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Above the Crowd

On the Road to Recap:

Why the Unicorn Financing Market Just Became Dangerous…For All Involved

In February of last year, Fortune magazine writers Erin Griffith and Dan Primack declared 2015 “The Age of the Unicorns” noting — “Fortune counts more than 80 startups that have been valued at $1 billion or more by venture capitalists.” By January of 2016, that number had ballooned to 229. One key to this population growth has been the remarkable ease of the Unicorn fundraising process: Pick a new valuation well above your last one, put together a presentation deck, solicit offers, and watch the hundreds of million of dollars flow into your bank account. Twelve to eighteen months later, you hit the road and do it again — super simple.

While not obvious on the surface, there has been a fundamental sea-change in the investment community that has made the incremental Unicorn investment a substantially more dangerous and complicated practice. All Unicorn participants — founders, company employees, venture investors and their limited partners (LPs) — are seeing their fortunes put at risk from the very nature of the Unicorn phenomenon itself. The pressures of lofty paper valuations, massive burn rates (and the subsequent need for more cash), and unprecedented low levels of IPOs and M&A, have created a complex and unique circumstance that many Unicorn CEOs and investors are ill-prepared to navigate.

Many have noted that the aggregate shareholder value created by all of the Unicorns will vastly overshadow the losses from the inevitable failed unicorns. This likely truism is driven by the clear success of this generation’s transformational companies (AirBNB, Slack, Snapchat, Uber, etc). While this could provide some sense of comfort, most are not exposed to a Unicorn basket, and there is no index you can buy. Rather, most participants in the ecosystem have exposure to and responsibility for specific company performance, which is exactly why the changing landscape is important to understand.

Perhaps the seminal bubble-popping event was John Carreyrou’s October 16th investigative analysis of Theranos in the Wall Street Journal. John was the first to uncover that just because a company can raise money from a handful of investors at a very high price, it does not guarantee (i) everything is going well at the company, or (ii) those shares are permanently worth the last round valuation. Ironically, Carreyou is not a Silicon Valley-focused reporter, and the success of the piece served as a wake-up call for other journalists who may have been struck by Unicorn fever. Next came Rolfe Winkler’s deep dive “Highly Valued Startup Zenefits Runs Into Turbulence.” We should expect more of these in the future.

In late 2015, many public technology companies saw a significant retrenchment in their share prices primarily as a result of a reduction in valuation multiples. A high performing, high-growth SAAS company that may have been worth 10 or more times revenue was suddenly worth 4-7 times revenue. The same thing happened to many Internet stocks. These broad-based multiple contractions have an immediate impact on what investors are willing to pay for the more mature private companies.

Late 2015 also brought the arrival of “mutual fund markdowns.” Many Unicorns had taken private fundraising dollars from mutual funds. These mutual funds “mark-to-market” every day, and fund managers are compensated periodically on this performance. As a result, most firms have independent internal groups that periodically analyze valuations. With the public markets down, these groups began writing down Unicorn valuations. Once more, the fantasy began to come apart. The last round is not the permanent price, and being private does not mean you get a free pass on scrutiny.

At the same time, we also started to see an increase in startup failure. In addition to high profile companies like Fab.com, Quirky, Homejoy, and Secret, numerous other VC-backed companies began to shut their doors. There were in fact so many that CB Insights started a list. Layoffs have also become more prevalent. Mixpanel, Jawbone, Twitter, HotelTonight and many others made the tough decision to reduce headcount in an attempt to lower expenses (and presumably burn rate). Many modern entrepreneurs have limited exposure to the notion of failure or layoffs because it has been so long since these things were common in the industry.

By the first quarter of 2016, the late-stage financing market had changed materially. Investors were becoming nervous and were no longer willing to underwrite new Unicorn-level financings at the drop of a hat. Moreover, once high-flying startups began to struggle on the fundraising trail. In Silicon Valley boardrooms, where “growth at all costs” had been the mantra for many years, people began to imagine a world where the cost of capital could rise dramatically, and profits could come back in vogue. Anxiety slowly crept into everyone’s world.

About this same point in time, the journalists that focus specifically on the venture capital industry noted something quite profound. In 1999, record valuations coexisted with record IPOs and shareholder liquidity. 2015 was the exact opposite. Record private Unicorn valuations were offset by increasingly fewer and fewer IPOs. If 1999 was a wet (read liquid) bubble, 2015 was a particularly dry one. Everyone was successful on paper, but in terms of real cash-on-cash returns, there was little to show. In Q1 of 2016 there were zero VC-backed technology IPOs. Less than one year since declaring it the “Age of the Unicorns,” Fortune Magazine was back with a dire warning, “Silicon Valley’s $585 Billion Problem: Good Luck Getting Out.

As we move forward, it is important for all players in the ecosystem to realize that the game has changed. Equally important, each player must understand how the new rules apply to them specifically. We will start by highlighting several emotional biases that can irrationally impact everyone’s decision making process. Next we will highlight the new player in the ecosystem that is poised to take advantage of these aforementioned changes and emerging biases. Lastly, we will then walk through each player in the ecosystem and what they should consider as they navigate this brave new world.

