You were warned – beware of those profitless Unicorns

You were warned – beware of those profitless Unicorns

As regular readers know, we’re not great fans of profitless ‘Unicorns’ – the name given to startups valued at over $1 billion – like Tesla, Slack, Uber, Peloton, Lyft and WeWork. For a long time we’ve been hyper-critical of these companies in our blogs, The Australian, Professional Planner and Money Magazine. And, as that latest from WeWork reveals, boy have our concerns been justified!

With a convincing pitch and a compelling vision, the path to success was scale and market dominance. But an assumption was also that when they ‘arrived’ there would be no competition, no copycats that would fragment the market and reduce the total addressable market. To achieve their ambitions they sold $100 notes for $50, sending many established players out of business.

Of course, ‘loss-leading’ and losing billions has proven to be one way to achieve household name status and investors, allergic to low-yielding term deposits, have been more than willing to fund the dream. But for the dream to become a reality, these enterprises need to convert revenue to profits and positive margins require the ability to reduce costs, raises prices or both.

And that’s where competition becomes an issue. The ability to raise prices can be thwarted by competition. Meanwhile costs are difficult to cut when market share needs to be maintained in order to sustain the hope that one day prices might be raised to generate positive margins. The belief therefore, that simply throwing money at a disrupter was sure to cause them to both disrupt and magically generate positive margins, is potentially misguided.

Our specific warning has been that if funding dries up or if interest rates rise, investors might be less altruistic and less willing to continue funding loss-making ventures no matter how big. Who would risk investing in a start-up without any prospect of making a profit for ten years, if term deposits were earning five or six per cent? And even if rates stay at or close to zero might investors patience and willingness to fund losses wear thin?

Finally, when looming equity escrow periods end, early investors and employees will hammer the stocks through their rapid exit. Uber’s lockup for example expires 6 November 2019.

If these Unicorns crash thousands of employees could be sent to unemployment lines and millions of investors may run towards the arms of class action lawyers, ensuring a decade of work sorting out the mess.

Of all of the Unicorns, however, it was WeWork that exemplified the euphoria surrounding startups.

Variously referred to as ‘WeWTF’ and ‘WeAreAlmostOutOfMoney’, WeWork, which most recently received private funding at a US$47bn ‘valuation’ and lost $1.9 billion last year, has been heading for bankruptcy unless it could obtain desperately needed funding. According to CNBC, ‘WeDoesNotWork’ was on track to run out of cash by mid-November and reports suggested there were only two candidates who wanted throw WeWork a lifeline.

The two alleged supporters were Japanese-based SoftBank and JPMorgan Chase (led by CEO Jamie Dimon, whom the former WeWork CEO and founder described as his personal banker).

In the end it was Softbank, its largest investor, who arguably put good money after bad with a financial rescue package that has also ended the reign of co-founder Adam Neumann.  But don’t cry for him, he’s reported to be receiving US$1.7bn to leave.

As may prove to soon be the case for all Unicorns, the rescue package is at a valuation of US$8bn – 82 per cent lower than the last private funding round.

Michael Mauboussin has noted; “Normal markets consist of pessimists, neutral people and optimists, who can take either side of a trade so the price can settle to some kind of equilibrium, but that’s not the case in a private market, where it’s difficult to sell and pessimists can’t easily express a view.”

And as we have warned will happen many times, it is now being reported that up to 5,000 WeWorkers could lose their jobs.

Elsewhere, Bloomberg is reporting a possible private market valuation of less than US$8 billion. If SoftBank invests another US$5 billion they will have invested more than $15 billion in a company with a valuation of possibly less than half. And it’s not making money.

Finally, let’s chat briefly about Airbnb. At its most recent VC-funding round last year, the gig-holiday-rental company was valued at US$31 billion. And having reported a US$19 million profit last year, many thought it had turned the corner from being profitless to profitable.

Alas, it takes more than a disruptive idea to become a profitable business. This week digital media website The Information reported that Airbnb posted an operating loss of $306 million during 1Q, more than doubling its losses from 1Q 2018.

The loss was largely attributed to the US$367 million spent on sales and marketing.  Presumably, if you are the only player you don’t need a whole lot of sales and marketing.  Remember, many of the Unicorn valuations are based on the assumption that by the time they grow large they’ll have the market to themselves. This assumption has proven to be misguided and across many sectors Unicorns are finding, thanks to low barriers to entry, they are competing with many other unicorns and wannabe unicorns willing to lose money to gain share.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.