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Private Tech Start-ups Pose Increased Credit Risk

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Snapchat, a messaging app founded in 2011, is valued at $16 billion. Above, the Snapchat corporate office in Venice, California.

America's top securities regulator, SEC Chair Mary Jo White, sounds the warning bell on the lofty valuations of private pre-IPO business start-ups known as unicorns.  "Nearly all venture valuations are highly subjective." 

The chair of the Securities and Exchange Commission (SEC), Mary Jo White, warned in a speech last week of the risks posed by a new breed of Silicon Valley start-ups known as unicorns whose valuations are as high as the largest publicly-traded companies but lack the financial reporting controls and regulatory oversight of their public counterparts.

"Beyond the hype and the headlines, our collective challenge is to look past the eye-popping valuations and carefully examine the implications of this trend for investors," Ms. White said in a speech at the SEC-Rock Center for Corporate Governance at Stanford University.  Like many, the SEC has questions about the validity of the soaring valuations of companies such as Uber, Airbnb and Snapchat.  "The concern is whether the prestige associated with reaching a sky high valuation fast drives companies to try to appear more valuable than they actually are," said Ms. White.

Venture capital has long been a hit or miss investment as typically nine out of 10 private start-ups fail.  But never before have so many private start-ups had valuations north of the $1 billion mark or or as much equity funding made possible by trillions of dollars in Fed stimulus and years of near-zero interest rates.  It took Amazon.com years to reach a valuation of $1 billion after going public yet Uber is valued at $51 billion without issuing a single financial statement. 

In her speech, Ms. White noted that the decision of Silicon Valley start-ups to stay private longer creates challenges for investors.  "The risk of distortion and inaccuracy is amplified because start-up companies, even quite mature ones, often have far less robust internal controls and governance procedures than most public companies," said Ms. White.  "Rapidly growing enterprises present significant risks if the appropriate control structure is not in place."

Companies valued for activity not directly related to asset base, revenue growth or cash flow exist solely at the whim of outside investors, a point Ms. White made in her speech.  "Seventy percent of failed start-ups die within 20 months after their last financing, having raised an average of $11 million," according to Ms. White.  "In other words, not only are these investments highly risky, they fail quickly too."

Consider the case of Snapchat, a message app co-founded in 2011 by its CEO Evan Spiegel while still a student at Stanford.  In August 2014, the Wall Street Journal ran a feature story that Snapchat had reached a valuation of $10 billion despite "virtually no revenue," according to the Journal article.  The company was valued at $2 billion just one year earlier.  Today, Snapchat's value has grown to $16 billion, which ranks sixth among the highest valued unicorns (see chart above).

All of this has occurred to a company that has remained amazingly secretive only sharing metrics about its business with a few investors when they visit the CEO in person at the company's corporate office, as reported in the WSJ.  Interestingly, value doesn't seem to be a paramount concern to Snapchat.  "The valuation of our business and our capital requirements are the least exciting aspects of supporting the Snapchat community.  We have no further comment at this time," a Snapchat spokeswoman told the Journal. 

In December 2014, Xiaomi Corp., a Chinese smartphone maker, raised $1 billion bringing its value at the time to $45 billion, as reported in the WSJ.  The billion dollar funding round was led by AllStars Investment, a tech investment fund run by former Morgan Stanley analyst Richard Ji, the Journal article stated.  Other participants included DST Global, a Russian investment firm, Singapore sovereign-wealth fund GIC and Yunfeng Capital, a private-equity firm affiliated with Alibaba Group Holding Ltd.

Xiaomi was founded in 2010 and its corporate structure comprises a web of offshore and Chinese entities, which is farily common among Chinese technology companies due to investment restrictions by the communist Chinese government.  At the top of its corporate structure is Xiaomi Corp., a Cayman Islands incorporated entity.  Xiaomi Corp hasn't disclosed its earnings and it is unclear if the company is even profitable but an offshore entitiy in Hong Kong, Xiaomi H.K. Ltd., recorded a net profit of $566 million in 2013, according to a confidential document viewed by the WSJ in November of 2014.