21 August, 2015

Uber (Part 3b) - Does fundraising through foreign subsidiaries raise a Yahoo/Alibaba question?

This is a speculative post, prompted by this morning's news that Uber plans an IPO in 12-18 months and has been actively fundraising through foreign subsidiaries since at least late 2014.

I'd like to briefly discuss the latter point, which for the purposes of our ongoing conversation is a bit of a buried lede.

Among the challenges I outlined for Uber is the degree to which they'll need to raise dilutive external funds to expand operations, particularly in high-potential markets such as India and China.  The negotiation on allocating upside/downside that goes along with that fundraising (points 3.e through 3.h in my discussion framework) is a concern because Uber's $50b valuation already prices in a substantial global win.

Fundraising through a foreign subsidiary is one such dilutive source.

Taken from the perspective of a new investor, this makes sense: if that investor thought UberInc was generally overvalued, or simply wanted to invest $1 billion in Uber-like services in China, would the investor be willing to "settle" for 1/50th of Uber's future value?  Because that's the result of investing directly in UberInc today.

If a new investor believed that China will drive more than 2% of Uber's value long-term, and particularly if Uber needed the money to open China because it couldn't fund the expansion otherwise, a 2% stake would probably not be enough.

Instead of such a small slice of the pie, that investor might want to either fund a China-focused competitor at a reasonable valuation or be a partner with Uber in a subsidiary venture rather than a minority investor in the whole shebang.  And today's Reuters report suggests that UberChina may be that vehicle (though I think Reuters confuses run-rate revenue with total annual accrual).

This development is consistent with my overall thesis, though I'm starting to wonder if Uber could be as much a Yahoo/Alibaba question as it is Groupon vs. Amazon.

Uber is doing absolutely better in China, but relatively worse

As of late 2014, Uber was less than 5% of China's 150 million user on-demand ride market, which was dominated by two non-Ubers.  In an investor letter leaked earlier this year, Uber stated its market share in China is close to 50% when measured solely by on-demand rides, and the two market leaders (by userbase) are legacy taxi apps that Uber should be able to beat.  Since Kalanick's letter, those two competitors merged and recently raised $2b on a $15b valuation.

Regardless of details, it's clear that competition in China is heavy and expensive.  And also that Uber is growing faster in China (in a relative sense, and likely by early next year in an absolute sense) than any of Uber's US cities.

Uber has maybe half of the China market of on-demand rides and much less in taxis.  In the US its market share is much higher.

If Uber can afford to hang on in China, there's no reason why the value from any China "win" won't be as big or bigger than the one in the US market: China has more people, is shifting towards a higher degree of urbanization, and cost/PPP differences between the US are continuing to erode rapidly (links later, perhaps).

Prior investments in UberInc likely priced in the China market.  Wins there will now accrue to UberChina instead, a subtle distinction that matters

This is not my area of expertise; I'll reach out to some friends next week and see if I learn anything interesting.  If I do, I'll come back here and update the post.

My current understanding is that UberInc has created a foreign subsidiary called UberChina into which it jointly invested with new investors (possibly starting in late 2014).  Perhaps this is incorrect. 

Assuming it's at least directionally correct, I'm interested in exploring the impact on the valuation of UberInc and it's subsequent effect on strategic priorities elsewhere.  Not the accounting (cost, equity, or consolidation) or control rights (I'm assuming Uber can exert control as needed). 

While UberInc controls UberChina, there are a variety of laws (probably in both countries) dictating what Uber can and can't make UberChina do - it has a fiduciary responsibility to both sets of shareholders.  And it's quite common for controlling owners to shift money around even companies that are legally separate (see for instance SpaceX loaning money to SolarCity).

Basically, UberInc "owns" the future free cash flows coming from UberChina in an amount proportional to the shares it has in UberChina.  Before, our valuation for UberInc assumed a global taxi market of $100b, and (in 4.a) an on-demand ride market as big as $750m by 2025.  Now, we need to not only estimate Uber's winning market share and margins in China, but also how much stake in UberChina will accrue to UberInc.

Two thought exercises: "guesstimate" UberChina valuation, then show the implications

Just like most new companies raising money, UberInc had prior business operations in China it contributed to the venture which was valued through negotiation.  For a highly fictitious example, imagine UberInc got Goldman Sachs to agree Uber's existing China operations were worth $2 billion, and each side would put in $1b.  Then UberChina would be "worth" $4b and UberInc would own 75% of it.

Without an UberChina, that $1b investment would have bought 2% of UberInc instead of 25% of UberChina.  If an investor thinks the China market is likely more than 2% of Uber's future potential, it's clear why an investor uninterested in UberInc's  high valuation could be much more willing to invest in UberChina.  

