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Uber offers a cautionary lesson for retail investors

June 13, 2014, 4:55 PM UTC
SAN FRANCISCO, CA - JUNE 12: A sticker with the Uber logo is displayed in the window of a car on June 12, 2014 in San Francisco, California. The California Public Utilities Commission is cracking down on ride sharing companies like Lyft, Uber and Sidecar by issuing a warning that they could lose their ability to operate within the state if they are caught dropping off or picking up passengers at airports in California. (Photo by Justin Sullivan/Getty Images)
Photograph by Justin Sullivan—Getty Images

Are venture investors confusing future value with present price?

Last week, a group including Fidelity, Wellington, and others plunged $1.2 billion into taxi app Uber, valuing the company at $17 billion. It was the latest in a string of multi-billion deals for tech startups. The companies might be worth big prices someday. But hitting those marks comes with risk. In the meantime, investors paid tomorrow’s price today. It is an instructive lesson to the next group of investors–likely the retail lot–in valuation.

Venture investments are often binary. Either they increase value by multiples, or they disappear. It is a risky bet, and that’s why venture capitalists often put 30 companies or so into a fund. A few home runs drown out the many duds.

Investors are meant to adjust for this risk several times over. For example, venture capitalists should discount projections of their targets by 90% because of something called “entrepreneur optimism,” or the idea that the founder is often overexcited about the company’s prospects, according to a study from Ajay Subramanian, professor at the Robinson College of Business at Georgia State University. (For reference, if Uber investors used this discipline, it suggests they think it will eventually be worth over $100 billion.)

Young companies like Uber also often have no cash flow, so investors value them based on revenues instead. If investors aren’t careful, they might confuse “intrinsic value” – or the actual value a company derives from its cash flow — with “relative value” – the implied value a newer company can receive by simply slapping on a multiple from another wacky deal. This is where the self-perpetuating bubble dynamic in the tech world often comes into play.

A big part of venture investing is determining how much “dilution,” or future equity funding the company will need, will be needed. Facebook isn’t burning cash. Twitter is. Though the companies are similar, investors are meant to consider Twitter’s cash needs more carefully.

Recent deals have let much of this caution fall by the wayside. WhatsApp is regularly compared to Facebook (FB), a dangerous precedent given the two companies different life cycle stages. Uber believers are making far-flung assumptions and valuing the company without big discounts. Uber may in fact take 50% of the taxi market eventually, as the New York Times recently suggested, but it doesn’t have that market share yet, and there is significant risk in getting to that level. Ditto on becoming a delivery service.

So why are smart investors buying into companies at what appears to be full value? “The question is whether these investors are using disciplined risk-adjusted return analysis to value these companies, or are valuations driven by competition – the need to get in the deal, to get a big piece of a hot deal in a hot space” says Jerome Engel, faculty director of the venture capital executive program at UC Berkley. “I believe these qualitative factors – gut calls, not hard math – are helping create a surge in these mega – deals”

Lately, the public market has been accepting venture-funded deals in their earlier stages of their lives as companies. Twitter (TWTR) was one of the more high-profile companies without profits that listed shares last year.

The roster in Uber’s deal suggests it could be next to list — and the investors have a good pulse on retail investors too. Wellington, Blackrock, and Fidelity are said to have taken big stakes. These firms are more often on the other side of an IPO. They may be tired of picking up scraps.

It is hard not to be swept away in the excitement. But retail investors shouldn’t forget they are living in the present, not some unknown future.