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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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Hot shot startup investor Bill Gurley just wrote a cryptic tweet about the looming tech bubble — once you understand it, you’ll be a little freaked out

The other day, Bill Gurley, who has to be on the Top 5 most successful and smartest VCs, had a few semi-cryptic tweets. Cryptic to non-VCs, at least:

At our recent LP meeting, an LP told me industry wide distribution $ relative to paper value is at an all time low.

Wet bubbles (1999) are more fun than dry ones (2015).

Many of you may not even know what an LP meeting is. It’s where VCs meet with their own investors, the “Limited Partners.” And it might be a bit cryptic what this LP said to him.

But it’s very interesting, and here’s the actual data from Cambridge Associates (Thank You!), the leading industry analysts of VC data — albeit only through the end of ’12 (though as we’ll see below, nothing’s really changed since then):

venture capital unrealized valueSaaStr

There is even more VC industry lingo in here, but once you understand it, it’s quite interesting.

The top line, or “TVPI”, are paper mark-ups + cash back out (distributed capital). “DPI” on the bottom is just the actual cash back out. You can see the delta is quite, quite large.

What’s a paper mark-up? Well, some late-stage private market investor invests in my company at a $1 billion valuation. If I invested at a $10 million valuation, I get a 100x paper mark-up. I’m a hero at the firm. I brag. I run a pre-victory lap and tell myself how brilliant I am. That I see the future.

But…

In this scenario, as brilliant as I look with my 100x mark-up…I’ve actually returned nothing in cash. No cash. Not a nickel. It’s a gain, yes — but on paper only. Until an IPO, or an acquisition, no cash goes back out. Sometimes a little goes back out in a so-called secondary sale, but even when it does, this is usually pretty small.

So the bottom line on this cash, DPI, is hard cash back out to the LPs.

And as you can see, there ain’t much cash going back out. In fact, DPI or “cash out” from VC funds hit rock bottom in ’12, and the gap between mark-ups and cash distributed is at an all-time maximum.

Bill GurleyFlickr/TechCrunchBill Gurley thinks there is a dry bubble.

Hence — Bill Gurley’s Dry Bubble. It’s a bubble in valuations. But there ain’t no cash. The bubble isn’t an IPO bubble, like Broadcast.com or GeoCities or TheGlobe. No cash is going back out to create the next Mark Cubans, at least not that much. At least not yet.

Now, some great IPOs in ’16 can “cure” this and generate cash back to those folks putting all this money into Unicorns. And many of the best companies are intentionally holding off on IPO’ing, taking time to grow faster without the scrutiny of Wall Street. This delta, this gap, may be temporary. An Uber IPO, an AirBnb IPO, etc. will boost that bottom line substantially. If every unicorn IPOs, all will be right in the world, and the Dry Bubble will become very, very Wet (i.e., cash rich) indeed.

You can see though that even with 2014 data, from this great A2Z prez below, the “gap” between private Unicorn $$$ (75% of investment) vs. “real” Unicorns (from an IPO or acquisition) is still quite high:

With 75% of invested capital trapped in private Unicorns (another way to look at it), that’s pretty dry.

So for now at least — it’s a roach motel. All this money is going in at higher, all time higher, valuations — but very little is coming back out.

The optimists believe it’s just a matter of time. But if you’re say the guy that sold Broadcast.com to Yahoo! for $5.7 billion…you might think this really is the driest of all bubbles, of all time.

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Venture Capitalist Sounds Alarm on Startup Investing
Silicon Valley Has Taken on Too Much Risk, Gurley Says

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By YOREE KOH and ROLFE WINKLER CONNECT
Updated Sept. 15, 2014 3:17 a.m. ET

Venture capitalist Bill Gurley, shown in 2010, says cash-burn rates at tech startups are alarmingly high. Bloomberg News
Silicon Valley is a risk-driven place. But over the past year, it may have taken on more than it can handle, according to one prominent venture capitalist.

“I think that Silicon Valley as a whole, or that the venture-capital community or startup community, is taking on an excessive amount of risk right now—unprecedented since ’99,” said Bill Gurley, a partner at Benchmark, referring to the last tech bubble.

