Dropbox, Snapchat, and Square: The Case of the Shrinking Unicorns

By Alex DUMORTIER, CFAFool.com

U.S. stocks are higher in early Wednesday afternoon trading, with the Dow Jones Industrial Average and the S&P 500 up 0.01% and 0.01%, respectively, at 1:10 p.m. EST.

Not all unicorns will turn into Facebook.

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The evidence is mounting that some of the private valuations attached to "unicorns" may have been fanciful, as investors hoping to find the next Facebook pushed valuations skyward. "Unicorn" refers to a start-up company that achieves a valuation at or above $1 billion in a private financing round. Unicorn sightings have become much more frequent in Silicon Valley over the past several years.

Yesterday, the Financial Times reported that Fidelity had written down the value of its stake in privately held messaging platform Snapchat. According to data from research companyMorningstar, the Boston, Mass., fund manager that controls $2.1 trillion in assets marked Snapchat's value at $22.91 per share at the end of the third quarter, down from $30.72 at the end of June.

Similarly, last month, securities filings showed that the world's largest asset manager, BlackRock, had marked down the value of its investment in Dropbox by 24%. BlackRock led a $350 million funding round in the cloud storage company in January 2014 at a $10 billion valuation, a leap up from its September 2011 valuation of $4 billion. Fidelity also marked down its investment in Dropbox.

One of the primary methods investors use to value private companies is to refer to a set of the closest comparable companies that are publicly traded and use the valuation mutliples at which they trade as a benchmark. In theory, therefore, the markdowns could simply reflect a drop in the valuations of the companies' peers.

However, it seems there may be something more going on in this case. If we take Snapchat, for example, the 25.4% markdown is much larger than the 13.5% decline in the Solactive Social Networks Index. The index tracks the share performance of companies with a primary business focus on social networks. As of Nov. 9, Facebook, Tencent Holdings, LinkedIn, and Twitter represented 61% of the index.

(Dropbox's case is less clear-cut: Shares of its closest public market peer, Box, which began trading in January, fell 32.5% in the third quarter.)

Finally, last week, Square, the online payments company co-founded and led by Twitter CEO Jack Dorsey, set a pricing range of $11 to $13 per share for its imminent initial public funding round. The midpoint of that range represents a 22.4% discount to the $15.46 per share price established in the last private funding round in October 2014.

For late-stage private round investors (such as Fidelity and BlackRock), this phenomenon means they may not be able to book blockbuster gains once the companies go public.

That situation looks very likely in the case of Square, which has chosen to forge on with its flotation in a tepid market for initial public offerings. This columnist would be surprised if the investors who participated in its last investment hit breakeven at the end of the first day of trading.

But private round investors' setback is public market investors' gain. Investing in the initial public offerings of technology start-ups is a difficult game because of inflated valuations, but the odds of betting on a unicorn are now a bit more favorable.

The article Dropbox, Snapchat, and Square: The Case of the Shrinking Unicorns originally appeared on Fool.com.

Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Facebook, LinkedIn, and Twitter. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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