broader market was down more than 10 percent.

The huge success of the FANG stocks, however, distracts from the reality that the web has ground down the barriers to entry in many technology markets, increasing transparency and competition. For new entrants, lower barriers create opportunity. But they create the same chance for scores of other start-ups, too, making it challenging to build a durable advantage.

Just when a firm seems to be getting a dominant foothold, a plethora of start-ups emerge to erode its advantage. Less than a year ago, GrubHub had a market cap of more than $4 billion and seemed to be on the way to a powerful monopoly in food delivery. But myriad start-ups, backed by billions of dollars, have been competing for its market. Investors no longer see GrubHub as a putative monopoly. Accordingly, its stock is down more than 60 percent over the last year.

There are limited sources of genuine competitive advantage in Silicon Valley, as with other businesses. Most significant are economies of scale. McDonald’s buys ingredients more cheaply than a stand-alone burger joint, and its marketing costs are spread across tens of millions of customers.

For technology companies, the holy grail is a specially durable subset of scale advantage: network effects, virtually unknown in the rest of the economy. The most potent flavor is on the consumer side, where a service’s utility increases as more people use it. That creates a powerful barrier: If one’s friends and family are all on Facebook, an alternative social network, even with superior features, is unlikely to be tempting — which is why Facebook has more than 1.5 billion users each month, and rising. A Big Mac, in contrast, does not taste any better even with millions of simultaneous consumers.

In Silicon Valley, virtually every pitch deck claims network effects — but they are rarely spotted in the wild. The largest on-demand home cleaning service in any locale may have a cost and speed advantage versus competitors, which helps attract more consumers and more cleaning people.

But this virtuous cycle, despite the common misconception, is just a garden variety impact of local scale — not network effects. A large customer base does not make any service even a smidgen more valuable to someone getting their home cleaned. For a small discount, customers will happily try an alternative cleaning service, on-demand car valet or flash sale. Monopolies in these categories, like most others, are unlikely. In contrast, it’s unclear what — if anything — it would take to pry Snapchat out of a teenager’s hands — but it sure wouldn’t be a cheap coupon.

It’s not just start-ups that find it hard to build a monopoly. Even in the rarefied air of the FANG stocks, monopolies are hard to come by.

Amazon is a powerhouse with substantial scale advantages — its latest quarterly revenue was $36 billion, and it has increasing customer loyalty, including more than 50 million paying Prime subscribers. But Amazon is far from a monopoly. In retail, beyond a few narrow categories where it dominates (notably: books), Amazon is a leading player in intensely competitive markets. In cloud computing, its innovative Amazon Web Services is the leading player serving start-up customers and is making inroads with enterprises. But it does not have the cloud to itself. It is locked in ferocious competition with Microsoft, Google and several others. Unsurprisingly, in the decade since its debut, the service has cut prices more than 50 times.

Similarly, Netflix is the leading subscription video distributor. It has more than 75 million subscribers and is producing hundreds of hours of original content. Netflix has scale advantages and strong customer captivity, but zero network effects; it does not become more entertaining with more subscribers. It is well placed to create enormous value as a long-term leader in this market but is far from a monopoly. It’s too late for start-ups to enter the fray, but there are already formidable competitors, such as HBO and Amazon, driving up content acquisition costs and keeping a lid on consumer prices. Netflix is already on track to spend more than $5 billion on content this year — more than half its forecast revenue. And other deep-pocketed players, such as YouTube and Apple, have adjacent businesses that are strong enough to be potentially serious future players as well.

That Silicon Valley is not all bulletproof billion-dollar companies and “winner take all” markets is no cause for gloom. The current environment is a reminder of the primacy of business economics and market structure. At least for the moment, investors will revert to saving billion-dollar valuations for exceptionally defensible, growing businesses. That closes the chapter on the ill-fated unicorn experiment, which valued growth at any cost. Hopefully, it also spells the end of the term itself — which predictably turned out to be as useless a descriptor on the way down as it was on the way up.

I've already covered the subprime unicorn boom in tech, but I've been keeping a close eye on these developments as something is going on in Silicon Valley and it's a cause for concern.

Kostadis Roussos, a friend and tech expert living out there, wrote an interesting blog comment recently on Manufactured Unicorns:

A friend of mine and I have been debating unicorns for months. And what we concluded is that there are two stories.

The first story is that there are a bunch of excellent businesses that are worth billions. These are the true unicorns. I won’t hazard a guess of how many or which companies fit that bill.

The second story is that there are a bunch of donkeys with horns that are using creative deal structures to acquire valuations that are questionable. And that the story of the true unicorns is hiding the story of the donkeys.

