May 6, 2016 at 21:49Towering over the crowd
- Transfer
On the way to recapitalization:
WHY THE MARKET FINANCING THE “UNICORNS” HAS BEEN SIMPLY DANGEROUS ... FOR EVERYONE INVOLVED IN IT.
Last February, Fortune magazine authors Erin Griffith and Dan Primack proclaimed 2015 the “era of unicorns,” pointing out that “Fortune has more than 80 startups, each of which are valued at more than $ 1 billion by venture investors.” By January 2016, their number soared to 229. One of the determining reasons for such an increase in the population of “unicorns” was the remarkable ease of mobilizing capital to create such a beast: state a new estimate of the company's value much higher than the last one, come up with a representative headline, demand proposals - and watch the flow from hundreds of millions of dollars to your bank account. After twelve to eighteen months, you “set sail” and do it again - amazingly simple!
Although it is not visible on the surface, a fundamental transformation has taken place in the investment community, which has made increasing investments in “unicorns” a significantly more dangerous and difficult practice. All participants in the unicorns — the founders, employees of the company, venture investors, and their investment partners (LPs) —are seeing their conditions under threat from the very nature of the unicorn phenomenon. The pressure created by extremely high paper valuations, a significant rate of combustion (and the subsequent need for more money), and unprecedented low levels of IPO and M&A created a complex and unique situation in which many key executives (CEOs) of unicorns and investors are poorly oriented .
Many people point out that the aggregate stock market value created by all such startups far exceeds the losses from their inevitably bankrupt brothers. This seemingly commonplace is based on the clear success of the qualitatively new companies of this generation (AirBNB, Slack, Snapchat, Uber, etc.). While this circumstance could give some sense of comfort, most of these startups are not represented in the basket of “unicorns”, and there is no sign that they can be bought. To some extent, the majority of participants in such an economic system can influence the specific effectiveness of the company and is responsible for this, which explains exactly why it is important to understand the changing landscape.
Perhaps a notable “bubble collapse” event was an investigation by Theranos by John Carreiro and published in the Wall Street Journal. John was the first to show that the mere ability of a company to raise money from a handful of investors at a very high price does not mean that (i) everything in the company is going smoothly or (ii) the value of its shares remains at the value of the last round. Ironically, Carreiro does not specialize in Silicon Valley affairs, and the success of his publication served as a call to action for other journalists who may have been struck by the “unicorn fever.” Next came Rolf Winkler’s in-depth analysis, “High-priced startup Zenefits is random.” We can expect the appearance of similar materials in the near future.
At the end of 2015, many public information technology companies saw a significant reduction in the price of their shares, primarily as a result of lower valuation ratios. A highly efficient, fast-growing SAAS company, which was previously estimated at more than 10 annual revenues, suddenly began to cost 4-7. The same thing happened with many Internet companies. This massive reduction in the ratio naturally affected what investors were willing to pay for more established private companies.
The end of 2015 also brought a "reduction in the price of the mutual fund." Many "unicorns" took private attracted dollars from mutual funds. These mutual funds re-evaluate securities daily based on current quotes, and fund managers periodically receive compensation on this basis. As a result, many firms have independent internal groups that periodically analyze company valuations. When public stock markets went down, these groups began to lower the cost of the unicorns. Once again, fantasies began to fall apart. The last round does not mean a fixed price, and being private does not mean that you will receive any concessions when carefully considered.
At the same time, we also began to see an increase in startup problems. In addition to high-profile companies like Fab.com, Quirky, Homejoy, and Secret, numerous venture capital firms have begun to hide behind. There were so many of them that CB Insights began to maintain a list. Suspension has also become more common. Mixpanel, Jawbone, Twitter, HotelTonight and many others made the difficult decision to reduce the total number of employees in an attempt to reduce costs (and, apparently, the rate of combustion). Many modern entrepreneurs have limited the impact of the concept of a malfunction or suspension of activity, because this has long been common in industry.
In the first quarter of 2016, the late-stage financial market has changed significantly. Investors became nervous and were no longer ready to invest new funds in unicorns without hesitation. Moreover, before ambitious startups began to fight for fundraising. On the board of directors of Silicon Valley companies, where "growth at all costs" for many years was just a mantra, people began to imagine a world where the cost of capital could grow substantially and profit would again become commonplace. Anxiety began to slowly enter the world of everyone.
