Tech Investors And “The Winner’s Curse”

Private investors offer many tech start-ups huge valuations and lose money when the company goes public. It’s the so-called ‘winner’s curse’.

Unicorns are a weird new concept in the world of investing: private companies worth more than a billion dollars.

They tend to be sexy tech companies. And they appear from nowhere seemingly overnight. I wrote about them before in Penny Sleuth (RIP).

Last week I sat down with Dan Denning on the Capital & Conflict podcast to talk about unicorns, technology, and the “winners curse” which afflicts lots of investors in these companies. You can hear the whole thing at this link – what follows is a short excerpt.

Live from the Capital & Conflict studio

Dan Denning: But you sent me an article today which I read, and I can’t remember who it was by. Who was it by, you remember?

Sean Keyes: Oh, that was by Ben Thompson, he runs a site called Stratechery.

DD: It was a really interesting article and you can go and read it if you want.

But he talked about Facebook, Apple and Amazon. He made the observation that these companies… which were all, by the way, start-up companies, you know, very small companies at one point. He said that they’re companies that are built on software but they’re differentiated by something that complements that software.

So in Facebook’s case it aggregates this large audience for advertisers. And in Amazon’s case it utilises this world class logistics network. And then Apple, you have to buy their devices, you know, their devices are integrated.

This is an interesting point for investors. You’ve got to keep in mind whether or not we’re at you know, the year 2000 peak in tech stocks, or whether this is a different situation.

Because I… I read this article in the FT which I mentioned at the top of the show. It said that the IPO valuations for a lot of Silicon Valley companies are getting revised. One of them is Square which is a payment technology company. It had a valuation of $6 billion dollars in October of 2014, and now that the company has floated on the market that value has gone down.

Then you’ve got Uber, at $50 billion, Airbnb at $24 billion, Snapchat at $15 billion. The FT article says these numbers have become a symbol of the outsize ambition of this generation of start-ups. So it’s a, kind of, warning that this could be a peak. Any concern for you that people are interested in this stuff now, and it’s indicative of what happened in 2000?

People are paying a lot of money for companies that don’t really have a lot of earnings yet.

SK: Right, well, there’s a couple of things to say about it.

The first is the valuations of a lot of companies that you’re referring to are private valuations. In other words, private financiers are going to these companies and offering them tons of cash for a slice of their equity.

And that’s how they’re working out that Uber is worth $50 billion: because some private financier bought a slice of the company that values the overall company at $50 billion. But $50bn is not equivalent to the market price of a public company.

So the difference between now and then is that in the year 2000 there wasn’t this giant market of private capital for young start-up companies. Basically when Amazon needed to get some funding to grow, it had to go straight to the public markets and it floated at… I don’t know how much, but it would have been quite a small valuation like $100 million, or thereabouts.

Now, you’ve got 70, 80, 90 companies worth over a billion dollars which haven’t yet floated on the public markets. Some of them are huge – Uber’s the size of Toyota!

DD: How is that possible though? I mean I’m a big subscriber to the idea that, if it’s a transaction between two willing parties, that’s the price, right?

But when you look at that, does that… does that… Toyota makes cars, they sell cars all over the world, they’ve been doing it for years; there’s just decades of embedded IP and technology in their manufacturing process.

SK: Well the bull case for Uber is that, you know, ride sharing, there’s a lot of margin in it. Which there isn’t in cars.

And if Uber can get there first… that’s why Uber is raising all this capital and expanding in places like India and China and all over the world so aggressively. Because it thinks that if it can get there first, and if it can embed itself, worldwide as the go-to transportation company, then that will create a network, then they’ll just own that market forever. And they’ll get to keep their huge margins.

Okay, that’s the bull case. But the bear case… if Uber was valued at 50 billion on the public markets it would be a very different thing to being valued as it is by private investors.

There’s something in microeconomics called the winner’s curse. The winner’s curse happens when you have an auction for an asset of uncertain value. In those circumstances, the winner of the auction will tend to overpay because they’ll be the ones most willing to push and push their bidding. And by necessity the one who wins is the one who is willing offer the best terms or pay the most.

That could be what you’re seeing with a lot of these private tech companies which are being offered these huge valuations.

Now, if this were in the public markets you wouldn’t see that same dynamic where there’s, kind of, an auction for the capital. So that’s another thing to say about it. It’s almost certain that a lot of the investors who put money into these private companies are going to lose money.

But that’s fine. That doesn’t mean ordinary investors should be worried. It doesn’t mean that the tech industry or these start-ups are in any way sick. It just means that some financiers, not all of them, will have overpaid. End of story!

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