Monday, April 13, 2015

Killing Unicorns--Putting Sky-High Startup Valuations Into Perspective

photo credit: Unicorn Silly Bandz Unicorn Macros
July 09, 20102
via photopin (license)
We have all seen statements such as "Uber is worth four times more than Hertz, and it doesn't own a single car." While there is a kernel of truth to this statement--Uber's latest round valued the company at $40B while Hertz's current market capitalization is $10B--the difference between startup valuations (so-called "unicorns" with valuations of $1 billion or more) and publicly held companies' market capitalization is so profound that the two are hardly comparable. Understanding the distinction is vital if we want to cut through hype, understand risk and assess the market changes underway.

It Is Important To Put The Hype Into Proper Perspective

To be clear, I am a big fan of digital, mobile, Internet of Things (IoT), big data and collaborative economy opportunities, and I believe they will continue to grow and challenge traditional forms of business. That does not mean, however, that I believe every startup will win or that VC valuation decisions are a valid yardstick for comparing financial worth between VC-funded firms and public corporations.

While the hype around new these nascent businesses can benefit established firms by forcing them to take notice, it can also hurt by setting unrealistic expectations. Back in the dot-com era, established companies were spooked by all the e-commerce hype and leapt without considering the hard work and long road ahead.

In the late 90s, the buzz about Silicon Valley valuations and the focus on gaining new users rather than revenue models created an environment for silly decisions. Acting fast was more important than devising the right strategy; having a website was the goal rather than retooling the organization for a digital world; and patience was in short supply. When companies' new ecommerce programs did not instantly deliver profits, many companies diminished investment in digital efforts, only to reinvest years later to match growing consumer demands and competitive threats. Some firms even opted out of the ecommerce race altogether--Borders sealed its fate when the company got frustrated with dot-com losses and turned over its soon-to-be-vital online business to Amazon.

Valuation hype encourages short-term rather than strategic thinking. How can it not as headlines continue to trumpet Uber's rise from $60 million in 2011 to $300 million later in 2011 to $3.5 billion in 2013 to $17 billion early in 2014 to $41 billion before the end of 2014? That means from February 2011 to December 2014, Uber increased its valuation by almost $30 million per day. There's gold in them thar hills, and just like every other gold rush, there will be more losers than winners.

This is why a more sober view of IoT, big data, mobile and sharing economy opportunities would be beneficial. Established companies need to be less impressed with billion-dollar valuations and more concerned with consumers' changing habits around media consumption, mobile adoption, wearables and collaborative consumption. While Uber's, Slack's, Snapchat's and Sprinklr's $1 billion+ valuations make it seem the brass ring can be snagged on the next turn of the merry-go-round, the fact is that real, defensible, consistent success will require years of hard work for these companies--and yours.

Startup Valuations And Corporate Market Caps Are Fundamentally Different

Both startup valuations and publicly held companies' market capitalizations begin with a dollar sign. Beyond that, the two have little in common.

Market cap is set by millions of investors buying and selling shares in an open market based on information the company publishes adhering to stringent SEC rules that ensure a fair marketplace. You can find a company's market cap on any finance site (Apple's is $740 billion), or you may easily compute it yourself using public data (Apple's share price of $127.10 multiplied by its 5.82 billion shares outstanding).

Startup valuations are set by a much different process--secret backroom deals between a very small number of parties. The company and its VC partners do not make their negotiations, financial information or terms of the deal public. In fact, even the valuations themselves are not really part of public record but instead are announced (or not) by the parties involved.