Emotional Biases

When academicians study markets, one common assumption is that the market participants will act in a rational way. But what if the participants are in a position that leads them to non-optimal and potentially irrational behavior? Many biases bring irrationality to the Unicorn fundraising environment:

  1. Founder/CEO — Many Unicorn founders and CEOs have never experienced a difficult fundraising environment — they have only known success. Also, they have a strong belief that any sign of weakness (such as a down round) will have a catastrophic impact on their culture, hiring process, and ability to retain employees. Their own ego is also a factor – will a down round signal weakness?  It might be hard to imagine the level of fear and anxiety that can creep into a formerly confident mind in a transitional moment like this.
  2. Investors — The typical 2016 VC investor is also subject to emotional bias. They are likely sitting on amazing paper-based gains that have already been recorded as a success by their own investors — the LPs. Anything that hints of a down round brings questions about the success metrics that have already been “booked.” Furthermore, an abundance of such write-downs could impede their ability to raise their next fund. So an anxious investor might have multiple incentives to protect appearances — to do anything they can to prevent a down round.
  3. Anyone that has already “banked” their return — Whether you are a founder, executive, seed investor, VC, or late stage investor, there is a chance that you have taken the last round valuation and multiplied it by your ownership position and told yourself that you are worth this amount. It is simple human nature that if you have done this mental exercise and convinced yourself of a foregone conclusion, you will have difficulty rationalizing a down round investment.
  4. A race for the exits — As fear of downward price movement takes hold, some players in the ecosystem will attempt a brisk and desperate grab at immediate liquidity, placing their own interests at the front of the line. This happens in every market transition, and can create quite a bit of tension between the different constituents in each company. We have already seen examples of founders and management obtaining liquidity in front of investors. And there are also modern examples of investors beating the founders and employees out the door. Obviously, simultaneous liquidity is the most appropriate choice, however, fear of price deterioration as well as lengthened liquidity timing can cause parties on both sides to take a “me first” perspective.

The Sharks Arrive With Dirty Term Sheets

Who are the Sharks?  These are sophisticated and opportunistic investors that instinctively understand the aforementioned biases of the participants and know exactly how to craft investments that can exploit the situation. They lie in wait of these exact situations, and salivate at the opportunity to exercise their advantage.

“Dirty” or structured term sheets are proposed investments where the majority of the economic gains for the investor come not from the headline valuation, but rather through a series of dirty terms that are hidden deeper in the document. This allows the Shark to meet the valuation “ask” of the entrepreneur and VC board member, all the while knowing that they will make excellent returns, even at exits that are far below the cover valuation.

Examples of dirty terms include guaranteed IPO returns, ratchets, PIK Dividends, series-based M&A vetoes, and superior preferences or liquidity rights. The typical Silicon Valley term sheet does not include such terms. The reason these terms can produce returns by themselves is that they set the stage for a rejiggering of the capitalization table at some point in the future. This is why the founder and their VC BOD member can still hold onto the illusion that everything is fine. The adjustment does not happen now, it will happen later.

Dirty term sheets are a massive problem for two reasons. One is that they “unpack” or “explode” at some point in the future. You can no longer simply look at the cap table and estimate your return. Once you have accepted a dirty offering, the payout at each potential future valuation requires a complex analysis, where the return for the Shark is calculated first, and then the remains are shared by everyone else. The second reason they are a massive problem is that their complexity will render future financings all but impossible.

Any investor asked to follow a dirty offering will look at the complexity of the previous offering and likely opt out. This severely heightens the risk of either running out of money or a complete recapitalization that wipes out previous shareholders (founder, employees, and investors alike). So, while it may seem innocuous to take such a round, and while it will solve your short term emotional biases and concerns, you may be putting your whole company in a much riskier position without even knowing it.

Some later-stage investors may be tempted to become Sharks themselves and start including structured terms into their own term sheets. Following through and succeeding at such a strategy will require these investors to truly embrace being a Shark. They will need to be comfortable knowing that they are adverse to and in conflict with the founders, employees, and other investors on the capitalization chart. And they will need to be content knowing that they can win while others lose. This is not for the faint of heart, and certainly is not consistent with the typical investor behavior of the past several years.

Let us now take a deeper dive into what this new fundraising environment means for each participant in the ecosystem.

Entrepreneurs/Founders/CEOs

Today’s Unicorn entrepreneur has been trained in an environment that may look radically different from what lies ahead. Here is the historic perspective. Money has been easy to raise. The market favors growth over profits. Competition also has access to capital. So, raise as much as you can as fast as you can, and be super-ambitious. Take as much market share as you can.

Never in the history of venture capital have early stage startups had access to so much capital. Back in 1999, if a company raised $30mm before an IPO, that was considered a large historic raise. Today, private companies have raised 10x that amount and more. And consequently, the burn rates are 10x larger than they were back then. All of which creates a voraciously hungry Unicorn. One that needs lots and lots of capital (if it is to stay on the current trajectory).

