Bill Gurley wrote an excellent post last week on Why the Unicorn Financing Market Just Became Dangerous…For All Involved. It’s a must read, as the investing landscape has changed dramatically, courtesy of the outrageous number of unicorns, many of whom are still functioning under old paradigms: traction over profits; marketing/perception uber alles; too big to fail. Gurley warns about a new twist in the landscape: sharks with dirty term sheets, whom he defines as “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.” It’s terra incognita and definitely not for the faint of heart – or the young and inexperienced (ahem). “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,” Gurley explained.
One of the problems that led to the first tech bubble was inexperienced investors throwing too much money at startups that didn’t make business sense or were just stupid. Some people did get rich and the idea of sudden and easy money was intoxicating. These unicorn valuations have led to a different problem, as Gurley points out. The inexperienced investors are back, but now experienced investors (not to be confused with the sharks) – who invested heavily in unicorns and are tapped out – are approaching novices. “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… You are not being invited to a special dance, you are being approached because you are the lender of last resort…
“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.”
Gurley has contended for quite some time that we’re in a bubble – or that the bubble is about to burst and Chris Sacca seemingly agrees, as he recently told The Atlantic, “Most venture capitalists are sheep. We’re coming out of an era now where they all were chasing the same deals, trying to collect the same logos for their résumés, and marking up and encouraging the markup of their own investments for the sake of ego. We’ve got a lot of paper gains out there that aren’t necessarily supported by any realistic exit scenarios. There will definitely be a time of reckoning… I think everyone knows fundraising for a venture fund is going to be harder by the end of the year.”
So now you know the timeline – or have a better idea of it, at least – and in our humble opinion, unlike the first time around, we’re not necessarily in a bubble, but rather, a funnel. As Sacca said and well we know, most VCs are like sheep and less savvy investors tend to follow them, lemming-like. The herd is about to be culled, but as for tech itself, pretty much most of the landscape was decimated after that first bubble, but it is a bit more siloed, this time around. There will be a separation of the wheat from the chaff, and we’ll see if there truly is such a thing as too big to fail. Isn’t it pretty to think so, but we hear the ‘p’ word being mentioned more and more frequently – that’s ‘profitability,’ for the as-yet uninitiated: it seems investors are not above pivoting, either.
Why is it a funnel and not a bubble? During the Web 1.0 days, entrepreneurs – and investors – were feeling their way around, pretty much making it up as they went along, and experimenting to see if there was indeed an industry there, waiting to be created. The answer was, ‘yes,’ but it was not going to include any and every dumb idea that came down the pike, unbeknownst to naïve/inexperienced investors and founders who were caught up in the heady throes of it, anxious to jump on the bandwagon. It wasn’t called FOMO then, but that’s what it was, all the same. That part has repeated itself – however, now we know that there is an industry here. The thing is: is it a business? Hence, funnel. It’s not quite the same: the real companies – and investors – will make it through. Webb Allen of Landscape Capital spoke at one of our recent Investor Breakfasts and mentioned two companies in the same space, that he had vetted. The East Coast based company was further along, yet the West Coast company had raised significantly more money. Location, location, location? As the NY Post recently pointed out, Some of Silicon Valley’s startups wouldn’t last a day in New York. And reminded that the “internet stock bubble of the late ’90s, (was) also incubated in Silicon Valley.” One thing is certain: the shake out is coming, which many are predicting will be a nuclear winter. Take heed: business models/profitability are the new black – pun intended – because no matter what else goes on out there, the old adage still holds: money changes everything. Onward and forward.