Last week, we highlighted the not-so-surprising fact that many private tech company valuations are completely made up. To let the VCs who fund these companies tell it, the problem isn’t that Snapchat isn’t worth more than Clorox (as their valuations would suggest), but rather that us simple folk don’t really understand what the word “valuation” means. You see, things like cash flow and operating costs are “less important than you might think”, as long as you’ve got “hockey stick” growth in some metric that you arbitrarily decided matters most for your company. Furthermore, it’s important that you command the market in your industry. Of course in many cases, startups have created entirely new concepts and so there naturally are no competitors and if you can’t command a high market share in a market that you made up, well, you’ve got a real problem. But this is all part and parcel of the startup mentality, wherein VCs and founders are more focused on whatever Mark Zuckerberg or Jack Dorsey or Marc Andreessen or [fill in famous tech guru] said recently about how to grow your startup from 10 users to 10 billion rather than on how to generate revenue and profits. The problem with this is that while the Cloroxs of the world generate hundreds of millions in profits every three months, the Snapchats of the world.. well… don’t, and in the final analysis, it doesn’t matter if you have 10 trillion users if you can’t make any money. Here’s what we said: Well, now that everyone is jumping on the “there’s no way that app is worth $50 billion” bandwagon, Bloomberg is out with a startling revelation: “Snapchat, the photo-messaging app raising cash at a $15 billion valuation, probably isn't actually worth more than Clorox.” No, probably not, but it sure is more fun than doing laundry, which is why it absolutely makes sense that the number VCs are putting on the app makes absolutely no sense… So while we thought “valuations” were numbers that indicate how much something is worth, what they actually are are complete shots in the dark which, if necessary, can be “adjusted” later to reflect economic realities. Today, Bloomberg is out with another piece that bemoans what very well could turn out to be a giant bubble in late stage tech startup valuations. Here’s more: Hedge funds and mutual funds that once shunned venture-style deals are flocking to the market’s hottest corner, paying 15 to 18 times projected sales for the year ahead in recent private-funding rounds, according to three people with knowledge of the matter. That compares with 10 to 12 times five years ago for the priciest companies, one said. While some of the startups may become profitable, others are consuming cash and could fail. The torrid action is spurring talk that 15 years after the collapse of the Internet bubble, the market may be setting itself up for another bruising fall. “Some of the valuations are mind-boggling,” said Sven Weber, investment manager of the Menlo Park, California-based SharesPost 100 Fund, which backs late-stage tech startups. Companies now valued at 16 times future revenue could easily lose a third of their value in a market pullback that Weber and others say may occur in the next three years… Private values also are soaring. Online scrapbooking startup Pinterest Inc. raised $367 million this month, valuing the company at $11 billion. Snapchat, the mobile application for sending disappearing photos, is valued at $15 billion, based on a planned investment by Alibaba, according to people with knowledge of the deal. Uber’s valuation climbed more than 10-fold since the middle of 2013, reaching $40 billion in December. Mutual funds and hedge funds have elbowed into late rounds, both to boost returns and to ensure they can buy blocks of shares in IPOs as competition for tech offerings intensifies. Mutual-fund giants Fidelity Investments, T. Rowe Price Group Inc. and Wellington Management Co. and hedge funds Coatue Management and Tiger Global Management took part in at least 37 pre-IPO funding rounds totaling $5.55 billion from 2012 to 2014, according to Pacific Crest Securities, a Portland, Oregon-based technology investment bank and IPO underwriter. It’s worth taking a moment here to revisit how these valuations are determined because it’s a highly scientific process that takes into account objective factors such as how much the founder thinks his/her dream is worth. Here’s our take accompanied by two quotes from a previous Bloomberg piece: The reason this makes sense is because these companies often command huge market shares in markets they made up and also because their founders are arrogant. Here’s Bloomberg again: "Some VCs defend the practice by saying valuations are just a placeholder number, part of an equation fueled by other, more important factors. Those can include market share, growth projections, and a founder's ego." All of this makes complete sense of course, but it does lead us to wonder how valuations for the next