For the first time, perhaps in their lives, these entrepreneurs may face a situation where they cannot raise a clean incremental financing at a flat to up round. This is uncharted territory. There are a few alternatives:

  1. The first option available to many Unicorns today is a dirty term sheet. As discussed above, these terms can cleverly fool the inexperienced operator, because they are able to “meet the ask” with respect to cover valuation, and the accepting founder does not realize the carnage that will come down the road. The only reason one would accept such a deal is to maintain valuation appearances that simply do not matter. Taking a terms-laden deal is like starting the clock on a time bomb. Your only option is to hit the IPO window as fast as possible (Note: Box and Square were able to thread this needle successfully), otherwise, the terms will eat you alive. The main problem is that you will never raise another private round again, as no new investor will want to live on top of the termy round. So you will be stuck negotiating with the lender that already proved they were smarter than you.
  2. Take a clean round at a lower valuation. This will seem like a massive failure to many modern entrepreneurs, but they should quickly adjust their thinking. Reed Hastings at Netflix raised money in a high profile down round as a public CEO. Every single public CEO has had days where the stock price falls — it is common and accepted. The only thing you are protecting is image and ego and in the long run they absolutely do not matter. You should be more concerned about the long-term valuation of your shares, and minimizing the chance that you have the whole thing taken away from you. Terms are the true Godzilla that should scare you to death. A down round is nothing. Get over it and move on. Option #2 is way better than option #1.
  3. Buckle down and do whatever it takes to get cash-flow positive with your current cash balance. This might be the most foreign of all the choices, as your board of directors has been advising you to do the exact opposite for the past four years. You have been told to be “bold” and “ambitious” and that there is no better time to grab market share. Despite this, the only way to be completely in control of your own destiny is to remove the need for incremental capital raises altogether. Achieving profitability is the most liberating action a startup can accomplish. Now you make your own decisions. It will also minimize future dilution. Gavin Baker, a high-profile portfolio manager at Fidelity has a message for Unicorn CEOs: “Generate $1 of free cash flow, and then you can invest everything else in growth and stay at $1 in free cash flow for years.  I get that you want to grow and I want you to grow, but let’s internally finance that growth by spending gross margin dollars rather than new dilutive dollars of equity.  Ultimately, internally financing growth is the only way to control your own destiny rather than being at the mercy of the capital markets.”
  4. Go public. In the long run, the very best way for founders to look after their own ownership as well as that of their employees is to IPO. Until an IPO, common shares sit behind preferred shares. Most preferred shares have different types of control functions and most of them have a senior preference over common. If you really want to liberate your own common shares and those of your employees, then you want to convert the preferred to common and remove both the control and the liquidation preference over your shares. Many founders have been erroneously advised that IPOs are bad things and that the way to success is to “stay private longer.” Not only is an IPO better for your company (see Mark Zuckerberg and Marc Benioff on this subject), but an IPO is the best way to ensure the long-term value of your (and your employees’) shares.

It is worth noting that stock prices go up and stock prices go down. There is not a single high-profile public company that has been able to avoid time periods where their shares underperformed. Amazon went from $106 to $6 as a public company. Salesforce went from $16 to $6 and stayed below $10 for many months. Netflix went from $38 to $8 in six months. Remember Facebook’s first six months as a public company?

If you cannot handle a down valuation you should seriously consider abandoning the CEO position. Being a great leader means leading in good times as well as tough times. Taking a dirty deal is jeopardizing the future of your company, solely because you are afraid to lead through difficult news.

Employees

The explicit details of the capital structure of a company are typically obfuscated from the average employee. You know you work for a Unicorn, and you know you have some common shares. You might also know what percentage you own. And unfortunately, you may assume that the product of your Unicorn valuation and your percentage ownership is what you are worth. Of course, for that to be true, you need to reach a liquidity event (IPO or M&A) at or above the last round valuation with no incremental dilution from new rounds. But guess what: M&A is scarce (no large company wants to pay these prices or absorb these burn rates), and many founders have been told IPOs are bad. So how will you ever get liquid?

For the most part, employees are in the exact same position as founders (above), with the exception that they don’t participate in the decision tree outlined above in 1-4. That said, they should be asking the exact same questions of management:  Can we get to break-even on the money we have?  Do we need to raise more money?  If so, ca we do it on clean terms (vs. dirty)?  Employees should want to know if the founder/CEO would/did take a dirty deal, because common is at the most risk in such a situation. And then you should want to know if your leader is anti-IPO. If your CEO/founder will take a dirty round, and is also anti-IPO the chance that you will ever see liquidity for you shares anywhere near what you think they are worth is very, very low. You should probably move on to another company.

INVESTORS

Disclosure: It should be noted that the author of the article and his investment firm reside in this category.

For the most part, early investors in Unicorns are in the same position as founders and employees. This is because these companies have raised so much capital that the early investor is no longer a substantial portion of the voting rights or the liquidation preference stack. As a result, most of their interests are aligned with the common, and key decisions about return and liquidity are the same as for the founder. This investor will also be wary of the dirty term sheet which has the ability to wrestle away control of the entire company. This investor will also have sufficient angst about the difference between paper return and real return, and the lack of overall liquidity in the market. Or at least they should.

The one exception to this is the late-stage investor or the deep-pocketed investor who may represent a substantial part of the overall money raised. This particular type of investor may have protected their ownership through the use of active pro-rata or super pro-rata investing. They may have even encouraged the aggressive “spend-to-win” mentality knowing that they can keep writing checks. They have been acting like a loose-aggressive player at a poker table.