The differences between the two are evident:
  • Value determination: Market caps are set by a vigorous marketplace that is as close to an economically "perfect market" as exists on the planet. On an average day, investors buy and sell 48.5 million shares of Apple stock, and this is the mechanism that determines the corporation's value (or market cap). Startup valuations are set behind closed doors based on the evaluations of a small number of deep-pocket venture capitalists, and unlike liquid shares of stock, once the funding round is complete, startup investors have limited and complicated ways in which to divest themselves of their investment.
  • Available information: You and I may come to a different decision as to the future opportunities for a publicly held corporation, but by law, we both must have access to the same information disseminated by the company. Thanks to SEC filings and annual reports, we can see the same detailed information about company performance, from revenue to profit/loss and even management's assessment of potential risks. For example, in Facebook's recent 10-K filing, it acknowledges, "We believe that some of our users, particularly our younger users, are aware of and actively engaging with other products and services similar to, or as a substitute for, Facebook." Compare that to what we know of Airbnb's and Uber's performance, growth, risks and management assessment (which is, essentially, nothing).
  • Performance history: Another obvious difference is that publicly held companies generally have well-established business models that demonstrate a track record. By comparison, the business models of startups are new, untested and evolving rapidly. We know Uber for its ride-sharing service, but the company is also testing new ideas like UberRush, a package delivery service, and UberFresh, a Seamless competitor for food delivery. Whether these two services catch on and produce profits is uncertain, but it is apparent Uber is still figuring out its business model.
  • Known versus unknown risks: Along with more performance history comes a strong sense of the known risks faced by publicly held companies. While established companies face new laws and lawsuits every day, leaders and shareholders understand the type of legal risks the company faces. In comparison, the risks inherent with startups like Uber and Airbnb are poorly understood and rapidly developing. From labor laws to legal liability to taxation to compliance with state and local regulation, the future profitability and growth of these startups is less certain due to the unknown risks.
  • Special deals: The final reason public corporations' market caps are profoundly different than startup valuations is that VC firms don't invest millions (or hundreds of millions) without negotiating special conditions to protect their interests. According to Bloomberg, startups offer incentives for big-number late-round investments, such as guarantees that the VCs will get their money back first if the company sells or will earn additional free shares if a subsequent round's valuation is less favorable. By contrast, an individual shareholder in a corporation cannot ask for special consideration outside of rare special circumstances, such as when one accumulates a significant portion of shares (Carl Icahn forced Ebay to consider splitting Paypal from the rest of the company) or bands together with other activist shareholders (such as when the Humane Society attempts to force a change in Kraft policies by engaging shareholders via SEC filing.) 

Bombs Versus Screen Passes--The Risk/Reward Continuum

The mechanisms, information, marketplace and bargaining power of parties is profoundly different for the funding rounds that determine startup valuations than for the stock market that determines corporations' market caps, but it all comes down to one thing: Risk.

Headlines about startup valuations promote just one concept--value--while ignoring the other equally important attribute that drives all investing and pricing decisions--risk. To simply compare the (supposed) value of two wildly different organizations (or any dissimilar assets) without also considering questions of risk makes the two dollar amounts seem equivalent, but they are far from it.

To draw an analogy from the world of football, the average screen pass earns a little over 5 yards per attempt while a "bomb" pass attempt delivers an average 12-yard gain. Given this data point, why do teams ever run or throw for short yardage when each deep pass averages a first down? The answer, of course, is risk--a long pass is a low percentage play, so even though the average completion delivers over 50 yards for the offense, fewer than one in four passes of 40 yards or more are completed. By comparison, the completion rate for screen passes is 79%.

Football coaches do not assess the relative value of one play over another based solely on average yardage. This is why teams tend to stick to higher percentage and safer short plays most of the time, turning to the more risky, lower-percentage plays when they trail late in the game.

In the same way, venture capital firms are in the business of making lower-percentage, high-risk investments with the hope that, across a wide portfolio of similar long-shot investments, a few will pay off handsomely, even though most will fail. In fact, just like deep passes in football, three out of four startups fail. Meanwhile, like a screen pass, an investment in a NYSE listed stock may not yield spectacular gains, but it is not likely to fail outright, either.

The Unicorn Population Explosion And What's Ahead

In times when money is cheap, a great deal of cash gets invested into innovative startups, elevating valuations and making headlines. Once money gets tighter, as it inevitably does, many of those startups suffer.