The recent article on TechCrunch tells us that the number of potential donkeys is on the rise.

And so my buddy and I debated the impact of these potentially faux-Unicorns.

The first narrative, dominating the press, is the effect of faux-Unicorns on investors. After a lot of discussions, we concluded that the recent faux-Unicorn phenomenon of artificially constructed valuations is benign to positive. Positive because it mitigates the downside risk, and because it captures more of the upside if an acquisition occurs at the cost of investing more capital in a business that has achieved a certain amount of success.

If you take a unicorn job in 2015 and never say the words “liquidation preferences”, you are the sucker at the table https://t.co/cbh3lPRA9a

— Alex Stamos (@alexstamos) December 24, 2015

The second narrative that is emerging is the impact of faux-Unicorns on employees. There we agreed that the story is downright appalling. The shift of risk from investors to employees who find themselves locked in, or worse, have their interests misaligned with the core investors, or even worse is not positive.

The derisking for investors and founders is increasing the risk of employees.

And so what?

The danger is that employees eventually figure this out. And they start demanding higher salaries, longer periods between when they quit and when they have to sell their shares or just plain refuse to work for any company that is not publicly traded.

Furthermore, as more employees figure out that a Unicorn or a startup is not a path to riches, and that the investment strategies are being used that minimize their already minimal chances of wealth, people will over the long-term lose interest in working at startups.

And worse, because employees are not investors they have a hard time deciphering faux-Unicorns from real Unicorns.

If a startup is a job where you work long hours, at low pay, to change the world, there are a lot of options that are not working in tech.

We can talk about culture, and opportunity and learning and if there is no money, then people will go elsewhere.

The people who work in the tech sector have the ability to do anything they want. And eventually, they figure that out.

Kostadis followed up this comment with another one, How demand creates valuations:

Great post here by Mark Suster at Bothsides

Lots of good stuff here.

My key takeaway is here:

The vast majority of this recent boom in prices is not being driven by VCs but rather by hedge funds, mutual funds, corporate investors and other sources of non-traditional venture funding. In the chart below you can see that a decade ago for every dollar a VC raised from LPs a dollar went into a startup. Now for every dollar a VC raises $2.50 goes into a startup.

Many moons ago, I wondered where the hell the money was originating. Mostly non-VC money chasing yield has descended on the valley. And like the subprime mortgage crisis, the non-VC money figured out that using preferential terms allowed them to invest in riskier assets with less risk.

Shifting risk, and increasing the value of assets without increasing their value never ends well.

Why are these comments interesting? Because they highlight what more and more people out in Silicon Valley are quickly realizing, namely, that many startups are pipe dreams, donkeys with horns fueled by yield chasers who don't really know what they're investing in.

And the few startups that are home-runs, the payoffs are completely skewed to the founders and VCs/ hedge funds/ PE funds that are backing them up to the point where employees are now rightfully asking themselves if it's even worth working at a startup.

And this will have profound long-term implications for the U.S. technology sector which has been the engine of growth and rising productivity. It will also favor established technology companies (Cisco, Microsoft, Amazon, Google, etc.) which actually pay employees properly as they will be able to recruit more and more people looking for a safe, secure income, not chasing a pipe dream which will likely never pan out.

The cycle is turning out in Silicon Valley. You already see this in the high-end real estate market in San Franscisco which is cooling.  People are scared and they're more hesitant to buy expensive homes (also realize that the tech boom doesn't last forever so they need to prepare for downturns and stop spending like drunken sailors!).

[Interestingly, the Caisse's Ivanhoe Cambridge, the largest foreign investor in U.S. commercial real estate last year, bought 16 San Francisco apartment buildings for about $200 million, adding to its business there with partner Veritas Investments.]

Also, Venky Ganesan, Managing Director of Menlo Ventures, looks at the state of venture capital in tech right now and the lack of IPOs. This is an interesting discussion worth listening to.

Lastly, Rocket Lawyer CEO Charley Moore discusses how to survive another bubble bursting. "There were a number of companies at the turn of the century that really had very immature business models, they really hadn't demonstrated they were solving a big problem, that they were good stewards of capital," he says. 

As this comment discusses, the problem is a lot deeper than this. There are many manufactured unicorns selling pipe dreams to their employees and as the latter figure this out, and also realize the asymmetric and grossly distorted payoff of these startups is insanely skewed to favor founders and funds backing them up, they will bolt in search for a more secure source of income at traditional tech companies.

And that has serious implications for the entire startup culture and it will not only lead to the death of manufactured unicorns, it will ultimately lead to the death of Silicon Valley as we know it.