There are two forces which have began to slow down this type of investor. First, as failure has begun to arrive on the scene, these investors have suffered some really big write-offs. These spectacular losses result in a lack of confidence not only for the investor, but more importantly for their LPs. The second problem is that for many of these investors, a single holding can become too large relative to the overall fund. They basically cannot afford to expose themselves to any more risk in a particular name. They use euphemisms to describe having over-eaten such as “fully allocated” or “at capacity.”

This form of big investor indigestion has created a really bizarre and unprecedented activity in the Unicorn world. High-profile investors, who are already armed with plenty of capital, have resorted to hitting the phone banks to solicit others to pile in behind them in their names. The voracious Unicorns need even more capital than these big-boys can afford. Ironically, if you look at the big historic wins of this investor class, there is no record of sending out Evites to other investors. But now they “need” others, which should signal risk to all parties involved. More on this later.

Investors also have to worry about raising their next fund, which can lead to unusual behavior that is independent of each individual company’s situation.  Do you support the dirty term sheet because this allows you to keep your paper-mark and not spook your investors?  Even though you know this may be bad for the company in the long run?  Do you feel the need to raise more capital quickly before the prices erode further and bring down your IRR? Do you feel the need to have more money to keep feeding the cash hungry companies you have already funded?

LIMITED PARTNERS (LPS)

LPs are the large pools of capital, such as endowments and foundations, that invest in VC firms, hedge funds and the like. They are the real capital that make the system work. LPs evaluate the performance of the different investors in the ecosystem and make decisions about whether to fund their next effort or not. It’s a difficult job because the feedback cycles are so long — especially when it comes to investing in illiquid assets like startups (and Unicorns).

Another big challenge for LPs is that they are asked to measure the performance of these illiquid assets even though doing so is quite difficult and may not be indicative of future real cash returns. In this case, many LPs have incorporated the high performance of Unicorn valuations into their overall results which has created very strong performance gains for the venture capital category. In a sense they have already “banked” the gains. The problem obviously is that the lack of any material liquidity in the market combined with the recent correction creates a risk that they may not see the actual cash returns for the paper gains they already booked.

Furthermore, as mentioned earlier, they may face increased solicitation from VC firms who want to accelerate their fundraising process in the middle of this highly anxious environment. A recent WSJ article, “Venture-Capital Firms Draw a Rush of New Money,” highlights that VC firms are raising new funds from LPs at the highest rate in 15 years, even though cash liquidity is sitting at a seven-year low. A few sentences from the article are worth republishing here:

  • In recent years venture firms have written bigger checks and encouraged companies to spend to battle for market supremacy.  That left some venture firms short of cash, requiring them to raise money sooner than in years past to continue reaping fees and making new investments.
  • Some venture capitalists say the fundraising spike is timed to ensure that paper gains on startup investments still look attractive.
  • Cash distributions are what matter at the end of the day, but big paper gains still make for good fundraising pitches.

In addition to these issues, there has also been an increase in “inside rounds” where investors write new checks into companies where they are already investors, avoiding the “market check” that might have resulted in a potentially down valuation. This activity, which has an obvious conflict of interest, makes the LP’s job of judging VC performance even more difficult.

Against this difficult backdrop, many firms are asking their LPs to make new accelerated commitments to their next fund, exactly when evaluation is most difficult and anxiety may be at a cyclical peak. Moreover, deep down most LPs know that performance in the VC sector is counter cyclical to the amount of money raised by VCs. If you over-fund the industry, aggregate returns fall. Writing huge checks to bloated multibillion dollar VC funds could easily exacerbate the problems that already exist.

One response from the LP community might be to demand commitments from new funds that prohibit inside-led rounds and cross-fund investing. This can help to ensure that new capital is not put to use in an attempt to save previous investment decisions — an activity known as “throwing good money after bad.”

If this were not enough, some LPs are also being solicited to participate in SPVs (Special Purpose Vehicles), frequently from the very funds they have backed. As discussed earlier, some investors have reached a stage when they are overcommitted to a particular company in a particular fund (“at capacity”). Yet these investors want to keep providing capital to their Unicorns and support a growth-over-profits attitude. So they create a one-time special purpose investment vehicle (while greedily asking for even more carry). And the SPV has the added risk that is has no portfolio diversification or “look-back” feature to provide downside protection.

Obviously the LPs can just say “no” to participating in the SPV (even though they may feel the pressure of obligation from the fund). This is likely the smart move. First, someone is asking you to write a check at the exact time everyone else is overcommitted.  Hey, come help us out, we are drowning over here!  Second, you already have ample exposure to this exact company, through your original investment. Lastly, it is quite unlikely that a historical study of peak-cycle SPV participation shows good returns.