In this case, pre-existing UberInc investors will now get less than 100% of value from winning China (in this UberChina example, UberInc would get 75% of the value whereas if the equity had been raised directly through UberInc its pre-existing investors would have received 98% of it.  Or 100%, if they had raised it using debt).  
A thought exercise to help you think about this is to imagine if UberInc's prior valuation had been more like $9b instead of $50b and we just focus on the addition of China without a separate entity.  In that scenario the new investors could have received 10% of all of Uber; Uber's pre-existing investors would receive 90% of China.
In that $9b valuation world, by funding UberChina separately, Uber's pre-existing investors would be saying that they're willing to trade some portion of China upside (15% in this example), for some portion of global upside (10% in this example).  This would be a neutral trade if you believed China was 40% of the global market.
Instead, with a $50b valuation, Uber's pre-existing investors would be saying that they're willing to trade 15% of China upside for 2% of global upside.  This would be a neutral trade if you believed China was only 12% of the global market.  Since you likely believe China is bigger than that, this wouldn't seem like a good trade.  
This is only a thought exercise, of course - in reality, without that investment, Uber doesn't "have" a China market to make that trade-off.  Also, I made that 2/1/1 scenario up.

In reality UberChina was a negotiation, though the $2b on $15b recently raised by Uber's larger (merged) and well-established competitor may help ballpark what Uber was able to negotiate with its own investors.

UberInc investors have likely been (effectively) diluted by UberChina  (though some/all could be the same people)

UberChina doesn't change the overall value for the Uber idea, but it does begin to segregate which shareholders receive that value.  Because Uber can't afford to expand in China without raising funds, and funds are hard to raise because of Uber's sky-high existing valuation, if Uber doesn't do this deal it would need to expand in China much more slowly (if at all).  

Uber views the global on-demand ride market as winner-takes-most, though, and under that point of view slowing down is equivalent to failing.

There are two common scenarios I think of when I hear someone talk about dilution.  

The first, and most frequent, is that later stage investors are given shares in a company which effectively reduces the ownership stake of existing investors.  The thinking is, existing investors would rather have a smaller piece of a larger pie.  

So if the company needs external money to efficiently grow, existing shareholders will welcome the investment if the money comes at a reasonable "price" (often, new investors are actually old ones putting in more money).  

This is generally seen as a positive: as long as the new money is not absolutely needed the company has a do-nothing (or wait until) option.  Uber is burning through lots of cash, but it's expansion cash: in the short term, they could slow/stop expansion to bridge funding needs.  

The second, less-but-still-common scenario I think of when I hear dilution is a "down round."  This is like the first scenario, except that the pricing of the shares also declines from the prior value.  So the percentage stake that the new money buys is greater than it would have been if invested with the previous round.  

Externally funded subsidiaries are a third-and-less-common-still scenario I think of for dilution.  

This is a kind of back-door dilution - the ownership stake in UberInc hasn't changed, but the profit pool represented by that stake has now disappeared.  In its place has appeared a percentage of that profit pool, clearly less than the equivalent percentage if the investment had been made in UberInc.

And this could be further diluted through later investment - which is fair, if Uber needs the money to grow.  It's a recognition of the limitations of Uber's relevant experience in the rest of the world: helpful to winning China, but probably not $50b helpful.

This is without judgement - perhaps existing investors were given the opportunity to invest, pro rata, in UberChina.  And even if not, perhaps the terms were relatively favorable to Uber.  This solution to the capital-raising problem recreates the same valuation/funding concerns in a differently shaped package.  

Perhaps Uber is similarly segmenting its fundraising in other large, global markets such as India.

In a public company, calculating the fully diluted ownership stakes would be possible if a bit convoluted.  In a private company, that's much harder.  And the more a company uses equity as payment (for compensation or acquisitions), the more it matters which piece of the cash flows you're getting a stake in.  

As far as tech companies go, this is a rather simple setup.  And Uber is a rather simple business.

This raises an interesting Yahoo/Alibaba question

Once upon a time (2006), Jerry Yang led Yahoo to invest $1b cash and all of YahooChina (valued at $700m) for a 40% stake in a small Chinese firm called Alibaba.  This was right before Yang was elevated to CEO of Yahoo in 2007.  Yang served as CEO until 2009 when activist investor Carl Icahn, upset that Yahoo wasn't accepting a takeover offer from Microsoft, forced out Yang and installed Carol Bartz.  Yang remained on Yahoo's board.

In 2012, activist investor Dan Loeb won a few board seats, forced Yang out of his board seats, and installed Scott Thompson as the new CEO.  Thompson is notable both for his four-month tenure (having been caught with a resume showing a computer science degree he never earned) as well as his capitulation to Loeb's demands to sell half of Yahoo's stake in Alibaba for $13/share.  

Alibaba would later hit $94/share after its 2014 IPO, though today is in the high $60's - about the same as it's IPO.  Recently, Yahoo's remaining stake in Alibaba has sometimes accounted for more than Yahoo's market value.

Said differently, once the value of the stake in Alibaba is subtracted, investors seem to sometimes think Yahoo itself is worth less than nothing.  Yahoo has filed to spin off its stake in Alibaba into a separate company, and as of 8/21/15 the market cap of Yahoo - $32b - remains roughly equivalent to its remaining stake in Alibaba.  

So Yahoo's core operations (run by Marissa Mayer since 2012) are currently valued at approximately $0.  In 2006 these operations were valued by investors at approximately $55b.

UberChina is much, much different than YahooChina... isn't it?  Of course it is.  

But if a large portion of Uber's long-term value is in places like China (according to CEO Kalanick), and UberInc can only raise money through focused subsidiaries such as UberChina (speculative), then a large portion of the value potential in the Uber idea and its early execution will accrue to late-stage investors, many of whom have yet to invest.

Thanks for reading,

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