Mr. Gurley, who often voices his opinions on his blog, Above the Crowd, sat down with The Wall Street Journal as part of a Journal event series called “Tech Under the Hood.” The investor in Uber, Zillow, OpenTable and other Web startups spoke on a wide range of topics. What follows is an edited excerpt of a conversation specifically about potential cracks in the tech-startup investing scene.

WSJ: I want to read you something from your blog. You quoted Warren Buffett’s famous quote, “Be fearful when others are greedy and greedy when others are fearful.” And then you wrote: “Although we may have not reached the level of observing obvious greediness, there is most certainly an absence of fear. Those that managed companies in 2008, or 13 years ago in 2001, know exactly how fear feels. And this is not it.” What did you mean by that?

WSJD is the Journal’s home for tech news, analysis and product reviews.

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Mr. Gurley: Every incremental day that goes past I have this feeling a little bit more. I think that Silicon Valley as a whole or that the venture-capital community or startup community is taking on an excessive amount of risk right now. Unprecedented since ‘’99. In some ways less silly than ’99 and in other ways more silly than in ’99. I love the Buffett quote because it lays it out. No one’s fearful, everyone’s greedy, and it will eventually end. And there are reasons, which might take all night to explain, why this business is cyclical over time, and the more chance you have to see different cycles and to see how it slips away, you can see it.

There’s a phrase that I love: “discounted risk.” Do people discount risk? Right now you’ve got private companies raising $200, $400, $500 million. If you’re in a competitive ecosystem and you raise that amount of money, the only way you use it—because these companies are all human-based, they’re not like building stores—is to take your burn up.

And I guarantee you two things: One, the average burn rate at the average venture-backed company in Silicon Valley is at an all-time high since ’99 and maybe in many industries higher than in ’99. And two, more humans in Silicon Valley are working for money-losing companies than have been in 15 years, and that’s a form of discounted risk.

In ’01 or ’09, you just wouldn’t go take a job at a company that’s burning $4 million a month. Today everyone does it without thinking.

WSJ: Because the equity looks so valuable?

Mr. Gurley: Yeah, it’s a whole bunch of things. But you just slowly forget, and half of the entrepreneurs today, or maybe more—60% or 70%—weren’t around in ’99, so they have no muscle memory whatsoever.

So risk just keeps going higher, higher and higher. The problem is that because you get there slowly the correcting is really hard and catastrophic. Right now, the cost of capital is super low here. If the environment were to change dramatically, the types of gymnastics that it would require companies to readjust their spend is massive. So I worry about it constantly.

WSJ: You used the word silly—a lot of silly stuff going on since ’99. Give us an example.

Mr. Gurley: I’ll give you something that’s tactical. Part of it is why it’s cyclical right. For the first time since ’99, in the past 12 months, I’ve been in board meetings where the company says, “Our only option is a 10-year lease,” at record pricing on a per square foot basis here in San Francisco, which is two or three times what the rent was three years ago. And so this is why it’s all cyclical—because the landlords get greedy. They wouldn’t do a 10-year lease if they thought that the rates were low. So they’re implicitly telling you they want to lock this in for 10 years, which is its own form of greed because what happened in ’99 is half the companies went bankrupt and they couldn’t pay the lease over the 10-year period.

Anyway, it’s those kinds of things that happen. The most obvious one is just the acceptable burn rate. And that can be seriously, negatively reinforced by the capital market. In the software-as-a-service world, where the risk is potentially among the highest, Wall Street has said it’s OK to lose tons of money as a public company. So what happens in the board rooms of all the private companies is they say, “Did you see that? Did you see they went out and they’re losing tons of money and they’re worth a billion. We should spend more money.” And there are people knocking on their door saying, “Do you want more money, do you want more money?”

So it takes the burn rate up.

WSJ: As a result, is Benchmark pulling back?