Around the same time, journalists specializing in the venture capital industry noticed something fundamentally important. In 1999, record-breaking valuations coexisted with record-breaking IPOs and shareholder liquidity. The year 2015 turned out to be exactly the opposite. Record estimates of private “unicorns” were offset by an ever-decreasing number of IPOs. In 1999, the bubble was “wet” (well liquid), while in 2015 it was very “dry”. Everyone was successful on paper, but there was little to show from a position of net income. In the 1st quarter of 2016, there were no technological IPOs with venture capital at all. Less than a year after proclaiming the coming year as the “era of unicorns,” Fortune Magazine returned with a grim warning: “$ 585 billion Silicon Valley problem: end of takeoff.”
As we move forward, it is important for all players in the economic system to realize that the game has changed. It is also important that each player understands how the new rules apply to him. We will start by first examining several psychological factors that can irrationally affect the overall decision-making process. Then we will consider a new player in the economic system who is ready to take advantage of these aforementioned changes and developing factors. Finally, we look at each player in the economic system, and what they should consider when they enter this “brave new world,” as English writer Aldous Huxley put it in his dystopian novel in 1932.
When theoretical scientists study markets, it is initially assumed that market participants act rationally. But what if participants are in a state that is pushing them toward suboptimal and potentially irrational behavior? Many factors add irrationality to the funding environment for unicorns.
1. Founder / CEO. Many of the founders of unicorns and their CEOs have never had difficulty financing - they only knew success. Therefore, they have a strong belief that any sign of weakness (such as, for example, a lowering round) will have a catastrophic effect on the internal situation in the company (company culture), on the process of hiring employees and on the ability to retain them. Leadership is also a working factor; he has a fear - won't the lowering round seem to be the leader’s weakness to others? It is quite possible that it is difficult for us to imagine the level of fear and anxiety that may arise from a previously confident leader at such a transitional moment.
2. Investors. A typical representative of a venture investment company in 2016 is also exposed to psychological factors. Investors are likely peering at the stunning, paper-based gains that have already been recorded as a success by their own investor companion investors (LP). Everything suggesting a decrease in investment (lowering round) immediately raises questions about success indicators that have already been “capitalized”. In addition, many such price cuts could impede their ability to attract further investment. Thus, alarmed investors can have many incentives to defend illusions - to do everything they can to prevent a decline in investment (lowering rounds).
3. Anyone who has already “capitalized” the return of their investment. Whether you are a founder, leader, business angel, venture capital company or late stage investor, it is likely that you took the value estimate from the last round, multiplied it by your share of the property and told yourself that you are now wow! - stand so much! It is simply in human nature that, having done such a mental exercise and convincing yourself of the result, you will experience difficulties in rationalizing the decline in investment.
4. The pursuit of exit situations. As soon as the fear of downward price dynamics asserts, some players in the economic system try to quickly and desperately capture instant liquidity, guided primarily by their own interests. This happens in every transitional situation on the market and can create quite a lot of tension between the various participants in each company. We have already seen examples of founders and managers who received liquid assets before investors. And there are also modern examples of investors who kicked founders and employees out of companies. Obviously, providing simultaneous liquidity is the most suitable option, but the fear of lower prices, as well as an increase in the duration of the conversion of assets into money, can force both parties to choose the “I'm the first” course.
What does shark mean here? These are sophisticated and unprincipled investors who instinctively understand the effect of the above factors on participants, know exactly how to deal with investments, and can use the situation. They wait for the occurrence of such situations, licking their lips at the thought of the opportunity to profit.
Transactional agreements containing “dirty” or “structured” conditions are such proposed investments, where the main part of the economic profit for the investor does not come from the announced valuation, but rather through a series of “dirty” conditions hidden deep in the document. This allows the shark to meet the “question” of the entrepreneur and member of the VC board about the cost assessment, all the while knowing that excellent profits will be obtained even with outputs that are much lower than the coverage estimates.
Examples of “dirty” conditions are guaranteed IPO profits, retetches (or, otherwise, “ratchet”), PIK dividends, a series-based M&A veto, and exceptional preferences (privileges) or liquidity rights. A typical Silicon Valley transaction agreement does not contain such conditions. The reason that these conditions can make a profit on their own is that they lay the foundation for rebuilding the capitalization table at some point in the future. Therefore, the founder and members of the board of directors of a venture company can continue to think for a long time that everything is going fine. Correction will not occur now, it will be done sometime later.
