We live in a world of start-ups. Investors are always chasing the latest holy grail – the newest, hottest enterprise they can bankroll to see an impressive return on investment (ROI). The truth is, investing in start-ups is riskier than ever, thanks primarily to the overvaluation of start-up initial public offerings (IPOs) by investors. Most venture capitalists and investors try to invest in “unicorns” – start-ups they think will become the next Google or Amazon. In the world of venture capitalism, a unicorn is a privately owned start-up with a value of $1 billion or more. At HJR Global, we take pride in making sound investments and we want to see you make sound investments as well. Let’s take a closer look at why those companies are often mythical, just like a unicorn, and they are typically overvalued, making for bad investments that you should avoid.
Unicorns Are Rare For A Reason
In 1994, an entrepreneur named Jeff Bezos started selling books out of his garage in Bellevue, Washington. We don’t need to tell you about how Amazon pioneered e-commerce or why it’s the third most profitable company on earth right now – you already know all that. Amazon is famous among investors for reasons other than its status as an industry titan. Notably, it took until 2009 – 15 years after Bezos founded the company – for Amazon to get out of the red. For many investors, the idea of finding a unicorn, an Amazon of their own, is addictive. It’s also dangerous, encouraging investors to waste money on overvalued start-ups for years simply because they believe the start-up may turn into a cash cow. Start-ups can be a good investment with nurturing and a bit of luck, but smart investors need to do their due diligence. Unfortunately for venture capitalists, outliers like Amazon, Google and Facebook aren’t models the average tech start-up can reproduce. Yet, investors keep looking for the next major tech company. The current saturation of the tech market is a factor too few investors take into account when looking for their next score.
Why You (Probably) won’t find your own Amazon
Unfortunately entrepreneurship in the U.S. has been on a downtrend lately. That shouldn’t surprise anyone – most markets today already have a huge company (the Facebooks, Googles and Microsofts of the world) – lording it over them. If a start-up gets big enough to represent competition for these companies, it usually gets snapped up as an acquisition or the major tech companies will try to clone the user experience to maintain their hold. This essentially strangles competition and ingenuity at the startup level. Start-ups also face a hard uphill battle when they get established, and sadly around half of all start-ups will close their doors within two years. Statistically, here’s what it boils down to: You’re less likely to invest in a unicorn-like Amazon now than ever before. Yet, investors are still pouring money into hot new start-ups they think might become the next Amazon. The result? A systemic overvaluation of IPOs – particularly among tech start-ups. Well over 100 private companies in the U.S. have managed to achieve unicorn status by valuing at $1 billion or more. However, when Stanford Business School Professor Ilya Strebulaev analyzed the “actual value” of 116 unicorns (by applying a model that evaluated contract terms and their impact on valuation), she found something shocking. Fifty-three of the companies lost their unicorn status (in other words, dropped below a value of $1 billion) when she applied her model. Thirteen lost 100% of their value. Valuation of start-ups is often difficult because of the complex structures and different sources of funding start-ups use. Few investors know how to accurately value a start-up, so IPO overvaluation is exceedingly common, particularly in the tech market. As a result, investors often make bad business decisions concerning start-ups they think have potential.
WeWork (Until It Didn’t)
Here is a cautionary tale about over-valued unicorns. Real estate tech start-ups have skyrocketed to popularity in recent years. Airbnb is a notable example. So is WeWork. More accurately, so was WeWork. The office-leasing start-up pioneered by firebrand CEO and co-founder Adam Neumann was valued at $47 billion before it went public. Investors were tripping over themselves to impress WeWork and get a spot on the board. Case in point: a few months before WeWork started filing for its public offer, Neumann met with the heads of the New York Stock Exchange (NYSE) and Nasdaq. Neumann wanted to go public, but, he said, it would help if the NYSE and Nasdaq banned meat and disposable plastic from their cafeterias for environmental reasons. Most would see Neumann’s request as insane. It worked. NYSE President Stacey Cunningham was so desperate to get into Neumann’s good graces that she agreed to ban disposable plastic products such as cups and forks from the NYSE cafeteria (she did, however, refuse to ban meat). Nasdaq went one step further, offering to create an entirely new stock index for eco-friendly companies. Neumann chose Nasdaq. When WeWork filed for public offering, however, disaster struck. The company’s value dropped from $47 billion to $10 billion. Investors were burned. Neumann was let go. After his exit, the company dropped to a valuation of $5 billion. In November 2019, 2,400 WeWork employees were laid off.
How to avoid a bad business investment
Here are some tips that can help you avoid a bad business investment:
- It’s possible to spot bad business investments by looking at the classes of shares issued. Some preferred investors might get most of the profits, while other classes come with limited rights to assets and limited access to financial records. Pay close attention to what kind of shares you’re offered when a company appeals to you for an investment. Having an investment lawyer on retainer isn’t a bad idea – good ones have seen enough start-ups succeed and fail to know when you’re getting the short stick.
- Another common red flag is failure to generate consistent or predictable profits. Uber is an example: The company was valued at $82.4 billion when it went public in May 2019. However, experts have pointed out that most of Uber’s potential revenue streams are dead ends that will eventually stagnate or disappear. In other words, despite a high value, the company is engaging in unsustainable business practices that will eventually see its IPO tank unless changes are made. You need to look behind the scenes at more than just valuations when deciding to invest in a company.
- Additionally, trying to find the actual value of start-ups using different methods can help you avoid bad investments. A valuation can account for nuance by looking at price-to-earnings (P/E), price-to-sales (P/S), price-to-dividend (P/D) and enterprise value-to-sales (EV/S) ratios. Here’s what that looks like:
- P/E ratios relate share prices to earnings per share. High P/E ratios indicate an overvalued start-up.
- P/S ratios are calculated by dividing a company’s current stock price by sales per share. Low P/S ratios indicate cheap stocks and vice versa. A P/S ratio can reveal whether a company is overvaluing its stock or not.
- P/D ratios are determined by dividing the dividend per share by the price per share. P/D is also commonly referred to as “dividend yield.” P/D ratios measure how much return investors get on each dollar invested in a company. Looking at P/D ratios can help you see whether you’ll profit from an investment or not.
- EV/S ratios are calculated by adding the market cap to total debt and subtracting cash and cash equivalents. Using these ratios can help you determine whether a company’s sales are low for its valuation, pointing to inflation of value. Many experts consider EV/S a superior method compared to P/S or P/E.
When you’re approached by a company or contemplating an investment, start by calculating the EV/S ratio for the company in question. Then, calculate P/E and P/S ratios to determine how accurate your EV/S ratio calculation is. If all these measures point to an overvalued company, hold off on your investment or discuss it with the company’s leaders.
If you’re a business owner who wants to retain profits while growing and avoid overvaluing your enterprise, we can help. HJR Global specializes in helping businesses achieve long-term success without compromising short-term gains. To learn more, contact us now.