We saw this back in the dot-com era, when firms like Webvan were briefly valued at over $1 billion--what we today label a "unicorn"--before going under within a year. They were hardly made a splashy IPO in 1999 and liquidated just 268 days later, and eighteen months after eToys was valued at more than $8 billion, KB Toys bought its intellectual assets for just $3.4 million. Even the companies we know today as successes took an enormous hit when the dot-com bubble burst--Amazon lost more than 80% of its market cap from 1999 to 2001 and required six more years to return to its pre-crash value.

Today, cheap money is again flowing into startups. Business Insides notes that, "The use of the term 'unicorn' began with a blog from investor Aileen Lee of Cowboy Ventures in late 2013, when there were just 39 of the creatures and an average of four 'born' each year. The number created in 2014 rose to 38, according to CB Ventures."

Some say today's VC investments are different from those during the dot-com hysteria; that today's valuations are more justified and less risky. There may be some evidence they are correct. Collaborative startups such as Uber and Airbnb have business models (and probably even net income) in a way that many of the startups in 1999 did not. Still, other unicorns have a long way to go--Snapchat's last funding round valued the company at $15 billion (a 50% increase from nine months earlier) despite the fact the company was rumored to have virtually no revenue (much less profit) prior to launching its untested advertising program this year.

While established firms worry about competition from the startups, the startups themselves also have some unique competitive threats. Many folks who watch the collaborative economy space love to crow how the collaborative economy firms have established huge valuations despite owning virtually no assets. They are correct--Airbnb owns no rooms yet soon will rent more rooms than the world's largest hotel chains, and Uber owns no cars and is about to overtake taxis, limos and airport shuttles in the expense accounts of American business travelers--but this may be as much a problem as a benefit. Owning few assets allows for incredible leverage of cash, but it also means that barriers to entry and customer switching costs are incredibly low, as well.

Airbnb and Uber excel at providing a terrific customer experience, so neither is in imminent danger from competitors, but we should not forget that Myspace was once praised in the same way as today's collaborative startups. Insiders used to point out Myspace created and paid for no media, unlike the NY Times or NBC. Just like today's collaborative startups, Myspace enjoyed extreme leverage on its assets because consumers created content for each other at no cost to Myspace, and just like today's startups, Myspace owned nothing and had low barriers to entry, so it could not stem the loss of users once Facebook attracted critical mass.

It is hard to imagine the same thing happening to Airbnb or Uber, but then it was impossible to foresee that Myspace would crash when, in 2006, it surpassed Google as the most visited website in the United States. In fact, compared to the challenges of creating a profile and moving your entire social graph from Myspace to Facebook, the ease of installing a new app on your phone to order a car or reserve a room seems like child's play.

Social Media stocks vs. NASDAQ, YTD
So what is ahead for these startups? Silicon Valley analysts are voicing concern, and we have already seen some newer firms stumble. As recently as 2013, Fab was valued at nearly $1 billion, but in March, the remains of Fab were acquired for just $15 million. Meanwhile, I have been tracking the performance of a dozen US social media stocks that are post-IPO, and in 2014 they under-performed the market. Thus far in 2015, that trend has continued--NASDAQ is up 5.7% as of April 11 while a portfolio of social stocks (including Facebook, Twitter, Marketo, Jive, LinkedIn, Zynga, HomeAway and Groupon) is up just 0.5%.

Becoming A Unicorn Is Not A Reward--It's A Challenge

We would all be better off if we viewed billion-dollar valuations not as accomplishments but as challenges. Having a VC with an appetite for high risk assess your company at $1 billion is one thing, but it is quite another to reach a future state where that valuation is justified in a transparent and open market based on mature and recurring profitability.

Today, growth, opportunity, optimism and high risk propensity are driving startups' valuations, but in a few years--after the VCs claim their return and the firms go public--these companies' values will be determined more by stable business models as measured by revenue and net income. For Uber to justify its $40B valuation, it must someday deliver a stable or growing bottom line of between $1 billion and $2 billion.

