Startup Companies And Their Investors Face Far Greater Challenges Now Than Amazon Did A Decade Ago.

Global markets have been roiled by Silicon Valley Bank SIVB, -60.41%'s bankruptcy, the 16th-largest bank in the country. SVB bet against rising interest rates by using short-term loans to finance investment in lengthy bonds, stocks, and mortgages.

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The market value of SVB's long-term investments fell once the Federal Reserve started aggressively hiking interest rates to curb inflation around a year ago, but management was able to keep up the appearance of solvency by pricing the majority of the bank's bonds at par instead of market value.

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Due to depositor withdrawals, SVB was compelled to sell some of its bonds at a $1.8 billion loss in order to disclose this accounting error. Anxious investors leaving the SVB stock was the next domino, and the stock plunged another 60% on March 9 and then another 65% by the time market opened on March 10. The FDIC closed SVB before the day was through.

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Since its beginning, SVB has concentrated on Silicon Valley businesses and has assisted many of them in succeeding. Yet, most companies have been making huge losses, which provided a special set of difficulties that were only realized when rising interest rates destroyed SVB's balance sheet.

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For years, we have written about the challenges faced by startups (for example, here, here, and here). The years-long accumulation of startup losses is a concern for investors, stockholders, and lenders like SVB.

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Even if SVB had not placed a foolish wager that interest rates wouldn't rise, it still might have gone bankrupt. Unprofitable businesses have had a difficult time raising money due to the sluggish stock market since December 2021, which has forced them to use their bank accounts and credit lines. SVB's investment in long-term Treasurys only served to uncover the brewing issues earlier rather than later. 

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While they worry in private, some venture investors publicly mock startup losses by citing Amazon.com AMZN, -1.25%, which suffered losses for years before becoming the industry titan it is today. Yet, few businesses have been as successful as Amazon, and despite its losses appearing to be significant at the time, many of today's firms are far larger.

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In its tenth year, after having accumulated losses of $3 billion, Amazon started to turn a profit. At least 18 publicly listed American "unicorns" (businesses valued at $1 billion or more) had cumulative losses exceeding $3 billion, with three of them having losses over $10 billion.

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Most are also much older than 10 years. The 144 unicorns that are publicly traded in America are 14 years old on average. Nearly 60% of publicly traded American unicorns have accumulated losses greater than their 2021 revenues, which means that even if they are becoming profitable — a big if — it will be challenging for them to conquer their accumulated losses. While Amazon's $3 billion in cumulative losses were roughly equal to its revenues in year 10, this is not the case for most unicorns.

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According to some venture investors, things are improving and businesses are approaching profitability. The truth suggests differently. While it increased to 19% in 2021 from 16% in 2020 and 12% in 2019, the proportion of publicly traded American startups that are profitable decreased to 12% during the first three quarters of 2022. The end of lockdowns not just to meant the end of cheap cash for businesses who catered to people locked in their homes, but it also meant the end of strong revenue growth.   

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Delusions persist for a long time. According to CBI Insights, there will be 1,207 privately owned unicorns with a total market value of $3.79 trillion (yes, trillion) in March 2023. Since the having financial of publicly listed unicorns have been falling since late 2021, few people actually believe these self-valuations. Nearly all publicly listed American unicorns saw their market caps decline from their peaks in late 2021 by at least 50%, and most by even more than 80%.

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Due in part to the fact that they are not required to submit audited financial records, privately held startups also fudge their profitability. For instance, Revolut, one of the top fintech startups in Europe, recently said that it would turn a profit in 2021, making it only the second European fintech to do so. Yet it was later discovered that the only reason it was successful were fortunate cryptocurrency investments.

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Furthermore, Revolut's auditor claimed that it was unable to confirm those investments. It doesn't take a PhD in rocket science to understand that Revolut most certainly lost money in 2022 because the value of bitcoin BTCUSD, 0.35% and other cryptocurrencies has decreased by more than half since their peak in 2021. 

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These lies have been largely ignored by the media, which has occasionally even reported them as reality. In actuality, the most successful startups are those who go public first. People who choose to remain secret are unquestionably in worse circumstances than those who have chosen to become public. Their actual market value is undoubtedly much lower than their estimated $3.79 trillion self-worth. Our estimate is below $500 billion.

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Companies that invest in privately owned startups are affected by these facts. We have previously discussed SoftBank's 9984, -0.82% difficulties. Trade Algo story headlined "The SVB Tremors Will Shake SoftBank" dated March 16, 2023 forewarns of future losses from its startup portfolio. Softbank's share price has dropped more than 50% out of its peak in early 2021.

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The same day, a different Trade Algo article discusses the "$23 billion in value eliminated from Tiger Global's massive stakes of companies around the world," including TikTok parent company ByteDance and payments firm Stripe. Moreover, the head of the endowment at Harvard University, N.P. "Narv" Narvekar had cautioned that venture managers were not appropriately reducing the value of their capital investors in his annual letter in October 2022.

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We will not stop from declaring, "Told you so." The SVB collapse should be a wakeup signal for the worldwide startup system. Venture capitalists, banks, and stockholders have put far too much money into firms that are essentially just persuasive stories and pitches.

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Beginning with audited financial documents from all private startups, we should all demand more. Their market value should be recorded as zero if they decline.

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Former professor Jeffrey Funk is currently a self-employed technology advisor. Great Promises, Little Results: How Growing Hype and Misleading Narratives are Covering Startup Losses and Slow Development in New Science and Technology" is the working title of the book he is now finishing.

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Many academic papers and 16 books have been written by Gary Smith, the Fletcher Jones Professor of Economics at Pomona College. His most recent book is "Distrust: Big Data, Data-Torturing, and the Attack on Science" (Oxford University Press, 2023).