Transactional agreements containing “dirty” conditions are a serious problem for two reasons. One is that they are “unpacked” or “exploded” at some point in the future. You can no longer just look at the capitalization table and measure your profit. After the “dirty” offer is accepted, the payment in each potential future cost estimate requires a complex analysis, where the profit of the “shark” is calculated first and only then the remainder is divided among all the others. The second reason why they present a serious problem is that their complexity makes future financial investments almost impossible.
Any investor who will be asked to follow a “dirty” offer will look at its complexity and, most likely, refuse. This greatly increases the risk of either loss of money, or complete recapitalization, which will destroy previous shareholders (equally all - founders, employees, investors). Thus, while such a maneuver may seem safe and solve your short-term psychological difficulties and problems, you can put your whole company in a much more dangerous position, without even realizing it.
Some late-stage investors themselves may be tempted to become “sharks” and begin to include structured conditions in their own agreements on the basic terms of the transaction. Successful adherence to such a strategy will lead these investors to truly become sharks. It will be convenient for them to know that their interests contradict the interests of the founders, employees and other investors in the capitalization table and conflict with them. And it will be a pleasure to them to know that they will win, and others will lose. This situation is not for the faint of heart and, of course, is completely different from the typical investor behavior in the past few years.
Now let's take a deeper look at what this new medium for attracting investment means for every participant in the economic system.
Today's entrepreneur working with a unicorn gained his experience in an environment that could be radically different from what lies ahead. Take a look at the history of the process. Money comes in easily. The market prefers growth rather than profit. Competitors also have access to capital. Therefore, in order to win, one must grow extremely quickly in size and be super-ambitious. It is necessary to capture the maximum possible market share.
Never in the history of venture capital did startups at an early stage have access to so much capital. In 1999, if the company reached $ 30 million before an IPO, then this was considered a great historical success. Now private companies exceed this value ten or more times. And, accordingly, the combustion rate increased tenfold compared to what it was then. All this creates a monstrously hungry unicorn. He needs capital again and again (if he intends to stay on the current trajectory).
Perhaps for the first time in their lives, these entrepreneurs may face a situation where they will not be able to keep their net rising funding at the proper level to ensure investment growth. This is uncharted territory. There are several alternatives here:
1. The first opportunity many unicorns have is a deal agreement containing “dirty” terms. As discussed above, these conditions can cleverly fool an inexperienced player, because they are able to “meet the question” regarding coverage assessment; the founder accepting these conditions simply does not understand what kind of "slaughter" awaits him in the near future. The only reason that such an agreement could be accepted is to support the illusion of a cost estimate, which, however, simply does not matter. Accepting an agreement with such conditions is like launching a watch on a time bomb. Your only salvation will be to go through the IPO window as quickly as possible (note: the Box and Square companies managed to slip through this needle eye successfully), otherwise the accepted conditions will eat you alive. The main problem is that after that you will never again be able to get an investment, since no new investor wants to sit on a volcano. And you will get bogged down in negotiations with a creditor who has already proved that he is smarter than you.
2. Conduct a round of cleaning (capitalization tables) at a lower cost estimate. This seems a serious failure for many modern entrepreneurs, but they must quickly change their minds. Reed Hastings at Netflix raised money in a resonant lowering round as a public CEO. Each public general manager had days when the stock price fell - this is a common and common phenomenon. The only thing you defend is your image and pride, but, ultimately, they have no meaning. You should be more worried about the long-term valuation of your stock and minimizing the likelihood of losing everything. And it is precisely the conditions mentioned above that Godzilla is worth seriously fearing. A dropping round is nonsense. We must go through it and move on. Clear,
3. Get down to business and do everything so that the cash flow along with the funds in the account becomes positive. This may seem like the most inappropriate choice, since your board of directors has advised you to do the exact opposite for the past four years. They told you that you have to be “bold” and “ambitious” and that now is the best time to capture a significant market share. Despite this, the only way to completely control your own destiny is to completely eliminate the need for additional capital growth. Achieving profitability is the most liberating action that a startup can accomplish. Now you can make your own decisions. It also minimizes future dilution. Gavin Baker“Create a free cash flow for 1 dollar and then you can invest the rest in growth, remaining on that 1 dollar in free cash flow for many years. I understand that you want to grow, and I want you to grow, but let's finance this growth internally from gross profit dollars, and not from dollars for new dilutive shares.