If we all kept startup valuations in the right perspective, it would help us to appreciate the hard work ahead, both for firms like Uber and Airbnb, but also for our own companies. Ecommerce hype elevated startup values in the dot-com era and caused many companies to act out of panic, yet it has taken 15 long years for ecommerce to account for just 7% of total US retail sales.

Just as Kodak, Borders, Circuit City and others lost out by not acting quickly enough, your firm needs to establish its strategy in mobile, IoT, big data and collaborative economy business models sooner rather than later. But be careful not to buy into the hype so much that you think acting fast will deliver rapid bottom-line results. The future is here, but it will not drive your business results for many years.

Wednesday, April 1, 2015

Why Meerkat and Periscope Will Not Change the World

Even before SXSW, you could tell which new app would be heralded as the "hot new thing" at this year's conference. Meerkat launched at exactly the right time (March) and had exactly the right appeal ("I'm doing something interesting right now that you must see!") to create a wave of rapid adoption in Austin, but whether the live-streaming video service can convert that buzz into real-world success is far from certain. A careful evaluation of the opportunities and challenges faced by Meerkat and other real-time video broadcasting services, including Twitter's Periscope, suggests a rockier future than many are predicting.
As has happened for most "hot apps" to rise out of SXSW over the past decade (see Quora, Google+, Foursquare, Hashable, GroupMe, Beluga, Sonar, Highlight, etc.), many bloggers have been (too) quick to announce the many ways Meerkat and Periscope are destined to change marketing, social media and the world. As someone who has worked in digital innovation for 20 years, it is exhausting to see how quickly people jump from one new bandwagon to the next, desperate to be the first to anoint each the "next big thing"--a habit that says much more about their need for attention than it does about the technology.
Even in the midst of SXSW, when the buzz was white hot and Meerkat was ranked near the top 100 iOS apps, I had serious doubts about its future. I expressed them on Twitter and found myself in an argument with a couple of early Meerkatters who clearly thought they were destined become the PewDiePie of this new platform. That dialog hardly encouraged me to change my opinion. It came as no surprise to learn that Meerkat is already sinking precipitously. On Sunday, Meerkat had dropped to #523 on the US iPhone download chart; two days later it had fallen even further, down to 669th on the US chart. It seems the app that rapidly came out of nowhere is returning there just as quickly.
I do not think we will be talking about or using Meerkat in any significant numbers within a matter of months. We may see Periscope rise (pun intended), but I have doubts if even Twitter's own live-streaming application can attain broad appeal and usage. Here are the reasons Meerkat is destined to fail and why live-streaming video will be an interesting niche rather than a mainstream game changer:
  • Meerkat is built on someone else's platform (or at least it was): We have seen this problem since the early days of Windows, when eager young developers created new applications, only to see Microsoft adopt the same functionality into its Windows OS. More recently, Zynga rocketed to success and then stumbled when Facebook changed its rules to discourage the flurry of annoying posts from friends wanting everyone to become virtual farmers. (As a result, Zynga lost 70% of its value since its 2011 IPO and continues to battle lawsuits from shareholders who claim they were misled.) And it happened again two weeks ago, when Twitter changed Meerkat's access to the Twitter's API. Meerkat cannot survive or thrive without Twitter, and Twitter does not want to support a product competitive with its own Periscope application, so inevitably Meerkat will lose. Building a business model on someone else's platform will always remain a risky proposition.
  • We're not all broadcasters: One mistake that social media pros and influencers have made time (Quora) after time (G+) is that they evaluate new social platforms based on their habits and preferences rather than others'. In 2011, as social media "experts" abandoned their Facebook accounts and declared Google+ a "Facebook killer," the rest of the world shrugged and continued using the platform that already contained all of their friends and family. Normal people (i.e., those who do not know their Klout score) cannot pull their "audience" with them from one platform to another, nor do they have a burning need to broadcast their lives to the world as do digital influencers. This last point is key to explaining why digital insiders are wrong so often about new social and communications services--the vast majority of the world does not share influencers' insatiable need to transmit every thought and experience. Meerkat was perfectly suited to appeal to mass influencers while leaving others puzzled about all the fuss.
  • SXSW isn't the real world: There is a good reason each year's "hot new SXSW" app tends to fade from view--SXSW is not the real world. Since Twitter rose out of SXSW in 2007, I cannot think of another app that used SXSW as a launching pad to the mainstream. Foursquare came closest, but today it is seeing declining usage and little buzz. Other apps like Groupme, Sonar and Hashable were all the rage in Austin for a couple of weeks but never caught on outside of the SXSW bubble. There is a lesson here for evaluating SXSW buzz: The needs of the world's most digitally connected people while attending the world's most digitally connected event are simply not a good proxy for the needs of people who have busy lives, job stresses, family demands and are mostly overwhelmed with their existing digital communication channels and apps.