Mr. Gurley: There are two types of answers to that question. How do we go about investing on a day-to-day basis in terms of new things? And I happen to believe that innovation happens more continuously, even though there are financial cycles, so you can’t afford not to be out on the field. But I do think you want to look out for what is the long-term viability of something. I’d much prefer to do a Series A [funding deal] right now than I would later-stage because of this type of risk. So that’s one type of answer.

The other type of answer is what you advise your companies to do. That’s really difficult because if you have a competitor that’s going to double or triple down on sales and you just decide, “Oh, well I’m not going to execute bad business decisions, I’m just going to sit back,” you lose market share. So, choosing not to play the game on the field doesn’t work, so you’re left with trying to advise someone to be pragmatically aggressive with some type of conservative backdrop or alternative strategy in case the world shifts. But it’s hard.

WSJ: And you see people apps like Yo or Snapchat. These things get hefty valuations but in reality what we’re talking about right now is eyeballs. And once upon a time I remember people were really intrigued by eyeballs, and that didn’t work out.

Mr. Gurley: I don’t have that criticism as much simply because we’ve seen so many proven cases now of taking huge market share and then monetizing. That was said against Facebook, FB -3.74% and that was said against Twitter. TWTR -5.24% I think the jury is out on our sale of Instagram and whether we sold it too soon. And so I don’t necessarily buy into the well, you’re not monetizing so it’s not valuable.’ And I guess [WhatsApp’s sale to Facebook for $19 billion] is another data point.

But I think it’s different to employ a bunch of people when you don’t have the wherewithal to fund yourself through and what type of risk are you taking (in that situation). Anyway, it’s something I think about constantly. And, unfortunately, I’ve come to believe that bad business behavior is coincidental with the best of times in our field.

WSJ: What do you mean by that?

Mr. Gurley: So, the crazier things get, the worse people execute. I was thinking of writing this so I’ll test it out on this group.

So I took my family down to the Galapagos this summer and read this book on the way down there called “The Beak of the Finch” which is about this couple that has lived on Daphne Island for 40 years studying the finch. And, amazingly, when there are huge El Niño years and floods bring tons of food to this island, the finch population goes up like three or four times. Inevitably, when the rains are normal the next season there is massive death. Simply because once you get the food level back to a sustainable level. So, from a fitness perspective, excessive amounts of food lead to a lower average fitness and I think the same thing happens here.

Excessive amounts of capital lead to a lower average fitness because fitness, from a business standpoint, has to be cash-flow profitability or the ability to generate cash flow. That’s the essence of equity value. And so I think we get further and further away from that in the headiest of times.

WSJ: So who loses? Who is way ahead of themselves? Name some names.

Mr. Gurley: That’s obviously loaded. I do think there is a high likelihood that we’ll see some high-profile failures in the next year or two. I actually think that could be healthy for the ecosystem. You remember in March when the IPO window closed for like three weeks and everyone thought that the world was coming to an end? Like you really have to work hard to remember it because it reversed itself so quickly. I think having events like that can lead to sanity.

And another element is—that most people don’t think about—liquidation preference. This is pretty technical, but liq preference piles up on a startup. It’s not common stock, it’s preferred, and it has a debt-like element on the ability to get your money back. So if your liq-preference stack gets so big it makes it is really hard to raise the next incremental round of financing, unless you have some kind of financial behavior that says it definitely should be worth more. They calcify a bit. That’s probably the right metaphor.

WSJ: So what does that mean exactly? Last in, first out?

Mr. Gurley: Sometimes that happens when terms shift. But at the very least, your return horizon might be impacted by, you know, now we’ve got private companies raising between $200 million and $1 billion. If the company ends up being worth not that much, then you don’t even get your money back. And your return payout at different points on the horizon may be negatively impacted by the fact that so many people could take their money back instead.

So one of the first things that happens when that starts to become a problem is that you start to see derivative terms, which gets to what you were talking about—first money out. And those things are guaranteed returns against an IPO or some type of debt. You have creeping PIK dividends (dividends paid in preferred stock), that kind of thing. And that then starts to change your return profile for everyone underneath it.

