When a “Seattle-based Internet bookseller” had its IPO on May 15, 1997, the New York Times described Amazon’s $18 share price, above the expected range of $14 to $16, as a “sign of healthy demand.”
The share price valued the company at $429 million.
The next day, as trading began on Nasdaq, the demand was more than healthy. It looked positively fighting fit. The share price reached as high as $30 per share before falling back to $23.50. Investors who bought in the IPO had already profited by 30 percent.
Two things stand out about that rare dotcom bubble success story. The first is that before the IPO Amazon had raised less than $10 million in venture capital. The largest investment was $8 million from KPCB in June 1996, and Jeff Bezos and his family had invested about $300,000 of their own money. It’s a remarkably small start for a company to reach an IPO with a valuation of several hundred million dollars.
But the other outstanding characteristic is that even a company with as much potential as Amazon was still a long way from a billion-dollar valuation. The idea that a new company in 1997 could be worth a billion dollars looked unthinkable.
Twenty-two years later, Amazon’s shares trade at about $1,840 per share and the company is worth more than $900 billion.
One result of that massive and unexpected growth has been a greater acceptance of the idea of billion-dollar firms. In November 2013, Aileen Lee, a founder of Cowboy Ventures, a venture capital firm, found just 39 US software companies that belonged to what she called the “Unicorn Club,” companies worth at least a billion dollars Today CB Insights lists more than 150 unicorns in the US alone and a similar number around the world.
But Amazon’s IPO had a third characteristic also which caught the attention of critics at the time. The company was losing money, and the losses were growing each quarter. In the first quarter after the IPO, the company burned through nearly $10 million. By the third quarter of 2000, the losses had ballooned to more than $500 million.
Take a look at today’s unicorns though, and Amazon at the turn of the millennium appears positively thrifty.
Lyft, whose recent IPO valued the company at $22.4 billion lost $911 million in 2018. Rival Uber, valued at around $100 billion, lost more than $3 billion last year. WeWork, which is said to be worth $47 billion, lost $1.93 billion. And it’s not just American unicorns that are leaking cash. Meituan, a Chinese delivery service worth about $44 billion, burned through $17.2 billion. Ola, an Indian services firm with a $6 billion valuation, lost $380 million.
When the Economist looked at a dozen international unicorns in fields ranging from ride-hailing (Uber and Lyft) to music (Tencent Music and Spotify), the newspaper found that the companies worth $300 billion had together lost $47 billion since 2014.
“Today, according to Jay Ritter of the University of Florida, 84% of companies pursuing IPOs have no profits,” the newspaper says, “That is remarkably high. Ten years ago, the proportion was just 33%.”
So what’s going on? How are companies winning such huge valuations? Why are they leaking such massive amounts of cash? And what does the difference between the two numbers and the hype surrounding unicorns say about the start-up economy?
Blitzscale to a Billion
When investors look at companies like Facebook, Amazon, Paypal, and Alphabet, the parent company of Google, they don’t just see businesses with a good product or service that they’re delivering successfully to customers and clients. They see monopolies that have managed to take over markets larger than any market before. According to Global Ad Trends Report, online search advertising is worth more than $100 billion a year, growing at a rate of 11 percent—and remains dominated by Google.
Facebook’s data practically gives it a monopoly on online demographically targeted data, a position that won it $16.6 billion in revenues in the last quarter of 2018, even as it was being pilloried for the way it manages that data. The trust that Amazon has built, its reliability, and its networks with sellers and storage centers, make it the default place to buy anything online. Digital sales were worth more than $517 billion in the US in 2018. Amazon sucked up 40 percent of those sales.
The Internet might be a huge opportunity for investors but each sector is also a huge opportunity for the one company that can conquer it.
Network effects have made the grip of that one conquering company stronger. Facebook maintains its hold on social media because users know that their friends are on the platform. When those friends show signs of drifting to a new platform, like Instagram, Facebook is strong enough to buy it. If, like Snapchat, the company refuses to sell, Facebook is able to pour millions into copying its features.
When each sector of the digital economy is winner-takes-all, companies have to “blitzscale.” They try to grow big enough quickly enough to seize a position and hold off competitors. That blitzscaling has become easier thanks to three factors.
First, blitzscaling tools have become better and cheaper. The ubiquity of smart phones means that if a company can squeeze access to its services onto a handset, it can be reached by billions of people instantly. The App Store and Google Play have created genuine global markets with instant mass distribution.
Second, social media has made global marketing easier than ever. With more than two billion people on Facebook, companies can now spread their marketing messages around the world from a single hub. Lessons learned in one region can quickly be applied to another. The only major market cut off from those marketing channels is China, whose firewall blocks Google, Facebook, and Twitter. It’s no coincidence that many of the world’s unicorns, including Google and Facebook, have little presence in China while the country has managed to develop its own giant companies, such as TenCent and AliBaba, in fields dominated elsewhere.
