Are startups overvalued? According to those who possess a crystal ball shinier than ours, it would be a thin argument to defend otherwise. But, its what’s underneath these views that’s really interesting.
Michael Moritz sets the beat with his Subprime Unicorns. Here he puts forth that if the unicorns were public today, their stock prices would be decimated upon presenting their most recent (all red) quarterly financials to analyts. He intimates that the investors who led those abundant private rounds knew all too well that the price/share they paid was inflated. Otherwise, why would they have placed structure on their investments?
The structure Michael refers to is “debt in all but name” via protective provisions that guarantee a minimum return for the investor. The most common structures are ratchets (issuance of additional shares at IPO should the listing price fall short of the price of the last private round), >1x senior liquidation preferences (last money in, first money out, and then some at the expense of earlier investors), and participating preferred stock (a cut of common’s proceeds, typically without individual employees’ knowledge and certainly without their consent).
The presence of these structures is not uncommon. What’s new, that we’ve observed in the course of evaluating “people investments”, is that companies have increasingly been accepting overly aggressive protective provisions in their term sheets in order to garner the honorary headlines and with the belief they’ll grow into those valuations before they go public.
If Michael sets the beat, then Bill Gurley is the amp system. He has been clanging the “warning bell” repeatedly stating that “when winter comes, Dead Unicorns will fall”. He foretells that those destined to infamy are the startups who covet growth over profitability, with “reckless disregard” for how much it costs to feed their growth ambitions.
Fred Wilson concurs with Bill in what amounts to an open letter to Union Square portfolio companies where he declares that losing money, driven by investor’s largess, is not the path to building a real business. Aileen Lee of Cowboy Ventures, the author of the much lauded “Unicorn” term, has now introduced its variant “Unicorpses” as the label of those who will become a mere footnote should they not turn their businesses towards profitability.
Driving these prices ever upward has been a bevy of new or unheard of names—hedge funds, mutual funds and atypical corporates—along with opaque special purpose vehicles (the latter operating like “pop-up venture firms”). This lot operates on a valuation methodology that reflects an infinite price elasticity and an uninspired expectation for their return on investment. Instead, their motivations have been obtaining an allocation of a basket of goods now during the startups’ private lives or by securing access to a strategic asset before it becomes unattainable in the startups’ public life.
But, what if today's largest and fastest growing startups don’t get to profitable health and don’t get acquired or go public at a valuation greater than today's? As Mark Suster of Upfront Ventures states, it would be Mourning in VC where we’d witness broad based down rounds. He points out that we may not be too far off. 2014 witnessed 25% in down rounds from the last private round of financing to the IPO listing price. 2015 has already seen 71% (among them are names whose products are used daily by the average consumer or employee). Adding fuel to this fire is the recent media frenzy around Fidelity's and T. Rowe's markdowns of their portfolio company investments (and associated regulatory scrutiny). In fact, it’s why we've seen this ilk of investor all but disappear from the private company investing landscape.
As the hand-wringing and navel gazing continues, the question becomes “now what?”. Michael Moritz says “get disciplined for the shadows of private life afford no place to hide”. Bill Gurley says “get a Plan B to be able to turn on profitability at a moment’s notice”. Said differently, they're calling for a decisive move from free flowing cash to free cash flow.
For Founders Circle, we have been fortunate to work with #breakawaygrowth companies that are both great businesses and great investments. For us, both have to be present given the timing of when we’re invited in to help the team. And, if there’s a situation where our proposed program might be buried beneath the preference stack we’ll, regretably, pass on the investment. We won’t get it right every time, but we only move forward where we have strong conviction that a company is demonstrating operating leverage leading to sustainable growth and durable gross margins.
Along the way towards making our current investments, 942 people investments across 18 companies, we passed on 146 amazing companies. That’s 146 companies that exceeded our “40 Rule” but didn't have the required investment characteristics. Each time we choose not to get involved with one of these companies, it was painful because there's so much to admire about their businesses.
But we're always reminded of the brutal elegance of market forces. Startups will either make the move to profitability voluntarily or they’ll be beaten into submission by competitors and public investors. If, instead, companies choose to only turn on the afterburners, they’ve been forewarned by some of the most astute startup investors that they’ll (predictably) find themselves on a future Wall Street Journal list—The “ex-Billion Dollar Club”.