ALL PREVIOUSLY UNTAPPED FINANCIAL SOURCES (FAMILY OFFICES, SOVEREIGN WEALTH FUNDS, ETC)

If you have a large pool of money and you haven’t been approached to invest in a Unicorn, it’s simply because people do not know where to find you. There are three types of people who are likely now approaching you, all of whom you should engage with quite carefully:

  1. SPV promoters – As mentioned in the section on LPs, investors have also broadened their SPV marketing more broadly to family offices and other pools of capital. The pitches typically involve phrases such as “you are invited to” or “we will provide access to” an opportunity to invest. This “you are so lucky to have this opportunity” pitch is eerily Madoffian. And remember, this solicitation is coming from investors who actually have money, but already know they are overcommitted.
  2. Brokers and 3rd-tier investment banks promoting the sale of secondary shares in Unicorn companies – If you ask any large family office, they will tell you they are being bombarded with calls and emails offering secondary positions in Unicorn companies. Often with teasers such as “20-40% discount to last round price.”
  3. Incremental Unicorn round – You might also be called on simply to pump more capital into a standard Unicorn round. With many investors “at capacity” due to the historic amounts of capital already raised, some companies are looking under any and every rock they can for more dollars.

One of the shocking realities that is present in many of these “investment opportunities” is a relative absence of pertinent financial information. One would think that these opportunities which are often sold as “pre-IPO” rounds would have something close to the data you might see in an S-1. But often, the financial information is quite limited. And when it is included, it may be presented in a way that is inconsistent with GAAP standards. As an example, most Unicorn CEOs still have no idea that discounts, coupons, and subsidies are contra-revenue.

If an audit is included, it might have massive “qualifications” where the auditor lists all the reasons that this particular audit may not comply with GAAP standards and that things could change materially if they dig in deeper. Investors need to really open their eyes to the fact that these are not IPOs. The companies have not been scrubbed in the same way, and the numbers they are looking at on a PowerPoint deck are potentially erroneous. Here is a recommendation: If you are about to write a multimillion dollar check for an incremental Unicorn investment, ask to speak to the auditor. Find out exactly how much scrutiny has been applied.

New potential investors might also be surprised how few Unicorn executives truly understand their core unit economics. One easy way to spot these pretenders is that they obsessively focus on high level “gross merchandise value” or “multi-year forward bookings” and try to talk past things like true net revenue, gross margin, or operating profitability. They will even claim to be “unit profitable” when all they have really done is stopped being gross margin negative. These companies will one day need real earnings and real profits, and if the company does not proactively address this, you should not be giving them millions of dollars in late stage financings.

Perhaps the biggest mistake untapped investors will make is assuming that because there are branded investors already in the company, that the new investment opportunity must be of high quality. They use the reputation of the other investors as a proxy for due diligence. There are multiple problems with this shortcut. First, these investors are “pot committed.” They invested a long time ago, and without your money their investment is “at risk.” Second, as discussed, they are already full and nervous. They didn’t call you before when they built their reputation.  Why are they friendly now?

The main message for investors who are just now being approached is the following: it’s not the second inning or even the sixth, it’s the fourteenth inning in a five-hour baseball game. You are not being invited to a special dance, you are being approached because you are the lender of last resort. And because of how we meandered to this place in time, parting with your dollars now would be an extremely risky move. Caveat emptor.

SEC Visits Silicon Valley

A few weeks ago, on March 31, 2016, the Chair of the SEC made a trip to Silicon Valley and gave a speech at an event at Stanford Law School. For those that are participating in Unicorn investing or for those considering investing in Unicorns, it would be a good idea to read the entirety of her presentation (which can be found here). Bloomberg’s interpretation of her presentation was that “Silicon Valley Needs To Corral Its Unicorns.

Chair White seems quite aware of the issues and pressures that have an ability to distort the Unicorn fundraising process:

Nearly all venture valuations are highly subjective.  But, one must wonder whether the publicity and pressure to achieve the unicorn benchmark is analogous to that felt by public companies to meet projections they make to the market with the attendant risk of financial reporting problems.

And then she sends a message to all former and future investors regarding the need for increased due diligence:

As I will discuss, the risk of distortion and inaccuracy is amplified because start-up companies, even quite mature ones, often have far less robust internal controls and governance procedures than most public companies.  Vigilance by private companies about the accuracy of their financial results and other disclosures is thus especially critical.

It would be quite unfortunate if the fundraising behavior of the Unicorn herd led to increased SEC involvement and rules with respect to private venture-backed startups. But if those involved believe that “not being public” also means “not being responsible,” we will quickly find ourselves in that exact place. We will have deservedly invited more scrutiny.

Mo Money Mo Problems

Perhaps the biggest lapse in judgment for all of those involved is the assumption that if we can just raise “one more round” everything will be fine. Founders have come to believe that more money is better, and the fluidity of the recent funding environment has led many to believe that heroic fundraising is a competitive advantage. Ironically, the exact opposite is true. The very best entrepreneurs are relatively advantaged in times of scarce capital. They can raise money in any environment. Loose capital allows the less qualified to participate in each market. This less qualified player brings more reckless execution which drags even the best entrepreneur onto an especially sloppy playing field. This threatens returns for all involved.

