Is It The End Of The World As We Know It?
I don’t know. Maybe? Over the past few weeks, we’ve begun to see a number of high profile startups failing to raise new rounds of funding such as Homejoy, GoodEggs and StumbleUpon:
What Really Killed Homejoy? It Couldn’t Hold On To Its Customers
StumbleUpon Lays Off Dozens After Failing to Raise New Round
While I’m by no means the first investor with this observation, I do believe it reflects an acceleration in the number of publicized growth stage companies failing to raise continuation capital (of course, given the sample size, timing could be entirely coincidental, but it doesn’t feel that way). In fact, it’s a timely development because it’s specifically the lack of companies failing that is concerning a great number of venture focused LPs. For example, an LP friend of mine recently noted the following to me –
The larger issue is that loss ratios in venture right now are way out of whack and not a lot of companies are failing. There are obvious outliers like Fab, Homejoy, Zirtual and Secret, but still a lot of unrealized markups. So it really comes down to how good the companies are that you've invested in and how durable they are.
What needs to be unpacked from that quote is that if “not a lot of companies are failing,” then it follows that someone must be supporting them. So it’s imperative to ask: who is supporting them and why? The who, in my mind, is reasonably well understood at this point: everyone from traditional growth firms, to corporate venture, to mutual funds, to wealthy foreign family offices. The why – at a high level – should always be: expected value, with “expected” certainly the operative verb.
But those expectations and estimations of future value may well be changing. A friend at a Top 10 growth firm noted to me the following this morning:
I think you're right and, yes, seems like folks are pulling back.
One, public markets are the ultimate arbiter of truth and they've weighed in quite negatively on the mid-cap tech stocks : Yelp, Shutterstock, Marketo, etc etc
Two, the whole benefit of the mezz-pre IPO / late stage venture round : it's a bridge to an outcome. Not a bridge to another bridge. If those late capital rounds are just helping you kick the can down the alley, then forget it. If you have a reasonable and purposeful plan in place to i.e. use the $ to tweak economics, or crispen the public story, or grow just a year or two more so you can have size and strength to show -- then absolutely.
The consumer companies are struggling in particular. Haven't quite nailed unit economics in most of these cases. People are just like - what do I get from this round?
There's a lot of irrationality in the Seed/A/B rounds and a lot of rationality in the C/D/E rounds. Those two dynamics are coming to a head.
As a MicroVC with four years of investment experience under my belt, I won’t pretend to understand the nuances occurring at every stage of the ecosystem, but I will note a few of these "dynamics" I see coalescing:
Scale it Before You Nailed It
As a startup community, we are living in age of scale first. The reasons for that are below in the next section. And while there will be winners, scale first is both tremendously expensive and volatile. From the GoodEggs blog:
The single biggest mistake we made was growing too quickly, to multiple cities, before fully figuring out the challenges of building an entirely new food supply chain. We were motivated by enthusiasm for our mission and eagerness to bring Good Eggs to more people. But the best of intentions were not enough to overcome the complexity. Today we realize that in order to continue innovating in San Francisco, our original market, in order to continue figuring out all the complexity that is required to achieve our mission, we cannot productively maintain operations in other cities.
Similarly, from Ellen Huet’s Forbes article on Homejoy:
Homejoy faced pressures dreadfully familiar to many successful young startups: Raising a huge round (in this case, $38 million in 2013) comes with investor expectations of equally huge growth. To meet those expectations, Homejoy expanded quickly — too quickly, former employees said — into new and international markets, at one point opening in 30 cities in six months.
Cheung “was always telling the growth story … because we need to have this story to raise the next round of capital,” said the same former employee. “She really felt that if the company stopped growing really, really fast we’d be dead.”
As an investor, I am guilty of advising several of my investments to scale too quickly. What I’ve begun to realize is that in some ways it’s actually easier to scale than refine a business model.
For example, early on in my career playing poker professionally, I faced the following dilemma: I realized I was a big winner in $400 buyin games, but only a breakeven player in $1,000 buyin games (where the skill level was higher). I had two choices: I could study, grind, experiment and take a few months learning the ropes in order to beat $1,000 games. Or, I could simply play more tables of $400 games (thereby playing more hands per hour & winning more money). Initially, I chose the latter because it was the easier decision – I simply needed to play more (even if slightly more distracted) to win more money. I ultimately realized this was a mistake and spent months rebuilding my game.
Again the issue here is NOT that scaling is fundamentally incorrect. It's that if your scale ambitions are so high, and you've gone so wide so fast, well then, you're left with a "bridge to another bridge" - specifically what the market is beginning to reject.
Megarounds Causing a Loss of Fundamentals
The logic of today’s growth financing market operates as follows:
The majority of markets operate as Winner Take All where outsized returns accrue to only a single dominant player, as outlined by Wealthfront co-founder Andy Rachleff in Demystifying Venture Capital Economics.
Investors are therefore highly incentivized to create unicorns/decacorns/gorillas/whatever you want to call them.
Cost of capital is at historically low rates, to the point of even negative interest rates in Europe – “flabbergasting” Berkshire Hathaway investor Charlie Munger. For reference negative interest rates actually “punish banks that hoard cash” in order to force lending.
Therefore, focus is unilaterally on scale and growth ahead of fundamentals, with the theory being that once customers are locked in (either enterprise or consumer), the model can be refined.
Because companies assume their competitors are optimizing for scale (i.e. trying to raise mega-rounds) they also raise mega-rounds.
The convergence of multiple mega-rounds inflates cost structures/weakens economics for both companies forcing them to raise further funding.
From Bill Gurley’s Investors Beware:
The very act of dumping hundreds of millions of dollars into an immature private company can also have perverse effects on a company’s operating discipline. The only way to use the proceeds of such a large round is to take on massive operating losses. Historically, as a company neared an IPO level of revenues (say $50-$100mm), investors would expect convergence toward profitability. As these late-stage private companies digest these large fund raises, they are pushing profitability further and further into the future, as well as the proof that their business model actually works.
While the high level logic of the megarounds is sound: that unicorns should be prioritized for outsized returns – there appears to be an absolute uncertainty surrounding how far to scale and at what cost. Is 5 markets sufficient? 15? 50? 100? There will always be more potential ground to cover. Gurley’s point is that the recent spate of continual growth financings is akin to not knowing when to take some money off the table. The market may well give you a loan to double down – but should you?
Consumer Companies
As noted above, the carnage (for the moment) appears directed at consumer companies. What's disconcerting as a consumer investor is that it's not simply social or media plays devoid of revenue at all, but even revenue generating transactional models such as Homejoy, Goodeggs, or Fab. I don't have a good answer yet for why this is. If sales driven enterprise software companies are exempt from current market concerns, revenue generating consumer companies should also earn some credit. Maybe it's about margins or delusions of Long Term Value? Unclear, but worth more consideration.
It's also hard to know whether this is a coincidence of sample size, a temporary pause in the markets as investors get over-saturated with opportunities/deals (recall that the IPO markets entirely closed in the spring of 2014 for a month around the time Box.com was looking to go out - then boomed again), or a fundamental shift in investor perspective.
All that said, one thing is clear: from the people I'm talking to and the signs I'm seeing, it really feels different right now. Only time will tell.