  • Streaming video isn't new and isn't growing rapidly: I cannot imagine how all the excitement over Meerkat and Periscope must look to the folks who developed platforms such as Qik, Livestream, and a dozen other live-streaming platforms that have been around for years. Sure, the new live-streaming apps offer great social features and terrific user interfaces, but apps with similar capabilities have long been available. Of course, you could argue the same about Facebook, which was preceded by SixDegrees, Friendster and Myspace, but the difference in that case was that each successive social network was more popular than the last. This is not the case with live-streaming video apps, which are not seeing any sort of profound growth or success. After a rapid start, Qik faded and was eventually acquired and shuttered by Skype, while eventually shifted out of broadcasting the real world and into the more interesting business of broadcasting gameplay via Twitch.
  • The world has already voted, and people prefer pre-recorded video to live: One filter I use to evaluate new technology is how well it fits into existing models of human behavior. In the case of Meerkat and Periscope, one only needs to look at the early days of television, when all video was live, and compare it to the prerecorded network programming of today. The problem is that live TV is generally not polished, well paced or exciting; Jon Stewart may make moments in Congress look funny, but have you ever tried to watch C-SPAN live? The same is true outside of TV--consumers can watch live concerts by artists on Concert Window, but they still opt to stream the slick music videos on YouTube and Vimeo in much higher numbers. And Fathom Events beam live performances from The Met to theaters around the country, but far more people show up for the latest over-produced but disappointing Adam Sandler film. The entertainment industry long ago shifted out of live broadcasting and into prerecorded, edited, post-produced video that corrects the problems of live performance.
  • The world is timshifting more than ever rather than watching live: Not only have consumers shown a preference for prerecorded entertainment, they are increasingly rejecting the tyranny of watching anything on someone else's schedule. In today's fast-paced world, ever more people are timeshifting, opting to use streaming, DVRs, Netflix and YouTube to watch video when and where they want. Meerkat and Periscope are entering a world at a time when fewer people watch video as it is broadcast than at any time since TVs entered homes in the 1950s. This should tell us something about the appeal of real-time video, which is...
  • "Live" video brings no additional value over pre-recorded video outside of very specific use cases. Live TV is today reserved for special situations like American Idol (real-time voting), news and sporting events (real-time occurrences with broad appeal) and the rare stunt programming (real-time risk that Allison Williams' Peter Pan may trip over a prop on live TV.) If Hollywood cannot find a way to make live video appealing outside of select use cases, what does this say about the experiences you and I might broadcast? How many opportunities will you have to share urgent, timely, in-demand content? Will that beautiful sunrise or your dog's amazing tricks really be of interest to people in real time? Is posting a video to Instagram of something that occurred in the ancient era of two minutes ago really going to degrade the viewer experience? The reality is that outside of some select use cases, such as newsworthy events (the tragic explosion in NYC) and entertainment (Jimmy Fallon broadcasting a rehearsal), most of us have precious little reason to use Meerkat and Periscope to broadcast anything to others in real time.
  • Most brands will be too risk-averse to adopt live video: While many agency bloggers are predicting (and hoping) marketers will adopt Meerkat and Periscope in large numbers (and pay agencies to develop the live content), I struggle to see how most brand brands will accept the risk of raw live video. Even in the age of Facebook and Twitter, marketers still maintain tight control over the planning and vetting of content, and in those rare situations when brands staff "newsrooms" for real-time marketing, compliance and legal personnel are on hand to approve every word and image. You think brands are now going to point a camera live at an event or person and trust everything that happens will be appropriate, on-message, legal and compliant? All it takes is one person wearing a branded T-shirt, dropping an F-bomb or having difficulties with the product on a live video, and someone's head will be on a platter.
  • Few brands will have anything to share that people will need to see in real-time: Finally, even if brands can overcome the various practical and legal challenges associated with live video, will they have anything worthwhile to say in real-time? Today, organic reach for brand content is falling, with brand posts disappearing from Facebook news feeds and being ignored on Twitter. If most brands cannot find a way to be interesting with the luxury of time, what would they stream that might demand consumers drop everything right now to watch it live? Video is powerful, but between Instagram, YouTube, Vine and other platforms, are brands really lacking for ways to share video?
To be fair, I anticipate Periscope will see reasonable adoption and some exciting uses for very specific purposes, but I do not anticipate broad adoption for this or other live broadcasting platforms. Before we buy into yet another round of hot-new-thing-forever-changing-communication-and-marketing hype, I suggest we step back, assess the needs and wants of real people, consider which brands have opportunities and which do not and ensure we do not invest limited time and budget in yet another digital boondoggle.

