In medieval and Renaissance allegories, unicorns are rare and wild creatures that signify honesty, fidelity, purity, and healing.
In the world of finance, unicorns are venture-capital- (VC-)backed and privately funded companies with valuations in excess of $1 billion that are no longer so rare — and may not always be so pure. And that’s something investment advisers need to be especially mindful of. Why? Because unicorns are about to enter the initial public offering (IPO) market and become part of index funds that have a significant presence in retirement portfolios.
Earlier this month, the ride-sharing service Lyft kicked off what is expected to be a record year for unicorn IPOs by filing its pre-IPO Form S-1 with the US Securities and Exchange Commission (SEC). Lyft, which will be listed on the NASDAQ as LYFT, represents a whole new breed of unicorns that are galloping around global capital markets. Many of today’s unicorns are poised for IPOs despite losing quite a lot of money. Indeed, Lyft incurred a net operating loss of $911.3 million in 2018.
While such unicorns have strong growth prospects, they often have uncertain paths to profitability. They may be at the forefront of innovation, but many of them are also early-stage enterprises with a high chance of failure. And that’s why analysts and investors need to beware: As unicorns go public, they are added to major large-cap indexes and, through the mechanics of index funds and passive investing, find their way into portfolios all along the income and wealth spectrum, including portfolios with retirement savings. This exposes these portfolios to the risks — and potential rewards — currently associated with VC investing.
According to recent data from CB Insights, there are now more than 150 unicorns in the United States alone and sizeable cohorts in China, the EU, India, Singapore, Israel, Canada, Japan, and elsewhere. The US list includes high-profile enterprises that have transformed our consumer experience — from Lyft and WeWork to Airbnb and Epic Games.
US Unicorns, Cumulative and New, 2006–2018*
* As of year-end 2018
Source: CB Insights 2018 (cumulative); Preqin (all other data)
Which brings us back to Lyft. The company started operations in 2012 in California and reached unicorn status in 2015. For 2018, the company reported revenues of $2.2 billion, twice its 2017 revenues. The $911.3 million net operating loss was up from $688.3 million in 2017 and was mostly driven by its fleet of drivers and expenses related to intangible assets. With expenses of $3.1 billion, Lyft had a revenue/expense ratio of 68.8% for 2018, which is comparable to that of the median tech IPO in 1998 and 2001, which fell in the 60%–80% range.
The median revenues/expense ratio of tech IPOs bottomed out below 60% in 2000 and has been above 80% throughout the 2002–17 period. A significant component of Lyft’s expenses relates to its intangible assets and might be more properly capitalized as an asset on the balance sheet instead of an expense on the income statement. Still, Lyft’s revenue/expense ratio is historically in the low range of tech company IPOs.
In the S-1, Lyft’s management emphasizes the importance of key performance indicators (KPIs), such as revenue per active driver, rides by annual cohort, number of bookings, and revenue per booking in evaluating the company’s operating results. Lyft’s US ride-sharing market share was 39% in December 2018, up from 22% in December 2016. For the quarter ended 31 December 2018, Lyft had 18.6 million active riders and over 1.1 million drivers. These KPIs support Lyft’s expected IPO valuation despite negative free cash flows and no profits generated to date.
Aswath Damoradan recently estimated the value of Lyft’s equity at approximately $16 billion, including $2 billion from the IPO, at about $59 per share. He also estimated the possibility of Lyft failing within the next 10 years at 10%. Were that 30%, all other factors being equal, the IPO’s estimated valuation would be adjusted to $13.3 billion, or $47.7 per share. Because the IPO is oversubscribed, the actual IPO valuation will likely fall in the $20–$25 billion range.
After its IPO and a related “suspension” period, Lyft will become eligible for inclusion in various US large-cap indexes. The S&P 500 Index demands four straight quarters of positive as-reported earnings as part of its criteria. Other indexes, however, have far less stringent requirements. For instance, the NASDAQ 100 forbids an issuer in bankruptcy proceedings from issuing securities but does not have positive cash flow or earnings requirements. Lyft will also be eligible for inclusion in certain CRSP capitalization indexes designed to represent the market of investable US equity securities based primarily on size. Popular exchange-traded funds (ETFs), such as the Invesco QQQ Trust, which tracks the NASDAQ 100, and the Vanguard Large-Cap ETF (VV), which tracks the CRSP US Large-Cap Index, will end up holding many Lyft shares after the IPO.
The financial industry has been working hard to rebuild public trust since the Great Recession. Unicorn IPOs can offer significant return opportunities for investors and better distribute the wealth generated by VC markets. But in IPOs where initial unicorn shareholders will gain immediate benefits, a few questions need to be answered: Are these firms worth the cash that the IPO listing will provide them? What is the probability that cash-burning unicorns will end up turning a profit, and when? Which unicorns will be capable of long-term value creation for their investors?
Ultimately, the financial industry is responsible for providing the transparency investors deserve and ethics dictate. If unicorns are integrated into ETFs and mutual fund portfolios, investors must be adequately informed and receive suitable advice about how such companies fit into their index fund holdings. They can then make informed decisions on whether an exposure to VC-style securities, either directly or through index funds, is suitable for their investment goals.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: Domenichino, Public Domain
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Antonella Puca, CFA, CIPM, CPA/ABV, CEIV, is a Senior Director in the Valuation Services group of Alvarez & Marsal in New York and the author of Early Stage Valuation (Wiley, 2020). Prior to A&M she was part of the alternative investment group at KPMG/Rothstein Kass, where she helped launch RK’s Bay Area practice, the global hedge fund practice of EY in San Francisco and New York, the financial services team at RSM US LLP, and BlueVal Group in New York. Puca served as a director in the ethics and professional standards group at CFA Institute and as a volunteer focused on certifications and curriculum programs. She has served as an executive committee member of the board of the CFA Society of New York and as a member of AIMA’s research committee. She is a member of the Business Valuation Committee of the AICPA. Puca is licensed as a CPA in California and New York. She is accredited in business valuation (AICPA), holds the valuation analyst and the entity and intangibles valuation certifications. Puca is a member of the Italian Professional Association of Journalists. She holds a degree in economics with honors from the University “Federico II” of Naples, Italy, and a master of law studies in taxation from NYU Law School. She has been an adjunct faculty member at New York University, a research fellow at the Hebrew University of Jerusalem, and a member of the 420 Italian National Sailing Team.