The reason we are all in this mess is because of the excessive amounts of capital that have poured into the VC-backed startup market. This glut of capital has led to (1) record high burn rates, likely 5-10x those of the 1999 timeframe, (2) most companies operating far, far away from profitability, (3) excessively intense competition driven by access to said capital, (4) delayed or non-existent liquidity for employees and investors, and (5) the aforementioned solicitous fundraising practices. More money will not solve any of these problems — it will only contribute to them. The healthiest thing that could possibly happen is a dramatic increase in the real cost of capital and a return to an appreciation for sound business execution.

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Above the Crowd

A Rake Too Far: Optimal Platform Pricing Strategy

In a casino, the term “rake” refers to the commission that the house earns for operating a poker game. With each hand, a small percentage of the pot is scraped off by the dealer, which in essence becomes the “revenue” for the casino. While casinos use the term “rake,” a plethora of interesting word choices exist which all describe the same thing – keeping a little bit of the revenue for the company that is running the service. Examples include “commission,” “fee,” “toll,” “tax,” “vig” or “vigorish,” “juice,” “the take”, and “graft” (although this last one is typically associated with corruption in politics).

Many Internet marketplaces also have a rake or vig. The percentage rake is the amount that the marketplace charges as a percentage of GMS (gross merchandise sales), which typically represents net revenues for the marketplace. As an example, eBay’s 2011 marketplace revenues were approximately $6.6B against GMS of approximately $68.6B for a rake percentage of just under 10%. It may seem tautological that a higher rake is always better – that charging more would be better than charging less. But in fact, the opposite may often be true. The most dangerous strategy for any platform company is to price too high – to charge a greedy and overzealous rake that could serve to undermine the whole point of having a platform in the first place.

Before discussing the merits of low rakes versus high rakes, let us first take a look at current examples of different rakes across the Internet. The table above shows estimated rakes for several online businesses as a percentage of GMS. Do not assume that these numbers are specifically accurate as some vendors make these very hard to deduce.*  There is also the added noise of kick-backs that are common in industries like ticketing. You can see very high rakes in the case of iTunes, Facebook, and GroupOn down to especially low rakes for the likes of OpenTable and HomeAway. Amazon marketplace fees are published on their website, and vary by category, but they basically range from 6-15%, so lets say the average is approximately 12%. eBay recently launched an aggressive campaign attacking Amazon’s rate table on a vertical-by-vertical basis (those percentages can be found here). One company with an astonishingly high rake is recently IPOed Shutterstock, a photo-purchasing marketplace where the content owner receives only 30% of gross receipts. As we will argue below, this could in fact be a very fragile situation.

When evaluating new marketplace investments, we are naturally biased towards entrepreneurs who understand the strategic rationale behind the argument for a lower rake. If your objective is to build a winner-take-all marketplace over a very long term, you want to build a platform that has the least amount of friction (both product and pricing). High rakes are a form of friction precisely because your rake becomes part of the landed price for the consumer. If you charge an excessive rake, the pricing of items in your marketplace are now unnaturally high (relative to anything outside your marketplace). In order for your platform to be the “definitive” place to transact, you want industry leading pricing – which is impossible if your rake is the de facto cause of excessive pricing. High rakes also create a natural impetus for suppliers to look elsewhere, which endangers sustainability. These reasons are likely behind the struggles in GroupOn’s core Daily Deals business (North America Third Party Revenue is down in Q4 both YOY and QOQ). With a rake of approximately 38% (and this is “after” asking the merchant to underwrite a 50% discount to the consumer) the recovery from each transaction for the supplier is only 30%, representing an “effective” rake of 70%.

High volume combined with a modest rake is the perfect formula for a true organic marketplace and a sustainable competitive advantage. A sustainable platform or marketplace is one where the value of being in the network clearly outshines the transactional costs charged for being in the network. This way, suppliers will feel obliged to stay on the platform, and consumers will not see prices that are overly burdened by the network provider. Everyone wins in this scenario, but particularly the platform provider. A high rake will allow you to achieve larger revenues faster, but it will eventually represent a strategic red flag – a pricing umbrella that can be exploited by others in the ecosystem, perhaps by someone with a more disruptive business model. As Jeff Bezos is fond of saying, “your margin is my opportunity.”

Many people do not know this, but one of the most amazing Internet success stories is the European division of The Priceline Group, which operates under the brand Booking.com. Booking.com is the unquestioned leader in online travel in Europe, and represents a substantial portion of TPG’s astounding $35B market capitalization. Booking.com was not always the online leader in Europe – in fact they were a disrupter stealing the flag from other large incumbents. In the late 1990’s companies like Expedia and Travelocity had become enamored with what is known as the “merchant model.” Basically, these companies would “package” vacation offerings for the consumer and sell them as a bundled offering. The merchant model could produce a rake of well over 30%, and was therefore attractive to companies like Expedia. Booking.com took a much more aggressive approach (perhaps because it was the only one available) . They started with a 10% “agency model,” which not only represented a lower rake, but also provided better cash flow terms to the supplier. As such, they were able to signup nearly every small hotel in Europe. This resulted in more selection for the consumer and more support from the supplier base. Dennis Schall at  Skift.com has a wonderfully detailed account of how Booking.com came to dominate Europe, along with a more recent article addressing the lingering ramifications of the industry’s natural shift to the lower friction (lower rake) agency model.