Monday, March 16, 2015

"Purpose" Never Retires

Purpose is true north that never varies.
A lot of companies give lip service to "purpose" nowadays. I get tired of attending conferences and reading articles where business "purpose" is equated to Corporate Social Responsibility (CSR) initiatives, as if purpose is something a firms buys and plugs into a small corner of the organization with the goal of generating PR and purchasing goodwill.
USAA is widely recognized as a firm that leads with purpose, and it is a purpose that is earned primarily with sweat and focus, not just dollars and charitable donations. What "purpose" really means at USAA was demonstrated by a recent announcement from President Obama about the Veterans Administration. Joe Robles Jr., who just retired as CEO of USAA, was named the chair of a new committee to assist the struggling VA. The goal of this group is to provide short-term and long-range priorities to improve VA operations and services.
In the history of thankless tasks, this may rank near the top. At an age when most take on the challenge of improving their golf handicap, Robles is dedicating himself to improving one of the largest bureaucracies in the world.
In the 20 years Robles served as USAA's CFO and CEO, he personally demonstrated what purpose really is, never missing an opportunity to remind employees and leaders of the association's mission: To facilitate the financial security of those who serve their country and their families. He personally gave his time to organizations that helped active service members and veterans, and in his role as leader, he constantly demonstrated USAA's purpose by promoting measures of how the organization achieved its mission above and before measures of how the organization achieved financial success. As with many companies that lead with purpose, USAA has no difficulties achieving the latter because of its commitment to the former.
After serving his country for 28 years in the U.S. Army and then being employed at USAA another 21 years, you might think that Robles has done his duty assisting the military community. But just one month after retiring from USAA, he is again putting himself in a position to improve the lives of veterans and their families.
Of course, Robles is not the only leader to demonstrate that purpose never retires. Jimmy Carter remained active in international and domestic affairs long after he left office, traveling the world to conduct peace negotiations, observe elections, and advance disease prevention and eradication in developing nations. And former CEOs as diverse as Bill Gates and Herman Cain have used their fortunes and political clout to advance their causes and world views.
But so powerful is Joe Robles' purpose that three years after leaving the employ of USAA, I still am inspired by the strength of his purpose. He demonstrates that purpose is not a strategy or PR tactic; it doesn't come from focus groups and research; and it is not CSR. Robles' sense of purpose resonates so strongly because he demonstrates that purpose is something you are and do; something that drives you to continue when no one would blame you for stopping.
For Joe Robles, purpose never retires. Even after leaving USAA, his sense of purpose continues to serve as an example for USAA employees (both current and former) and for other corporate leaders.