There is an old joke about a new bar in Silicon Valley. On opening day, six thousand people come. No one buys a drink. The business is declared a roaring success.
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The joke is an homage to the oft-mocked truth that in the world of high-valuation startups, investors have historically favored growth above profits. Particularly in nascent sectors where early mover advantage matters, VCs have been all-too-willing to bankroll persistent losses in the pursuit of market dominance.
The expectation is that a least one of two things will happen. Ideally, the startup will get profitable as it grows up. If not that, then it will keep growing and public investors will eventually bankroll it at an even higher valuation.
In recent months, the WeWork fiasco, Uber’s post-IPO performance, and a host of indicators of slowing growth in the unicorn set have upended these expectations. Public investors, it turns out, are not always willing to pay astronomical multiples for money-losing companies just because founders, VCs and investment bankers spin a great narrative about their world-changing potential.
That brings us to where we are now: VCs are talking about things like revenue quality, gross margins, and unit economics. Even SoftBank is reportedly considering a more cautious investment strategy should it manage to go forward with a second Vision Fund. The firm, the largest backer of Uber and WeWork, now wants to concentrate on companies with clearer pathways to profitability and public offerings.
It’s easy to see how we got here. Too many startups raised too much money to scale businesses with too many losses. While it’s easy to poke fun at imploded unicorns and their masterpieces of financial obfuscation, this is not a clearly helpful exercise.
Instead, we thought it might be useful to look for some signal amid the noise. That is: What level and type of losses are acceptable to public market investors these days? And how might those translate into good or at least non-catastrophic exits for the current pipeline of high valuation venture-backed startups?
Here are a few of the points public investors are making with wallets:
We Make The Valuations, Not You: At some points in the business cycle, startup IPOs are essentially a seller’s market. Public investors are eager for new offerings, and it’s relatively easy for IPO underwriters to sell shares their at desired price. First-day pops can be pretty common.
In a buyer’s market, investors are pickier about offers. There’s diminished urgency about getting in early, and a sense that wait-and-see could be the better strategy. It’s logical to feel this way when by simply waiting a few weeks, even an enthusiastic buyer of Uber, Lyft, Slack and others could snap up shares at a steep discount to opening day prices.
Clean Up Your Numbers Before You Come Knocking: Continuing with the buyer’s market theme, let’s make an analogy to real estate. In a hot seller’s market, one can list a home with ugly pink bathroom tiles and still get multiple good offers in a few days. In a buyer’s market, it might sit for a while, and even interested buyers might demand a discount or some upgrades.
In recent months, public market investors have seen a lot of IPO filings with the financial equivalents of ugly pink bathroom tile. This includes things like meager growth coupled with massive losses, obfuscatory financial statements, a shrinking market, and even the ability to post negative gross margins while charging several dollars for a cup of coffee.
Now, we’re not in a full-on buyer’s market at the moment. U.S. indexes are still trading near multi-year highs, the IPO window is open, and public investors are looking for new growth stories. But while some balance sheet ugliness remains tolerable, do expect public investors to demand a discount.
Software Multiples Require Software Margins: This last point has been echoed by several in the venture business, and it makes sense. The unicorn boom has been replete with companies that pursued some of hybrid software-meets-real-world business model. There’s Uber – offering an app for the labor-intensive tasks of driving people and delivering their food. There’s Peloton – boosting returns on exercise equipment by adding connectivity and subscription classes. And so on.
Of course, there’s nothing wrong with hybrid models. Their revenue multiples, however, can’t be expected to compare to say, a SaaS company that incurs little-to-no cost for each additional customer. Markets are in the process of sorting out just what kinds of multiples these hybrid models should command. Early indications are they’re reasonable compared to non-software sectors, but not the lofty multiples venture investors originally targeted.
Losing Control Of The Narrative
Looking at the emerging standards of public market investors, a casual observer might say they seem pretty sensible.
For the unicorn private investor crowd, however, it’s a more ominous development than it seems. That’s because the entire unicorn phenomenon – the philosophy of scale fast and break things, the SoftBank Vision Fund, scooters everywhere, massive losses, Adam Neumann – is predicated on being the opposite of sensible. The broad goal behind all of high-valuation startup dealmaking is to hopefully back that handful of entrepreneurs just crazy enough to be brilliant.
For now, expect the startup crowd to talk about how a successful bar investment now includes selling some drinks, preferably at more than it costs to pour them. To anyone not in Silicon Valley, this would sound perfectly normal. But for the venture crowd, it’s a far cry from big crowds and empty glasses.
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