Rainbows in the World of Venture Capital

Little girls love to live in a make-believe world. I know this because I have one – a little girl that is. She understands that teddy bears don’t have feelings, that the moon isn’t made of cheese, and she grudgingly understands that unicorns don’t really exist, though a part of her loves the idea and wants it to be true.

I can sympathize. After all some folks have become lip-slobberingly rich with unicorns. Who doesn’t want a house on Mustique, a Gulfstream and a trophy wife?

Well, aside from a trophy wife, I’m all for it. Mine will do just fine, thank you. And though a Gulfstream may be a drain on the bank account, it’s almost certainly cheaper than a divorce from a brainless bimbo who’s impossible to converse intelligently with, where the lure of puffy lips has faded as fast as the recent value in Square.

Which brings me to Square’s valuation:

Source: EquityZen

Investors eager to participate in the lucrative world of venture capital exhibit the same traits as investors in any asset class. You’ll recall what investors in housing during the late 2000’s did. They assumed linear projections when in fact we live in a non-linear world. They bought the house down the street because similar houses where selling for a particular price. Income levels be damned. Cost of construction be damned. Yield be damned.

How is it that venture capitalists investing pre-IPO got it so horribly wrong?

Two possible reasons jump to mind.

Venture capitalists are usually eager to build assets under management and that means attracting capital. Visibility is important and visibility comes with the mythical creatures called unicorns. Once a company has reached this status the VCs who are invested immediately gain exposure.

The push therefore to have higher and higher valuations is a self reinforcing mechanism whereby venture capitalists are eager to have their companies reach this status, and those investing in the company once it’s reached this status add the “badge” to their portfolio and run out looking to raise more capital.

This has led to an explosion in capital in search of the mythical beast:

Source: CB Insights

I read an article recently by a VC who was making the case for investing in various private companies which are already worth hundreds of millions of dollars. It stands to reason since VCs are looking for liquidity and here is the irony.

VCs who invest early on sit on massive gains in companies, which are now staying private for much longer. Two pressures are at work now:

  1. Current investors need liquidity. Paper valuations are still just that.
  2. Since all the growth is now in private markets, not public the market participants who were making money in the IPO space are now forced further down the liquidity chain – into private markets – and are becoming buyers.

Problem is all of this is rubbish.

The VCs who invested in Square in its late stage rounds of financing were making the same mistake my daughter makes when dreaming of unicorns. She wants them to exist and those investors desperately wanted the unicorn to be so large a unicorn it would take its big horn and mate with some other unicorns spawning a gaggle of the damn things which of course would lead all the way back to the Gulfstream and trophy wife for those investors.

They should be thankful therefore that this IPO likely saved them from a messy and expensive divorce from a silicon bag of air covered in a veneer of skin.

They should also be thankful because they now have liquidity, which up until recently they didn’t have. The false dream of ever higher valuations when you’re so late to the game, which had them dreaming of the trophy wife in the Gulfstream, can now be put firmly to rest and they can go back to the analysis which they neglected to do beforehand. Analysis which would have highlighted the fact that the company is basking in rising losses on the back of slowing revenue growth.

There is a tension between growth and profitability and foregoing profitability for growth is a common and often hugely successful strategy. It is also much easier to pursue this strategy when markets are accommodating and impossible when they’re not.

I fear that too many companies are not profit focused and are misunderstanding the risks to this strategy.

Remember, profitability allows companies the freedom to raise money on their own terms, not on the terms of the market. Profitability allows companies to survive. Profitability allows slower growing (but profitable) companies to acquire their competitors when the markets inevitably turn south leaving those reliant on shareholder capital to stay alive to cough blood.

Looks to me like we’re entering such a time.

– Chris

“The early bird catches the worm.” – William Camden

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