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Billion Dollar Start-Ups Are Burning Big Tech Companies

By Sam Mattera - Sep 16, 2015 at 4:00PM

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Venture-backed companies are keeping top talent from public firms.

There are 117 venture-backed private companies worth $1 billion or more, according to The Wall Street Journal. That's up from 79 in January, and up from just 42 at the beginning of last year. Rising private-market valuations have prompted some to warn of froth in the tech sector. Investors as diverse as Mark Cuban, Fred Wilson, and Bill Gurley have all sounded the alarm, arguing that valuations or burn rates among many private start-up tech companies are simply too high.

This trend also appears to be putting public firms at risk. Shares of Yelp (YELP 4.71%) are down more than 55% in 2015. While the company has faced a variety of challenges, some of that loss appears to be due to the unusual interest in venture-backed tech firms.

Yelp can't hire as many sales people as it needs
Yelp has turned in three earnings reports so far this year, and each report has been met with heavy selling. Yelp's revenue and guidance deserve most of the blame: in July, Yelp shares tumbled, falling more than 20% after the company warned that its total 2015 revenue would come in below analyst expectations.

Yelp's business depends on its ability to sell local advertising to small businesses. Demand for that advertising is drummed up by the company's sales force. Yelp had planned to grow its sales force by 40% this year, but cut its target. Now, the company only aims to grow its sales team by 30% in 2015.

During the company's earnings call, Yelp's management blamed billion-dollar start-ups for its failure to secure enough talent. "With the strength in the tech sector, particularly in San Francisco, we have not grown the sales team as quickly as planned," Yelp's CFO Rob Krolik explained.

Later in the call, Yelp's Chief Operating Officer, Geoff Donaker, blamed Yelp's rising costs on the unicorn bubble. "You can see the cost in a couple of these areas have gone up, in particular product and development as a percentage of revenue continued to creep up and that's a function of compensation in the marketplace," he said.

With hundreds of millions (and, in some cases, billions) of dollars in the bank, and the promise of attractive stock options, these rapidly growing private firms can afford to hire the top talent that otherwise might've made its way to publicly traded firms like Yelp.

Benefiting from a bursting bubble
Somewhat paradoxically, then, a downturn in the tech sector could prove beneficial to Yelp's business, as most of its clients are not other tech firms. Restaurants, car repair shops, and other sorts of businesses scattered throughout the U.S. that buy Yelp's advertising may prove to be immune to a tech downturn, should one take place. If some of these billion-dollar start-ups were to "vaporize," as Marc Andreessen warned, the competition for talent could wane, and Yelp's costs could come down even as its sales force expands.

But Yelp isn't profitable under generally accepted accounting principles, and investors' appetite for unprofitable Bay Area tech firms in general could take a hit if interest in these venture-backed start-ups declines. Yelp's core business may benefit from a tech downturn, but its high multiple (its price-to-earnings ratio, based on its adjusted earnings, hovers in the mid-50s) might not.

Regardless, it's clear that these private firms are having an effect on publicly traded tech companies, and by extension, their investors. Even if you don't dabble in the private markets, the growing number of multi-billion dollar start-ups may be influencing your portfolio.

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