It turns out that the average rake at Priceline Group  is even higher today, as they allow merchants to voluntarily bid up their rake for better placement in the network (you can see this in the table above). This is one of my favorite marketplace business model “tweaks.” You start with a low rake to get broad-based supplier adoption, and you add in a market-driven pricing dynamic that allows those suppliers who want more volume or exposure to pay more on an opt-in basis. This way no one leaves the network due to excessive fees, yet you end up with a higher average rake over time due to the competitive dynamic. And when prices go up due to bidding and competition, the suppliers blame their competition not the platform (part of the genius of the Google AdWords business model). This also allows you to extract more dollars from those suppliers who desire to spend more to promote themselves (without raising the tax on those that don’t).

Here is another interesting story related to rakes. In 2006, Benchmark started spending time with Gary Swart and the team at oDesk. We were quite enamored with their marketplace for skilled global talent, and were amazed at how the tools in their online workplace allowed customers to hire, manage, and pay for work from distributed teams. Combined with a bidding and reputation system, oDesk had built an “ebay for work.” At the same time, there were several larger players in the market such as Freelancer and Rent-a-coder. After discussing competition at length, the team came upon the idea of lowering the commission from 30% (which was standard in the industry) to 10% of overall costs. We were excited to hear such aggressive strategic thinking from the team, and they were excited to hear from an investor with a long-term perspective (this change obviously reduced current period revenue to 1/3 of its current level).  The rest is history. By 2009 oDesk surpassed the nearest competitor, and they are now the clear leader (larger than their top competitors combined) in the rapidly emerging “online work” industry.

All of which leads us to two very interesting rake examples that are front and center in today’s Internet – Facebook and Apple. Both of these companies charge a hefty 30% fee for transactions on their platform. Because most of the developers building on these platforms make software, the developers do not experience immediate pain when they share 30% of top-line revenue. After all, marginal costs are near zero, and therefore the fee is tolerable. But the real question is: Does the 30% marketplace on top of the platform help to reinforce the strategic positioning of the platform itself? Or is it merely a revenue extraction exercise? And if so, is there a risk that a “rake too far” could be a net-negative from a strategic standpoint?
Let’s start with Facebook. For the first several years, Facebook’s application platform was a smashing success. The distribution power of their pervasive platform proved a remarkable vehicle for many companies; particularly games companies. The platform was so successful so quickly that many early adopters of the platform rocketed to hundreds of millions in sales. Zynga, which was particularly adept at surfing the Facebook wave, catapulted to $1 billion in revenue in its sixth year of existence! Everything looked incredible. Fast-forward to today (only a few years later), and games companies are no longer betting their whole company on Facebook. Oddly, they are aggressively and strategically looking to expand non-FB distribution.

It is really hard to pinpoint exactly what went wrong. One might question Facebook’s commitment to being a game platform. Some might also highlight the lack of breadth in its success, and argue that Zynga had it “too good” versus other players in the field. And some might point to the rise of mobile which created a difficult platform transition for Facebook (which we will address shortly). In addition to these issues, there is also a strong argument that 30% was simply an excessive rake.

When you consider that many of these same game companies were also large buyers of Facebook’s ad products, it suggests that the “actual” rake, the real cost of being competitive on the platform, was much higher than 30%. Given Facebook’s position as the leading global social network with high barriers to entry, there was no need to maximize revenue on day one. It was far more important to prove the platform as a viable and efficient distribution mechanism for a broad range of products and services, and to convince all partners of the unquestioned efficacy of the platform itself.

Last November, Zynga and Facebook together renegotiated their previous long-term business agreement. According to the old agreement, Zynga was required to shell out 30% of their revenue even if they generated revenue “off Facebook”.  That is a very aggressive rake. Now Zynga is freed from many commitments it had made to the Facebook platform, and is allowed to build independent revenue streams outside of Facebook. The reality is that Zynga is still highly dependent on Facebook. However, Zynga shareholders are now tracking Zynga’s percentage of revenue tied to Facebook and consider it a positive if they can reduce this dependency. The bottom line is that the entire gaming industry has lost some of its enthusiasm for the Facebook platform, and it will be difficult for Facebook to recreate the magic and momentum they once had.

The Apple case is more extreme as the impact is more consequential. Despite the fact that Apple had/has industry leading hardware margins on its incredible computing products, Apple felt the need to take 30% of the revenue that was created by its app ecosystem as well as 30% of the revenue from media rentals and sales. In retrospect, demanding to be paid on both sides was a sign of overconfidence. However, the truth is they made this work for a very long time. Many companies, thriving on the Apple platform, didn’t exist and wouldn’t exist were it not for iOS. For itself, Apple has created billions and billions of high margin revenue and corresponding bottom line profits as a result of the amazing success of its 30% rake. All of which helped catapult Apple to the very top of the business hierarchy – the largest market capitalization company in the world.

