I'm going to spill a dirty secret of technology start-up investing - brace yourselves.
Too many young tech companies have raised too much money, often at unjustifiably high valuations. Not all investors in private companies will make a profit from the bloated pool of startups. There will be (unicorn) blood.
There are understandable reasons that young technology companies are collecting more investment money than at any point in the past decade. Globally, people have few options to generate good investment returns, and they're grabbing slices of fast-growing start-ups that could become the next Facebook.
But those individually rational investor decisions have resulted in collective irrationality. Too many young companies have valuations far higher than reality can support.
For public companies, a common exercise is comparing how much investors are willing to pay as a multiple of earnings. Stock investors right now have determined that Facebook is worth 27 times its future earnings. Struggling, slow-growing General Electric is worth less. We understand how this works.
Many start-ups say this cold investment logic doesn't apply to them. They say they're doing something fundamentally different from any company that came before and deserve to be valued more richly than similar public companies.
Stitch Fix, an online personal stylist company, is about to tell stock market investors why it deserves a richer value than a traditional retail company. WeWork doesn't want to be considered in the same category as boring old office-leasing companies. Stripe doesn't want the stodgy stock multiples of traditional payments companies.
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It's true that these and other young technology companies are often changing existing industries in ways that permanently expand a market. When that's the case, investors can and should pay more for a company that still sells clothes but can reach many more people than traditional retailers ever could and at lower costs. But it's not always easy to tell the true market-expanding disrupters from the overvalued wannabes.
Honestly, profit or revenue multiples based on semi-fictitious start-up financials and semi-fictitious start-up valuations don't matter when companies remain private. But the rubber meets the road when start-ups go public. To steal from investor Benjamin Graham, the public markets are a weighing machine over the long term.
The market value of a company will eventually reflect what it's worth based on some multiple of its earnings. The whole idea of owning a piece of a business is to get a slice of its income. Few companies can defy the weighing machine for long.
That's why it's tough to look at companies like WeWork, Uber, Stripe and many other truly superb start-ups and not see potential pain in their valuations. If office-leasing companies are valued at eight times their projected revenue in the next year, at most, it's unlikely WeWork can be valued at 20 times.
This can only change in two ways. One, the start-up grows fast enough that its bigger revenue or earnings slim down the ratio of market value to hard numbers. That happened to tech companies such as Facebook that once had irrationally high valuations.
Or, the weighing machine tilts in the other direction and the value falls as the start-ups cross the chasm from private markets to public ones. That's when it gets bloody.
Shira Ovide is a former Wall Street Journal journalist and writes fro Bloomberg
