Unicorns and Market Efficiency

Unicorns and Market Efficiency

By Stephen Hart

Several years ago a new term showed up in the financial world, a unicorn. It refers to a recently established tech startup that has achieved a valuation of $1B. Think of companies like Uber, Dropbox or Airbnb. All of which are relatively young companies that very rapidly achieved a $1B valuation. Keep in mind that hundreds of similar tech companies are started every year and are either on the long road to $1B or will never get there at all. Thus, the successes have become as rare as a unicorn.

But, as of spring 2017, there were as many as 200 unicorns out frolicking around, mostly in Silicon Valley. One must ask, how did so many unicorns make it so quickly? Keep in mind that many of these are still privately held companies, so the valuation of said companies can be a bit fuzzy. A recent study of 116 of the 200 unicorns found that many of these companies are way overvalued, mostly because certain shareholders are made guarantees as part of their investment. This could come as minimum value for their shares, priority in share buyouts, or the authority to deny large quantities of stock moving.

Here’s the problem, in creating a private valuation there is an underlying assumptions that all shares are created equal, but we know from these complex investor arrangements, all shares are not equally valued. Some shares are better than others. When taking this into account, nearly half of the 200 unicorns lose their $1B status.

What does this mean for market efficiency? We know that when shares are moved to the open market, the market and its participants will set the best price for each share. The market absorbs all information and finds its own equilibrium. A prime example is the 2015 IPO of Square, a tech company that facilitates mobile payments. In 2014, during its final round of private funding, Square achieved a valuation of $6B. One year later after going public, its valuation was just under half at $2.9B. So what exactly happened?

Certain investors were guaranteed a share value in the $18.50 range. After it became apparent that the market did not feel that was an adequate price per share (it IPO’d at $12.85), Square was forced to issue additional stock to said investors to keep their overall value at the correct amount. But, the market knows this is happening, issuing additional stock without a material change to the perceived valuation only dilutes the value of each share. Within a few weeks of its IPO, Square had dropped below $9 per share. In the two years since its IPO, Square is now trading in the $25 range, but has seen some pretty sizeable fluctuation over time.

This is a prime example of the market efficiency. All available information is taken in by market participants and used to create a fair price per share. It is why we feel strongly that no one can consistently beat the market. Instead, exposing your portfolio to areas of the market the provide long-term excess returns, will reward the patient investor.

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