I have long been interested in why people invest in unprofitable companies. As a small business owner, profit is key (along with cash flow). Profit is how your company grows and how you feed your family. But for large companies like SpaceX, profit is not important. Growth is key, as we will see.
I chose to write about this not because it relates to the practice of law, but rather because I am fascinated by future technology. Most companies developing future tech fall into the category of profitless behemoths with seemingly limitless valuations.
I’ll start with SpaceX.
They recently grabbed attention by being the first privately held company to launch people into space. This is one of the reported 15 scheduled commercial launches this year. Each one earns SpaceX approximately $80 million (Forbes article), which means it should earn about $1.2 billion in revenue from launches in 2020. SpaceX is currently valued at $36 billion, roughly 30 times more than its revenue. That is a steep valuation, even for a tech company.
So how does it work? Where does the value come from?
Well, it comes from the concept of a moonshot (pun intended). Space travel is slated to be a $1 trillion industry by 2040 (per marketwatch.com). If SpaceX is a controlling player in the industry, it could be worth far more than $36 billion.
Most venture capitalists look to get their money out of a business within 7-10 years. This has to do with how funds work and what investors expect. The SpaceX gamble will take at least 20 years to play out, an uncommon investment. But SpaceX never claimed to be a common investment, even by VC standards. Venture capitalists are used to taking on risk, but a company like SpaceX is a huge gamble – a moonshot. If it pays off, the VC nets huge return on their investment, much more than they could hope to make on their normal (albeit, risky) portfolio.
We travel from sci-fi to fantasy – let’s talk about unicorns.
The term unicorn is used to represent a company that is a privately held startup worth over $1 billion. The term was coined by VC Aileen Lee in 2013. The idea was that these companies were so rare that the proper metaphor was a mythical creature (Wikipedia).
In 2019, 142 companies became newly minted unicorns (Crunchbase). Suddenly, they don’t seem so rare. However, VC investors bet on many, many more companies that become total flops. The idea is that they take losses on most of their investments and then make it all back (and then some) on the one unicorn company that returns 100x their investment.
There are a bunch of great examples of unicorns: Airbnb, Epic Games (makers of Fortnite), DoorDash, Udemy, Reddit, 23andMe, and Squarespace.
While most investments are either a bust or a unicorn (I’m sure there are some in the middle), a moonshot like SpaceX is something even bigger.
Sure, you must wait 20-30 years for your investment to make a return, but that return could be staggering. Consider Softbank’s CEO, Masayoshi Son, and his $20 million bet on Alibaba Group in 1999, which turned into $60 billion at the time of Alibaba’s IPO in 2014. That’s 3,000x return in 15 years.
That’s the kind of returns investors are looking for.
But there is a darker side to these investments. Consider WeWork.
WeWork was a company that specialized in co-working spaces in major cities like New York and London. It portrayed itself as a tech startup but was more like a real estate holding company and landlord.
WeWork was founded in 2010 by Adam Neumann, Rebeckah Neumann, and Miguel McKelvey. They raised $14.2 billion from investors, and in just nine years were valued at $47 billion and poised for an IPO of epic proportions.
But then WeWork imploded over the course of a few months. As they prepared for their IPO, their finances came under heavy scrutiny. It turned out that they were burning $230 million monthly and there was no profit in sight. There were also some serious claims about Adam Neumann (great article on the topic, here), including claims that he took hundreds of millions of dollars out of the company. Really, the accusations are astounding. Neumann ended up receiving $1.7 billion for separating from the company in a shocking display of Wall Street shenanigans.
Now WeWork is valued at just $2.9 billion. A spectacular failure. The venture capitalists that invested billions of dollars in WeWork lost their entire investment. This was a unicorn gone wrong.
Conclusion: Why moonshots?
The simple answer is you can make a ridiculous amount of money. The investments in these companies make sense because there is an outrageous upside. Sure, it could be worth nothing, but it could be worth billions or trillions of dollars.
The other thing to understand is that most of these VC companies are invested in many companies, some are riskier than others, and that is how their business works. They take a lot of risk on each investment, but the hope is that one or two investments will return the fund and then some. Their investors understand this, and, frankly, there is a lot of money to be made.