Write to Yoree Koh at yoree.koh@wsj.com and Rolfe Winkler at rolfe.winkler@wsj.com

 

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Above the Crowd

Grubhub and Seamless: Effecting The Elusive Private-Private Merger

Today, Seamless and Grubhub announced the signing of a definitive agreement to merge two of the nation’s premier services for ordering takeout online. As Benchmark is a large institutional investor in Grubhub, we were actively involved in the merger process, and we are quite excited about the potential of the two companies coming together. There are many synergies – different geographic strengths, different core customer bases, and different product strengths. And of course, we are afforded the advantage of greater scale.

Despite that there may be many obvious reasons for any two companies to combine, most private-private mergers (where both companies are private entities) never come to fruition. Public-public, and public-private are actually much easier to consummate. There are many reasons why private-private is so difficult, but allow me to highlight three specific challenges that seem quite prevalent.

 1)    Structural Challenges

Private companies typically have capitalization structures that are very complex. There are common stock, common options, and as many as three to five different layers of preferred stock, each with a specific liquidation preference. Finding a way to meld two complex capital structures is non-trivial, and may require compromise from many parties involved. But institutional investors are loath to give up previously negotiated rights, and this can be especially true when the investor in a competitive company is the one bringing the request. Even melding two separate option programs can be challenging. There are numerous techniques for bringing together two such structures, but none of them are remotely elegant, and they all involve spending many, many hours with lawyers. At the end of the day, structure is not a show stopper, but it creates a very high bar for consideration – you have to really want to make it happen to be able to sit down and sort through the complexity.

 2)    People Challenges

Prior to a merger, you have two separate management teams (with two separate cultures), and in order to merge, you have to agree on who is going to do what, and what each executive’s new title will be. It should come as no surprise that executives are fairly sensitive when it comes to topics of reporting structure and titles. Plus, you have the natural tendency to view any discussion as an “us versus them” type argument, which is not a frame of mind that is conducive to collaboration. The bottom line is that it is very hard to merge two management teams, especially when you consider the contracted time window typically associated with such a discussion. It’s speed dating. As a result, only if you have two teams with a shared vision for the future, and minds that are open to compromise could you ever hope to be successful. Some pretty high-profile mergers have fallen apart because of this issue.

3)    Investor/Founder Mindset Challenges

Most founders and investors typically think about their personal stakes in a private company in terms of “ownership percentage.” An investor may say “we own 22% of the company”, or a founder may note, “I still own 31% of my company.” These same constituents think about the overall company value in terms of dollars. As an example you might hear someone say, “we closed the last round at $100 million post.” When two private companies began discussions on merging, these overall corporate values are often debated. I call this the “dueling blowfish” problem. Private company valuation techniques are particularly specious (this contrasts with a public company that every day has a definitive market capitalization). Anyone can create any number they want (within reason), as there is no one specific formula or metric for such work. Most models are also based on forward forecasts, which offers another avenue for inflation. Basically, everyone uses loose finance arguments to over-inflate their own company’s valuation so that they can demand a bigger slice of the pie of the new company.

The only way around this is to reverse your way of thinking. First, you have to focus on the dollar value of your new stake in the combined company instead of focusing on the specific percentage. Even in a 50/50 scenario, each ownership stake is half what it once was. Assuming the deal is accretive, this should be “no-brainer” math; your new stock in the combined company is worth more than it was before. However, the “ownership” focused mind has a real problem with their stake being reduced so dramatically. Second, you need to only negotiate in terms of percentages (versus dollar value). One company will get X% of the combined company, and one company will get 1-X%. Taking this approach is the only way around the dueling blowfish problem. Assuming both sides think the merger is a good idea (and accretive) the future value is obviously going to be higher. The real question is how do we split the company amongst the two players, and focusing on this out of the gate will save an incredible amount of time.

These are just the challenges that you meet on the way to the altar. Many mergers fail not in the deal process but in the implementation process, as integration is very difficult, especially when it’s a merger of equals. And the human and cultural issues outlined above continue to exist as you attempt to merge two companies into one. Getting the “deal done” is only the beginning.

