Business Insider published an interesting article “The Steroid Era of Startups is Over” overnight, the subtext of which is what happens when the boom turns to bust? It is a worthwhile read. However, the best possible lesson learned seems to have been overlooked: Considering the amount of down round pain being felt in the U.S., maybe investors should learn from the regions which have not suffered the same fate? Some seem to do more with less.
Let’s examine the substance of the article, and add some perspective:
In April, venture capitalist Bill Gurley wrote an essay crystallizing what many VCs had been talking about for months.
Essentially, too many companies have taken too much money at unsupportable valuations. A lot of the money they raised came with huge caveats that would protect late-stage investors.
A lot of these businesses now have limited options, Gurley wrote. They can’t raise more money from the private markets because their last rounds came with such strict conditions. They can’t go public because their numbers aren’t good enough.
In other words, valuations were out of whack in part because VC’s were under pressure to place funds due to their internal economics. The terms attached to these funding rounds imply that the VC’s recognized that the wall was coming, so they planned accordingly. Unfortunately, the unintended consequence is we have created a large group of “Walking Dead” companies.
I wouldn’t say the easy money’s gone, but the price of oxygen has increased. —Keith Rabois, Khosla Ventures
The challenge is the entrepreneur accepted the money and committed to utilize it in accordance with the terms of the financing. They did so without the same insight as the VC’s and under the mistaken belief that if they operated according to the business plans their financings were based upon, there would be continued support for developing their business. Unfortunately, the plans were not realistic, and ought to have been modified to match a more sustainable model. Both entrepreneur and investor are responsible for this lapse.
The result of this error is being acutely felt by the companies. Entrepreneurs and employees of venture-backed company are having to scale back to operate accordingly to a more viable, organic growth model. Unfortunately, this is like changing the tires on your car while braking from 100mph to 30mph. It won’t be pretty. The reality is that raising the capital was not wrong, spending it in the way they did was. The responsibility for this error should be shared by the VC’s and entrepreneurs. Currently, only one group is being held accountable. This is absurd.
As an LP investor, I expect the VC to utilize their resources to investigate opportunities for investment more thoroughly and using greater fiduciary discretion on investments than I could as an independent investor. I also expect them, as board members to be astute and cautionary on spending. The first time entrepreneur receiving a large funding round has just had their unrealistic valuation confirmed. They are often giddy like a child receiving a new toy, unable to recognize that the battery will run out.
The venture community has realized that a number of companies were funded at valuations that were far ahead of their fundamental progress as businesses, and that some of those companies are not actually that great fundamental businesses. —Alfred Lin, Sequoia
This statement is absolutely correct. A lot of Valley-based, and U.S. based businesses that should never have been funded did in fact receive VC capital at unrealistic valuations because of internal fund economics. Why do I point the finger at the U.S? Today the U.S. marketplace is complaining about the down rounds, and using them as an excuse in negotiating. Who created the unbalanced situation that brought this forward? The U.S. VC’s.
The overwhelming majority of down rounds, in quantity, size, and as a percentage of total deals have occurred in the U.S. Investors elsewhere didn’t push their companies into this position. In 2015, there weren’t any documented down rounds in Canada. Yes, the company valuations were lower on earlier rounds, but perhaps that is because we applied proper fundamental logics to the initial rounds of financing?
It begs the question; As a LP (investor / Limited Partner) in a Valley based fund, why are you not requiring that the investor to whom you are trusting your hard earned capital exercise similar discretion as Canadian VCs are demonstrating? If you feel burned seeing your investments experiencing down rounds, perhaps you should look elsewhere? You may not end up with a share of Google or Facebook, but your odds of not losing your shirt on bad deals is much better. Tortoise and the hare?
Everyone likes liquidity events. But not every company will ever be able to provide one. Companies that raise capital based on unrealistic valuations will almost never provide their investors or employees anything other than big gains on paper. Liquidity events based on unrealistic valuations via the public market is not the solution either. Mark Cuban appears to argue:
For employees and investors they are SOL [s— out of luck]. That is, unless these companies wise up and start going public … The VC attitude of not going public is crushing the dreams of tens of thousands of employees with options. —Mark Cuban, billionaire investor
I disagree with the logic here. Cuban is an incredibly smart individual, but the fundamental problem is how can you advocate for more companies to go public if the companies are not viable as private entities? Going public just disperses the losses on these companies to a broader market, and rewards the VC’s for poor investments. Isn’t capitalism about making money, not about sharing the losses?
The problem is the financing model is broken, and the cycle is repeating. No one complains about the model until there’s a reckoning. If we continue to follow the logic Mark Cuban appears to advocate, and the result is to push more unsustainable companies to IPO, aren’t we just setting up the public markets for more failures, and dispersing the losses across a larger group? Would this not result in broader economic instability as confidence in the stock markets would be eroded?
Perhaps I’m jaded because this proposal sounds like an institutionalized variant on a pump and dump model, but I recognize that getting the wrong form of liquidity too early just moves the goalposts of death further out. An IPO isn’t a savior; it is still a sure death for nonviable companies. But it is less pain for the early investors.
Overfeeding a startup leads to poor decision making, because too much capital means startups don’t need to prioritize. —Mamoon Hamid, Social Capital
I agree with this statement, and think it touches on the fundamental problem. But it only tells half the story. The VC firm, and their internal compensation model means they are incentivized to invest more capital quickly. This becomes Board level pressure leading the company to make the mistake of spending the capital they raise too quickly. I have watched it happen. The spending ought to have matched growth, and been used to support growth.
The broken model explains why the investment community celebrates the few companies that are home-runs, and tries to ignore the failures. The failure isn’t just the company’s, or the entrepreneur’s, it is absolutely and at least equally also the failure of the investor.
“It resets the landscape back to normal. There’s a natural Silicon Valley ebb and flow, some small percentage of startups succeed, they’re transformative, they do change the world,” Rabois from Khosla Ventures said. “A lot of startups fail. That’s part of the business, it’s very difficult.”
It is absolutely true that a lot of startups fail. As investors and entrepreneurs we should accept this from the outset. But perhaps a reason that so many startups fail in Silicon Valley is due to an unrealistic financing model? It is not that the model broken because VC’s are bad or evil, as so many entrepreneurs seem to believe. There are some excellent VC’s, and as in every other industry, some less than excellent ones. Entrepreneurs often have unrealistic expectations as to the value of their ideas. Unrealistic expectations combined with an unrealistic financing model is not akin to two negatives make a positive.
At venture forums outside Silicon Valley, NYC, Singapore, London, and the other major centers, there are often agenda topics that argue if your region operated more like the Valley, your region would benefit for Valley-style investing. If there is one lesson learned from the slowdown in the investment marketplace, and the amount of down round pain being felt in the U.S., maybe it’s the Valley who should learn from the regions?
Ask us how we are doing more with less…
| Percent of Downrounds | Percent of 2015 Deals | |
| Asia | 3.4% | 18.5% |
| Europe | 8.6% | 17.8% |
| India | 5.2% | 1.3% |
| Rest of USA | 53.4% | 34.5% |
| California | 29.3% | 25.3% |
| Canada | 0.0% | 2.7% |
It is worth noting that CB Insights “Downround Tracker” has yet to identify a single downround for a Canadian company despite Canada making up 2.7% of all deals.
If it is the dawn of the next phase in the cycle, will you follow the same path as before, or will you learn from your mistakes? Is that not what VC’s and all the startup guides on “failing fast” preach?