The single-biggest problem with Apple’s aggressively high rake was its impact on potential long-term strategic partnerships. Specifically, two companies that potentially could have helped to reinforce the success of the iOS platform blinked, paused, and then went on to support a competitive platform. Both Amazon and Facebook could have been and should have been BFFs with Apple. And if Apple could go back in time, they would surely opt to be BFFs also. The most threatening company for all three players was clearly Google. However, Amazon owns a digital media business built around Kindle. And Facebook, as discussed, has a 30% rake business helping game developers distribute and monetize games throughout its network. When Facebook and Amazon read the terms of service of the iOS platform, and came to grips with the reality of the 30% rake, they saw an instant road-block – a show-stopper to their potential success on that platform. It was very hard to imagine their business model and Apple’s business model coexisting, and so they eventually punted on a full commitment to iOS.

The bottom line is they could have been amazing partners. If Apple had a lower rake, or even had they been less obstinate about their existing rake, a partnership could have formed (ask anyone in Hollywood – “splits” can solve any problem). iOS could have been both the definitive Facebook mobile device, AND the definitive Amazon shopping device. They could have been integrated from the beginning at a deep level: your social network in contacts; your Amazon 1-click credentials a fingertip away. Jeff Bezos, Mark Zuckerburg, and Steve Jobs on a stage together talking about the truly amazing things these companies have done together. It could have been awesome. But it didn’t play out that way.

Instead, as you are aware, Facebook’s new Home mobile application is available only on Google’s Android, Apple’s key nemesis of the past decade. There are currently no plans to offer Home on iOS, and Eric Schmidt, Google’s esteemed Chairman, cheered along in appreciation at the recent Dive Into Mobile Conference, “I think it’s fantastic — I love it,” Schmidt said. Instead of becoming a platform differentiator for Apple, Facebook is now aiding and abetting Apple’s only real competition.

The Amazon situation vis-a-vis Apple is more severe. In stiff-arming Amazon over its “30%” Apple not only alienated a key partner but launched a competitor. Amazon has obviously designed its Kindle Fire system on top of an Android variant. But that is only half the problem. Amazon, in true Amazon fashion, is now attacking Apple’s exposed business underbelly: the fat margins they receive by charging both high hardware margins and a high rake on content. As outlined in its recent Letter to Shareholders, Amazon does not believe that its customer should have to pay fat margins on hardware AND content. “Our business approach is to sell premium hardware at roughly breakeven prices. We want to make money when people use our devices – not when people buy our devices.” Amazon plans to subsidize the hardware platform and live solely on the content margin. The 30% rake basically launched a nasty competitor with a disruptive pricing model.

Number one on the list of Peter Drucker’s Five Deadly Business Sins is “Worship of high profit margins and premium pricing.” As Drucker notes: “The worship of premium pricing always creates a market for the competitor. And high profit margins do not equal maximum profits. Total profit is profit margin multiplied by turnover. Maximum profit is thus obtained by the profit margin that yields the largest total profit flow…” Most venture capitalists encourage entrepreneurs to price-maximize, to extract as much rent as they possibly can from their ecosystem on each transaction. This is likely short-sighted. There is a big difference between what you can extract versus what you should extract. Water runs downhill.

*Please let us know if you have other names you would add to the table, or if there are numbers you think need correcting. I will update the table and put the rolling updates in the answer to this quora post on the same topic.

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Article from AboveTheCrowd by Bill Gurley.

“Back in October, Techcrunch announced that Dropbox had raised $250mmat a seemingly absurd valuation. Many firms, including my firm Benchmark Capital, participated. When this happened, many people asked us why this was a special company that would cause us to break our standard investment paradigm. They didn’t quite understand why this was a company that deserved once-in-a-generation special attention.

The first answer to this question is rather straightforward, but not earth shattering. Drew Houston and his team had taken a hard problem — file synchronization — and made it brain dead simple. Anyone that had used previous file synchronization programs, including Apple’s own iDisk, constantly encountered state problems. Modifications in one location would get out of synch with those in another, ruining the  entire premise of seamless synchronization. It wasn’t that these other companies did not understand the problem, it was just that they could not execute on the solution. The Dropbox team solved this, which was a critical innovation.

Although this was critical, nailing technical synchronization would not necessarily warrant outsized valuations. In order to be worth $40B one day (which is 10X the $4B reported round, the objective return of a VC investment), the company would need to hold a place in the ecosystem that is far more strategic than that of a simple high-tech problem solver. So what is it Dropbox does that is so special?

This evening, TechCrunch reported that Dropbox would automatically synch your Android photos. Once again, someone could suggest “so what, how hard is it to do that?, and why is that worth billions?”

Here is why. Once you begin using Dropbox, you become more and more indifferent to the hardware you are using, as well as the operating system on that device. Dropbox commoditizes your devices and their OS, by being your “state” system in the sky. Storing credentials and configurations of devices, and even applications are natural next steps for this company. And the further they take it, the less dependent any user becomes of the physical machine (HW and SW) that is accessing that data (and state). Imagine the number of companies, as well as the previous paradigms, this threatens.

That is a major, major deal. And it comes at a time where there are many competing platforms on both desktop and mobile. This “unsure” market backdrop ensures the need for a cross-platform solution and plays right into Dropbox’s hand. You can lose your desktop computer, you can lose your smartphone. It doesn’t matter, because all you really care about is in the Dropbox cloud.”

To read the blog, and reach Bill Gurley, please click here.

 

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