Mad race of startup investment, valuation and unicorn

Unicorns are new creatures in the startup space across the world. Often loss-making young firms are valued over a billion dollars offering them membership in the Unicorn club. As reported in the media, there are more than 300 of them worldwide with a cumulative value of around $1,050 billion. Most of these unicorns have never made anywhere near profit and currently lose money miserably. But their valuations are astronomical, which are based on the price that new investors are willing to pay for a share.  For example, once WeWork was valued at $47 billion, and Uber was valued over $80 billion before the initial public offering. Many of them are in developing countries like India and China. According to a recent count, China, with more than 130, has the largest unicorn population, followed by the US (85), and India (20). Some of these unicorns also have very little intellectual property (IP) portfolio. In the absence of profitable revenue and a strong IP base, why are these startups valued so high? What are their underlying strengths?  

In most cases, these unicorns are in the journey of taking services from physical space to the digital domain. The ubiquitous mobile broadband connectivity, rapid growth of smartphone penetration and cloud computing combined have formed a new technology core. This technology core offers apps running on a smartphone for connecting service production and consumption through the cloud platform. For example, while the taxi is being called through mobile app and progress of its arrival is being monitored, back-end tasks like mapping, fare estimation and customer care services are being provided by software running on the cloud.  It's being assumed that once services are transformed over the connected digital space, they will have a very large scale, scope, and network externality effect-offering natural tendency of monopolising. Therefore, the winning formula is to monopolise the market and capitalise on the adage-winners take all. In this connectivity era of service transformation, startup valuation's foremost priority is customer acquisition through predatory pricing and mining of user data. Surprisingly, this is even more important than actual revenue and profit. Justification in favour of this approach has been that once the users are in place, you can start working on business and revenue models. Well, this sounds all right as long as venture funding is available, and investors value a customer base higher than the bottom line. But will it work once the mad race is over?

Contrary to improving service through innovation with the support of continued R&D, the winning strategy has been to practise predatory pricing with the support of huge subsidy, often billions, to kick out competitors and grab all the customers. And when you're the winner who takes all, you're a monopoly, with all the commercial benefits that might accrue.  And for that, you need money, tons of it to subsidise, which you have to spend like water to undercut incumbent firms that you plan to disrupt and eliminate competitors. Therefore, the proposition offered to investors has been: "you give us shed loads of money and stick with us until we get to be the winner that takes all. And then you can cash out." Due to the massive flow of subsidy, incumbents are wiped out because they cannot match your predatory pricing.

Let's assume that the winning startup succeeds in monopolising the market. Upon doing so, will monopoly in every service thrive to reach profit? In the absence of profit, will the market keep valuing winners giving profitable exit to investors? Quality of service and affordability will determine the customers' willingness to pay. In delivering that service, the winner will incur a cost for operation too. It appears that like Facebook or Google, many winners will not reach profit, as they have operating cost in physical space, which has limited scale as well as network externality effect. For example, Uber incurs a cost for running a car in offering each ride. Unlike network-centric service delivery like telecom or Facebook, Uber has a very limited scale effect. Moreover, the network effect is also limited within certain geography only. Moreover, the business model like the main product is free, and the revenue is earned from advertisements which will also be challenging to replicate in most of the e-service innovations. For example, how will it be feasible to make delivered food free and generate revenue from something else to make online food delivery a profitable transformation?

Research leads to the development of new technology core, opening disruptive innovation opportunities. To overcome the limitation of existing facilities to pursue this newly created disruptive opportunity, often R&D team members join hands to form firms to exploit the latent potential of newly developed technology, giving birth to a startup. In contrary to this approach, startups in the connectivity era have hardly roots in research. The technology core comprising mobile internet, smartphone and the cloud is new fuel for service transformation. There is no denying that it's a powerful technology core. But unlike telephone or social networking service, this technology core does not underpin every service to experience a strong natural tendency of monopoly-opening an infinite business opportunity to a winner in monopolising the market. Attributes like scale, scope, and network externality underpinning the natural tendency of monopoly vary from service to service. Moreover, some of the key attributes like operational costs also significantly vary. As a result, the market of each service in the connectivity era could not be termed as completely imperfect, which offers the 'winner takes all' opportunity.    

By the way, this is not the first time that we have been witnessing such unreasonable excitement. We have had the "2000 dot-com crash" and "2008 financial crash" among others. Often it's being argued that the dot-com boom was based on clueless and irrational exuberance about the commercial potential of the internet, so when it became clear that dot-com startups were never likely to make profit, the bubble burst as investors tried to get out. But this time it's different. But how far it's different is worth pondering. Not long ago, it was argued that "investors in Uber probably don't care if it never makes a profit, so long as it gets to an IPO that enables them to cash out with a big payoff." But Uber's lackluster performance in the stock market indicates that the reality is different. As opposed to witnessing an expected valuation of $120bn after debut in the stock market, market capitalisation of Uber has been sliding, reaching below $50 billion, consequently blocking late investors to exit with profit.

This market monopolisation-based valuation and investing in startups for service transformation over mobile technology core has significantly deviated the startup culture. Instead of focusing on the perfection of ideas, they are primarily focused on increasing the startup valuation and creating unicorns. The success of a startup is merely equated to its valuation, based on customer acquisition through massive subsidy. Young startups are resorting to shortcuts for quick growth and success. An increasing number of startups are turning to external investors for funding at an initial stage, simply to increase their company's valuation by exercising predatory pricing with a massive subsidy. In the end, such an approach will likely be going to make one winner, by killing the rest. Even upon winning, will the winner reach profit is a serious question as well. If the winner fails to generate profitable revenue, investors will likely not be able to offload their shares for exiting with profit. Moreover, winning through monopolisation will also slow down innovation resulting in suboptimal exploitation of the potential of the technology core. Such mad race appears to be highly detrimental to all stakeholders starting from investors, entrepreneurs to consumers. Instead of fueling this race with public funds for the purpose of creating innovation economy out of startups, governments should take measures to nurture competition to innovate as opposed to monopolising through predatory pricing.

M Rokonuzzaman PhD is an academic and researcher on technology, innovation ands policy. [email protected]