Cracks in Big Venture

The Big Venture formula that people read about always made little sense to someone like me.   I was reading Danny Crichton‘s article in TechCrunch and found myself thinking back to 1999.  Here is the formula as relayed by Danny:

Since the financial crisis, Silicon Valley has been running on what might be called the Big Venture Formula. It goes something like this: burn capital as fast as it comes to drive growth. Build momentum by hiring employees as quickly as possible. Dominate the media. Sell the vision to each new set of investors (albeit not the numbers!). Avoid disclosures. Stay private as long as possible. Get scale. Go from unicorn to decacorn to centicorn. Prosper.

I don’t think it’s just VCs that are advocating for this formula, there are regulatory and other incentives in place that make it appealing.  The ability to crowdfund has brought more money into early stage investing.  I love that technology makes this possible.  However, crowdfunding doesn’t have the same level of diligence that in person angel groups have.  It also has been more Silicon Valley centric.  Those companies find a “bell cow investor” and have an easier time raising than no name companies with no name investors.

It’s hyper expensive internally to be a public company.  Triple the accounting costs.  Sarbanes-Oxley and Dodd-Frank are no friend to public markets. Those laws are hurting Americans.  They can’t get into the deals early and assume risk to grow their own capital.  Mark Cuban clearly understands this and is working to change it. (link behind a paywall/email wall)  I think it’s better for companies to go public earlier.   Public markets have better transparency than private ones, and provide a different discipline than private markets.

The Federal Reserve 0% interest rate policy has changed risk/reward.  The cost to go public is more expensive because public money is more expensive.  When rates are normalized at around 4%, the trade-offs between the private market and public market are much different; and forces different financial decision making.

Corporate venturing, hedge fund venturing, Mutual fund venturing and other new money have come to the table.   I think we will see a lot of them pull out as market conditions go from bull to bear.  They came in at later stages and drove up valuations, which trickled down to the early stage market.

For most people, operating a business boils down to one question:  Does it make money?

I have seen thousands of pitches.  I laugh, because virtually every pitch has a net income chart that looks exactly like Al Gore’s Inconvenient Truth Global Warming chart.  The first two years, they lose money. The third year it’s right around break even.  The fourth year, it starts to take off and the fifth year the bank doesn’t know what to do with all the money they are making.  I also have never seen one of those things pan out-even with successful companies.

Does it make money?  In the Midwest, we are criticized for focusing on those basic business nuts and bolts.  Investors here are not seen as savvy because they always want to know the revenue model. Things like customer acquisition cost, lifetime value of customers, and net revenue are integral to the analysis of companies.  Who knew an income statement mattered?

At the same time, if a startup founder came to me and said their revenue model was advertising, I’d strongly advocate for a freemium model because the business is all about eyeballs.  But, in this hyper connected, frenzied, low attention, clickbait, online world we live in, eyeballs are hard.

I’d discuss valuations with other investors and we just shook our heads the past couple of years when we heard the valuations coastal investors were giving seed companies.  We’d read all the hype and see companies raise money at even higher valuations and wonder, “Are we wrong?  Are we missing something?”

I am starting to see investors pivot to a formula.  They have a checklist.  Formulas never work for investing.  Principles do.  Acumen does.  Process helps you evaluate.  Investors that get away from those core concepts will lose money.

In 1999, when I heard that there was a new paradigm.  Back then, it was easy to call bullshit.  Ironically, it might have been the Long Term Capital disaster in late 1998 that put the initial cracks in the armor of the tech meltdown that happened a year later. The geniuses weren’t geniuses and it’s impossible to pick nickels up consistently before eventually getting steamrolled.  Internet companies back then got away from the basic business model of generating bottom line revenue.

In August of last year, we finally had the first crack in the armor of the bullet proof bull market.  January of this year has shown that the easy money, quantitative easing, and a Keynesian government spending model of government doesn’t provide a sustainable solution.  There is a spill over effect into startup land.  Already seed valuations are adjusting.  It will take a couple of cycles for the later stage companies to adjust.

As a person who has been immersed in markets over my entire life, I could see things get a little frothy.  I really worked hard to maintain my discipline.  I didn’t write a lot of new checks to new deals, and really concentrated on supporting the deals I was already in.  Having the background that I have, I have a very very keen gut feel of risk/reward.   It’s almost as if you could smell the air and know.  It also helps not being in the echo chamber.  If you lived in Silicon Valley it would have been a lot harder to avoid the unicorn fever.

Additionally, I have heard people say Midwest investors weren’t that good. I have heard, “I don’t believe in Chicago.  They can’t build good companies there.”   Or, “We are sending all our capital to Silicon Valley because that’s where they build unicorns.”  Midwesterners were investing in $3M companies that were raising their next rounds at $10M, and their next rounds after that were sub $100M.  Unicorns were rare in the Midwest, and California had them on every corner.  But, most Midwestern companies had boring, sustainable business models.

I think that there are some pretty great companies being built today.  I also think that when there is fear in the air, it’s a great time to start a company.  Many companies that seemed bullet proof are laying off employees.  When that happens, it helps early stage startups find talented people.

If I were an entrepreneur starting out today, I wouldn’t hesitate because the Dow is gyrating like a carnival ride.  I’d go for it.  At the same time, I’d be realistic on my valuation.  Doing a priced round early at a $2-$4M pre money makes a lot of sense given what is going on.