Once again, I am quite excited about the Grubhub/Seamless merger, and tip my hat to Matt Maloney, Mike Evans, Jonathan Zabusky, and both the Grubhub and Seamless management teams. Had they not started from day one of our discussions with a partnership mindset, we would have never have reached this milestone. I look forward to working with them both, as well as the investors and independent directors from both sides to help take the merged company to new heights.

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  • NYC Needs More Iconic Companies, Fewer Early Exits, VC Says

    By Yuliya Chernova

    Mark Lennihan/Associated Press

    New York.

    Bill Gurley, partner at Benchmark Capital, leveled a number of serious charges at a ballroom full of New Yorkers this week–the city has yet to produce an iconic venture-backed company, he said. And, he added, people here are more likely to sell early rather than create a true home-run for a venture firm via an IPO.

    Out of the 50 venture-backed companies that raised the most money via sales or IPOs over the years, none were located in New York City and only five were based in the New York region–that is in New Jersey or Connecticut, according to data from Dow Jones VentureSource.

    “What New York needs is more iconic companies that last over a long time,” said Gurley, on stage at Disrupt NY 2013, a conference organized by TechCrunch. Gurley, who said that Benchmark has made two investments in New York recently, compared the city to Seattle, where the top four businesses, MicrosoftAmazonCostco and Starbucks, were all backed by venture capital.

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Article from GigaOm.

Snapchat, the hot startup that allows you to send and receive photos or videos that sort-of-maybe disappear afterward, has raised a $13.5 million Series A funding round led by Benchmark Capital’s Mitch Lasky, putting the company’s valuation at $60 million to $70 million. The company’s growth hasn’t exactly been controversy-free, but has demonstrated the intense interest right now surrounding messaging apps that transcend the basic SMS.

The funding news was first reported by The New York Times and TechCrunch and was confirmed to us by CEO Evan Spiegel on Friday evening. Om Malik reported in December that Snapchat was getting funded by Benchmark, the firm that was also one of the early backers of Instagram.

“People are looking to communicate in a real way,” Lasky told the New York Times on decision to invest.

The Times reported that Snapchat is now seeing 60 million photos or videos sent per day. Snapchat added video to its product in December, when it was seeing 50 million photos sent per day. Facebook has since rolled out Poke, its obvious competitor to the popular startup in December, but it’s unclear that Poke has really challenged Snapchat’s dominance in the disappearing content realm.

Update: On Saturday, Lasky published a blog post explaining that he’s joined the board of Snapchat and believes the company has real staying power among mobile users:

“We believe that Snapchat can become one of the most important mobile companies in the world, and Snapchat’s initial momentum — 60 million shared “snaps” per day, over 5 billion sent through the service to date — supports that belief. Snapchat’s ramp reminded us of another mobile app Benchmark had the good fortune to back at an early stage: Instagram.”

Read more here.

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Article from PEHub.

If there is good news to be had in private equity these days, it is that limited partners seem to want to put new money to work.

Several recent studies have pointed in this direction, including one from Preqin, which found that a large number of endowments, public pensions, family offices, sovereign wealth funds and foundations want to invest in the coming year.

The top area of interest is buyouts. Second on the list is venture capital. Almost half of potential investors name venture as an asset class they will consider, Preqin says in a report issued this month.

This is welcome news to the industry. That’s because there is no shortage of funds out looking for cash. Preqin, in its study, finds 372 venture capital funds on the road, or nearly a fifth of all private equity funds on the fundraising trail. Together they seek $47.2 billion in commitments.

Many GPs will argue that consistency is their forte. But only some can truly make that claim, the study finds. Preqin assembled a list of the most consistent performers in venture based on IRR, fund year, strategy and geography. Only active managers that have three or more funds with a similar strategy are included and still formative 2010, 2011 and 2012 funds are not included.

Tied at the top of the list are Benchmark Capital, GGV Capital, Pittsford Ventures Management and Sequoia Capital, with the strongest record of top quartile funds. The list from the report is reprinted below.

(Editors note: The average quartile rank in the table is determined by scoring each fund. A top quartile fund gets a “1” and a second quartile fund gets a “2,” etc. The ranking is an average. Photo above courtesy of Shutterstock.)

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