Facebook are determined because ultimately, you’re still left with the annoying task of having to get a funding round done, and even if it’s just a “middling shot,” it’s still a shot you have to take. Fortunately, there’s one completely unbiased party who is always willing to step in and tell you how much the business is really worth: “The number is typically set by the company…” “A founder often starts off with a number in mind, based on the startup's last valuation, the valuations of competitors, and, for good measure, the valuation of the company's neighbor down the street.” Of course none of this really matters because the idea is simply to make it to the liquidity event whether that’s a buyout or, better yet, an IPO. Ideally you want to take the company public because then you can count on the stupidity of retail investors to drive the valuation to ever more insane levels at which point you sell your shares and how the company will make money becomes someone else’s problem, namely the guy who bought his stock at the open on IPO day through his ETrade account on the advice of his broker whose firm underwrote the offering. In that context we guess valuations really don’t matter if you’re the VC or the founders. There is however, always the chance that something goes wrong (like your IPO temporarily breaks the market for instance) in which case you may not get the bonanza you were looking for which is why it’s important to ensure that the fine print says you can’t lose. Here’s Bloomberg again: Private valuations since then have gotten frothier, at times surpassing IPO values. In the past four months, cloud-storage service Box Inc. and Hortonworks Inc., a data-services provider backed by Yahoo! Inc., went public at valuations lower than their last private-funding rounds. Some late-stage investors have struck deals guaranteeing them a return in an IPO, typically in the form of additional shares they’d get if the offering is priced below what they paid. Known as ratchets, these arrangements water down the gains of other investors who haven’t yet cashed out. When Box’s IPO priced in January at $14 a share, or 30 percent less than Coatue and TPG had paid in July for 7.5 million shares, the firms salvaged a 10 percent unrealized gain owing to a ratchet, according to offering documents. Better still, even if you aren’t the home gamer who bought on IPO day and didn’t realize he was paying an obscene multiple on revenue the company imagines it may one day make, you may end up owning the shares anyway in your retirement account. Via NY Times: The retirement accounts of millions of Americans have long contained shares of stalwart companies like General Electric, Ford and Coca-Cola. Today, they are likely to include riskier private stocks from Silicon Valley start-ups like Uber, Airbnb and Pinterest. Big money managers including Fidelity Investments, T. Rowe Price and BlackRock have all struck deals worth billions of dollars to acquire shares of these private companies that are then pooled into mutual funds that go into the 401(k)’s and individual retirement accounts of many Americans. With private tech companies growing faster than companies on the stock market, the money managers are aiming to get a piece of the action. ...and while there are bound to be some killjoys out there like Bentley University's Leonard Rosenthal who think forcing investors into grossly overvalued, profitless tech startups is not necessarily right… “It’s great for the portfolio manager, but it’s not necessarily in the interest of the shareholders of the fund. If investors are looking for a portfolio of risky securities, there are plenty of stocks to trade in the public market.” ...the good folks at your favorite VC firm will explain to you that this is all about helping the little guy get access to something he wouldn’t be able to own if left to his own devices... “There’s a huge amount of wealth creation happening, and a very narrow set of people are benefiting from it financially,” said Scott Kupor, who, as a managing partner and chief operating officer at the venture capital firm Andreessen Horowitz. ...which is good because if there’s anything you want your retirement money doing, it’s chasing “unicorns” in a “shadowy market”... The dilemma for big fund managers is that fast-growing technology companies are so reluctant to sell private stock to the public that there is now a term — “unicorns,” reflecting just how wonderful and magical they are considered to be — for the dozens of private firms worth $1 billion or more… Those lofty valuations, combined with the eagerness investors show in bidding them up, have created a shadowy market for private stock issued to tech companies’ early investors and employees. * * * Call us old fashioned, but we agree with Prem Watsa who has the following to say about this circus: "We’re confident that most of this will end as other speculations have – very badly!" As a reminder, here are a few examples: