Are Silicon Valley’s Tech Startups Overvalued?

For any who aren’t familiar with the term, Silicon Valley refers to the the high-tech startup-dominated southern region of the San Francisco Bay Area. ‘The Valley’ accounts for more than 33% of all venture capital investment in the US, and houses over 1000 seed funded startups and a lot more still trying to raise money. VC (venture capital) and private equity firms invest in startups at various stages, with the aim of finding a future ‘unicorn’ ($1bn+ valued firm) and then profiting from its revenue, sale, or equity financing.

Snapchat, Cloudera, and other unicorns recently saw their valuations slashed, and had investors wondering if a wider trend is building up or if the valuations were simply a sporadic correction by the public markets.

There are multiple sides to every argument. Here are a few reasons why the average startup valuation is arguably overvalued, and why a bubble might already exist:


Loss-making Business Models

Investors are starting to ignore traditional metrics such as price-EBITDA and price-sales ratios and are instead opting for non-financial metrics such as user base and reach. This is a major issue. Uber is currently valued at around $70bn, despite making  a $2.3bn loss last year. Snapchat is currently valued at around $20bn, despite making around $500m in losses; its shares traded at more than 25 times its enterprise value. Pinterest was valued at $11bn in 2015, but has been struggling to build a revenue model to support its valuations and exit.

The trend continues. Valuing a company at a metric such as user base or user base growth is dangerous, not least because user base in itself is an extremely volatile number. Snapchat’s user base growth dropped 82% in Q1 of 2017 with the introduction of Instagram Stories. Does this mean its value is 82% less than it should be? No. But it does raise concerns over its valuation, given that it’s an app providing a single service – and one that’s now close to being replicated by the likes of Facebook who can arguably cross-sell the idea better and utilise their monetisation platforms to build a more commercially viable model than Snapchat.

These are popular and well known firms but the same is currently happening in the valley for lesser known startups; funds are backing start-ups and entrepreneurs based on ideas and dreams rather than how profitable they can be.


Low Interest Rates

Record low interest rates are swaying investors away from traditional risk-free assets such as CDs (certificates of deposit) and savings accounts in to more lucrative, albeit much more risky investments such as investing in private equity funds and startups.

It’s also a lot cheaper to borrow, increasing the amount of capital that VC firms have to invest. This, coupled with the increased pressure investors are facing to generate returns is resulting in more debt being borrowed than a few years ago, and most of this debt is pumped into startups hoping to back the next unicorn.

Taking on more risks because of cheap debt is one of the many signs of a bubble, and is another reason VC firms are less worried about backing unprofitable models. The problem becomes clearer when interest rates are increased and the money starts flowing the opposite direction: investors will borrow less as it becomes more expensive, and will consider less risky investments. Because of this, startups will find it harder to raise funding.

Those startups which are already backed and are based on unprofitable models will need to commercialise soon – or lose their business alongside, investors’ money. But this is difficult because a large proportion of those startups aren’t structured towards making profit. They haven’t thought about it at great length because they haven’t had to, not least due to the backers themselves allowing more leeway in that regard.


Cultural Change

The Valley used to be a place that enthusiastic and young entrepreneurs turned to in order to help make their visions become a reality. But this has changed: there is a big increase in the percentage of founders building and funding companies only to exit them for a premium and profit, without really pursuing the passionate dream that they convinced the investors was going to disrupt the industry.

This can lead to disappointing results, as it is difficult to identify those founders with a long-term outlook. Not all investors understand the technicality of the ideas they’ve invested in or their commercial potential. The worst-case scenario is that, after closing the deal, the founders profit, and the investors who bought equity in the firm find themselves with an overhyped and very illiquid asset that is difficult to hedge against since startups are not listed companies.

While it’s possible to hedge against this risk by going short on publicly trade private equity funds or large tech companies, these usually hold other investments and businesses, which makes the hedge indirect and ineffective. They are illiquid because it is difficult to sell the overvalued business to a buyer without significantly reducing the purchase price.


Valuation Discrepancies and Markdowns

Startup valuations are marked up when investors realise they are currently undervalued and are marked down when they believe they are overvalued. In the first quarter of last year, there were almost 12 markdowns of more than 5% for private companies valued at $1bn, and no markups.

The difference is a complete turnaround compared to the 8 markups and 2 markdowns in the same period the previous year (Q1 2015). The difference was the highest it has been for a number of years, and a direct indicator of inflated valuations. More recently, Cloudera saw its valuation slashed, from the $4.1bn that Intel valued it at when it bought shares at that price, to the $1.9bn it saw in its IPO.


Silicon Valley Overvalued: Risky or Safe?

To conclude, red flags such as cheap debt, investments in unprofitable business models, valuations ignoring profit metrics, large valuation discrepancies, increased risk taking and a record number of markdowns all indicate a potentially overvalued private market.

Because startups are not listed and only very few have undergone IPOs, the threat to the public in the event of a crash is minimal, as the average person is not exposed to the risk – unlike the subprime mortgage crisis. Due to Basel III and its liquidity coverage ratio requirement, banks will regularly report on their liquidity and ensure they hold a minimum number of high-quality liquid assets that can easily be converted to cash, thus limiting the number of startups they can invest in since these are very illiquid.

This – coupled with the fact that most banks aren’t big into investing in startups, and that the current ring-fence between them separates their retail side from their more risky business – means the retail financial system as a whole should stay intact. Regardless, the effect on investors and funds with high exposure to startups can be devastating unless they become more diligent before handing out money to founders, and start valuing them by their ability to generate returns to equity holders.