We have all seen the headlines: “XYZ Company valued at £3bn in latest funding round.”
Very often, it is a company we have never heard of. Almost always, the company has yet to make a profit. And yet, here it is, valued at billions of pounds (or dollars) and raising sums of money that make the amounts asked for on Dragons’ Den look like petty cash.
How? And why? How is it possible for a company that has never made a profit to raise that much money? And why do they attract such sky-high valuations, often way in excess of the valuations attached to companies that have premises we can walk into, and that have a long track record of making real profits?
A good example is Cazoo, founded in the UK less than four years ago. Cazoo’s business is simple: it sells cars. But what Cazoo is doing is “disrupting” the traditional car dealer/car salesman model. You buy your car online: Cazoo deliver it – and if you don’t like the car they’ll pick it up again. The company is very high-profile: it sponsors the shirts of Premier League clubs Everton and Aston Villa, and has just done a sponsorship deal with the Football League, giving it access to the clubs (and fans) lower down the football pyramid.
The company made a loss of £19m in its first year, but has just posted a profit of £3.7m (on turnover of £113.9m) for the first quarter of this year. But does that level of profit make the company worth £1.83bn – the valuation placed on it in October last year when it raised £217m in its latest funding round?
Perhaps we should explain the term “funding round.” Traditionally businesses borrowed money based on their track record of making profits and offered security for any loan taken out. There will be many business owners reading this who have had to offer their home as security for a business loan.
But when a start-up business, or a very new business like Cazoo, wants to borrow hundreds of millions, that becomes totally impractical. It has no track record, it generally isn’t making a profit – two years ago Uber famously warned that it “may never achieve profitability” as it geared up for a stock market float with an expected valuation of $100bn (£70.5bn at today’s exchange rate). And when his business is borrowing that much money, the founder’s house certainly won’t be adequate security.
So the company embarks on a funding round, giving outside investors the opportunity to invest cash in exchange for equity and/or partial control of the business.
For the investors, these early investments can sometimes pay off spectacularly. In 2004 Peter Thiel put $500,000 ($352,000) into Facebook when the company was valued at $5m (£3.52m). When the company went public in 2012, Thiel sold 16.8m shares for approximately $640m (£451m).
What investors are paying for is not profit – they are not expecting old-fashioned dividend income. They are paying for market share and/or a potentially dominant position in a lucrative market. In Cazoo’s case, for example, investors are paying for a potential pole position in the car sales market. In addition, a model which works well in one country will work well in another: one estimate puts the value of the used car market in the US at $2.15tn (£1.51tn) by 2027.
…And it looks like those investors who valued Cazoo at £1.83bn back in October may have got a bargain. By February the company was reported to be looking at a merger with its main rival in the US, and a stock market float potentially valuing the company at $£6bn.