Third, the growth of cloud services have also made it easier for growing startups to scale rapidly. Twitter’s Fail Whale is now extinct. Businesses that take off suddenly can now keep adding servers as demand grows, scaling in line with growth.
At the same time, low interest rates have made investors more adventurous just as evidence of blitzscaling’s success appears clearer than ever. Every time an investor searches on Google or buys on Amazon, they’re reminded of the opportunity that they missed the first time. They don’t want to miss out again. Blitzscaling works—as long as you pick the right winners early enough.
The Limits of Blitzscaling
So those massive losses may be a sign not of a company’s profligacy but of the need to move at lightning speed across a wide area. When the prize for coming fast is so large—and the prize for coming second so worthless—it makes sense for businesses to pour huge amounts into marketing to capture ground quickly.
But many of the unicorns currently leaking huge amounts of money are already large and may not have that much further to go. According to its IPO filing, Uber averaged 91 million monthly users at the end of 2018. That was a rise of 33.8 percent compared to 2017 but the previous year, Uber had seen growth of 51 percent. Facebook’s userbase grew by 9 percent in in the last quarter of 2018 after a period in which the number of users actually shrank in some regions. Apple is no longer breaking out the number of iPhone units sold in its financial filings as sales of new phones stagnate and the company pivots towards increasing growth in services.
Even markets as large as social media, search, and smartphones do get saturated eventually. For many unicorns, the gap between current expenditures and future profits is smaller than the space between their current large position and the amount of space left in which to grow. The Economist calculated that the dozen unicorns it studied would need to increase their sales by a compound annual rate of 49% for ten years to justify their valuations, the same average growth that Amazon, Alphabet and Facebook enjoyed in the decades after their IPOs.
“ If you take into account the fact that this is not the case, and that earlier shares are in fact less valuable, it is possible to calculate the degree to which such values are overstated. According to Ilya Strebulaev, who teaches at the Stanford University business school, such calculations show the average unicorn to be overvalued by about 60%.”
If unicorns aren’t able to grow their way into larger customer bases, though, they might be able to grow sideways by adding new services to those they already offer. Apple sees potential in its cloud storage services and music streaming. Uber sees food delivery and possibly autonomous cars as future revenue sources.
But a unicorn’s value is in the potential of the territory it dominates. As soon as it starts to move onto other territories not only does it run up against competition but it also shows that its own dominance is vulnerable. If a ride-hailing service can take a chunk of the delivery market, what’s to stop a delivery service from taking a chunk of the ride-hailing market?
That vulnerability prevents unicorns from growing another way: by squeezing more money out of the same users. That’s the strategy that Apple has used, raising prices on each new iPhone even as sales overall stagnate. But Apple faces more competition than ever in the smartphone market, and there’s a limit to what buyers will pay for what is often only a small advance on a previous model. Higher pricing creates openings for smaller firms to steal the market share on which blitzscaling depends.
The End of Blitzscaling
Government is increasing that threat. In a hard-hitting New York Times editorial, Facebook co-founder Chris Hughes, argued that Facebook should be broken up and regulated to make it more accountable to the American people. The FTC, with the Justice Department, should undo the company’s Instagram and WhatsApp acquisitions, he said, and ban future acquisitions for several years:
Facebook would have a brief period to spin off the Instagram and WhatsApp businesses, and the three would become distinct companies, most likely publicly traded. Facebook shareholders would initially hold stock in the new companies, although Mark and other executives would probably be required to divest their management shares.
A new agency empowered by Congress should protect privacy, guarantee the interoperability of digital information across platforms, and set guidelines for acceptable speech on social media. Hughes notes that government has already shown a willingness to tighten regulations on unicorns. Senator Elizabeth Warren has called the Facebook mergers to be reversed, and the FTC has announced the creation of a task force to monitor competition in the technology sector, including a review of previous mergers. Uber has been banned in Denmark, Hungary, Bulgaria, and in London, a significant market. AirBnB has seen pushback from the hospitality industry upset at hosts’ ability to serve tourists while avoiding regulations, and from residents who have seen their apartment blocks and residential areas turned into tourist sites. The service has been either banned or restricted in Los Angeles, Amsterdam, New York, and Barcelona among others.
Mark Zuckerberg used to tell his staff to “move fast and break things.” Regulators are now telling unicorns that they need to fix what they broke and are taking steps to protect what remains.
The technology industry is currently being pulled in two opposing directions. One force comes from investors who see the giant companies that they missed out on in the past and are pouring their money into new firms that look like they might be able to reap similar rewards. The other force comes from the limits of those markets and the greater willingness of government to regulate those rewards. If they’re willing to break up the monopolies on which those unicorn-sized valuations depend, blitzscaling will quickly look like a poor strategy.
At the moment, the investors—and their dreams—are proving to be the stronger force. But don’t underestimate the power of the market, and of government, to scupper even the biggest of dreams.
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