Venture Capital – Bernie Madoff would be Proud

Sad VC Unicorn

Sad VC unicorn

There’s a saying – you only know who’s been swimming naked when the tide goes out. I believe we are about to see a lot of Venture Capitalists standing naked holding a ping-pong racquet and a copy of Elon Musk’s autobiography asking themselves where it all went wrong. This bubble will pop. It will pop hard and there are some major structural reasons why. Let’s follow the journey of an early stage venture to understand:

Start: A typical business model starts with a blue sky view.  “If we can crack this market then we will be worth billions of dollars.” Just like in poker, the size of the potential pot allows VCs to justify investing with a very low percentage of success.

Growth:  Before we get to blue skies, we need to spend, spend, spend.  The ever elusive pursuit of scale is like a mirage: always just beyond the horizon.

Raise more money:  Whilst you’re still burning through cash, you have been passing certain milestones. The last raise was done at a value of $10m – but that was when we only had site traffic of 10,000. Now we have 30,000 and strong enquiries, therefore the value is … (licks finger, puts it in air) $20m. The investors who drank the Kool-Aid originally may call some of their VC mates to throw in as well. Raise gets over-subscribed. Pop the bubbly. Good job everyone!

Re-value your existing exposure:  Now that a new capital raise has been completed at $20m, the VCs can double the holding value of their stock. Hoo-rah! Looks at those (paper) profits flow in.

Linking the revaluation of unlisted equity to further capital raising rounds creates a couple of perverse incentives:

– VCs are almost aligned with the founders in wanting to see equity raises completed at ever loftier valuations as they benefit from a re-value across their entire holding. What were those “buy low, sell high” equity markets idiots thinking. The new VC catchphrase is “buy high, raise higher!”

– VCs are far more likely to throw good money after bad. The Blue Sky hasn’t changed. Maybe the strategy has had to pivot; tighten our focus … There are many clichés you can think of. The point is, I could raise more money and revalue the position upwards and defer the problem for another 12 months or I could put the company into administration and sack all the staff. Decisions, decisions …

But then there is the ultimate safeguard for VCs. When everyone finally admits to themselves that squeezing a packet of juice eliminates the need for a $400 juicer (after 17 investors, 4 capital raising rounds and USD 118m), the VCs revert to their investors without a hint of shame and say, “we’re about picking the game changers; the ones that will return 10x / 20x the money; a few failures are inevitable. Think of Uber; think of Facebook. Look at some of our other portfolio companies that have already quadrupled in value in 18 months (paper profits only, of course).” Voila! Failure be gone! Record wiped clean.

In this environment, it is almost unforeseeable how a VC could report anything but glowing progress in the early years. Thus, we have the perfect environment for a lot of very average players engaged in group-think to emerge – perfect bubble conditions.

Does this mean that you should avoid investing in VC? Absolutely not. There are good operators who will make a lot of money and have the potential to make even more if there is a collapse given technology will be available for acquisition at a fraction of its creation cost. You’ve just got to pick a good VC.

So, if you’re an individual or a super fund looking to throw an allocation to VC but want to pick a good operator – here’s a tip. Look at their reaction when they make an initial or follow on investment. If they celebrate – ditch them. I’ve never understood investors who celebrate putting money out the door. Any idiot can do that. Just pay more than everyone else. It’s getting the money back, at a profit, that’s the trick. At the point of investment, they should be at their most nervous and excited as they should have a list of things they want / need to do.

If you’re a business that is currently being backed by a VC: when the tide goes out, don’t find yourself partnered with someone naked. The best partner any business can have is themselves. VCs will want you to spend and shoot for the stars. The sooner you can get off the heroin that is periodic capital raises and get your business to being cashflow positive the safer you are. At the very least, you should always have a restructure plan that will get your business to profitability if the capital markets stall. If you’re 18 months away from being cash positive – try to raise 18 months worth of cash. “But the value of my equity will be worth so much more in a few months so I only want to raise as little as possible right now and then more next year”. Spoken like a true greedy so-and-so who will find themselves boring their dinner party guests with stories of how their company was worth $50m (on paper) before they went insolvent and have nothing to show for it. The Dotcom crash put an 18 month stop on capital raising in the tech space. Companies that weren’t cashflow positive, or didn’t have enough cash to wait out the drought, simply died. Don’t be one of them.

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