Ultimately, internally funded growth is the only way to control your own destiny, and not be dominated by capital markets. ”
4. Get public. Ultimately, the best way for founders to take care of their property, as well as their employees, is to go public. Prior to the IPO, ordinary shares are preference shares. Many preferred shares have various types of management functions, and most of them have significant privileges over common shares. If you really want to release your own ordinary shares and the shares of your employees, then you should convert the preferred shares into ordinary and remove the privileges, both in management and in liquidation of your shares. To many founders, various misguided consultants have repeatedly said that an IPO is bad and that the path to success is to "remain private for as long as possible." However, an IPO is not only better for your company (see
The stock price fluctuates. There is not a single high-class public (open) joint-stock company that did not have time periods when their shares showed low results. The joint-stock company "Amazon" has gone from 106 to 6 dollars per share. Salesforce went down from $ 16 to $ 6 and stood below $ 10 for many months. Netflix slid from $ 38 to $ 8 per share for some six months. And remember Facebook in the first six months of its existence as a public company?
If you cannot handle lower valuation, then you should seriously consider giving up the position of CEO. Being a true leader means being able to lead both in good and bad times. Accepting a “dirty” agreement jeopardizes the future of your company solely because you are afraid to lead through difficult new times.
The exact situation with the capital structure of a company is usually hidden from the average employee. You know that you work for this unicorn and that you have a certain number of ordinary shares. Perhaps you know your share of the property. And, unfortunately, you can assume that the result of your assessment of the cost of the unicorn and your share of ownership is all that you are worth. Of course, to be accurate in this assessment, it is necessary to achieve a liquidity event (IPO or M&A) with an estimate of the value equal to or higher than that obtained in the last round, without increasing dissolution from new rounds. But think about it: M&A gives obviously scarce funds (no large company wants to pay these prices or assume this burning rate), and many founders have been told more than once that an IPO is bad.
For the most part, employees are in the same position as founders (see above), except that they do not participate in the decision-making outlined in paragraphs. 1-4. But even so, they must ask the same questions related to management: Can we get to break even on the money we have? Should we continue to raise money? If yes, can we do this on “clean” conditions (not on “dirty”)?Employees, in fact, would like to know if the founder and / or CEO are going to enter into a deal with “dirty” conditions (or maybe have already entered into it), because the owners of ordinary shares are most at risk in such a situation . And you also need to know if your leader is an IPO opponent. If your CEO / founder enters a round with dirty conditions and is also an opponent of an IPO, then the chance that you will ever be able to get something remotely close to what you think they are worth now will be very, very low. You will probably be better off moving to another company.
Explanation: It should be noted that the author of the article and his investment company belong to this category.
In most cases, early investors in unicorns are in the same position as founders and employees. This is because companies, after the early investors, raised so much capital that the early investor is no longer an essential part of the holders of voting rights or liquidation privileges. As a result, most of their interests coincide with those of the owners of ordinary shares, and the desired key decisions on compensation and liquidity are the same as those of the founders. Such an investor will also be wary of a deal agreement containing “dirty” conditions, which has the ability to take control of the entire company. Such an investor will also have rather strong fear due to the difference between paper and real incomes and due to the lack of general liquidity in the market. Or at least all of this should be present.
An exception is a late investor or a wealthy investor, who may represent a substantial portion of all the money raised. This particular type of investor may have protected its property with proactive or oversized investment. They may even have encouraged the aggressive “forward to victory” mentality, knowing that they could continue to write checks. And they act like an irresponsible gambler at the poker table.
There are two forces that at some point can begin to slow down this type of investor. Firstly, when difficulties begin, some really large amounts may be debited from the accounts of these investors. These impressive losses create insecurity not only for the investor himself, but - more importantly - for his partner investors. The second problem is that for many of these investors, a single block of shares may become too large for the entire fund. They basically cannot afford to put themselves at further risk in their own name. They begin to use euphemisms to otherwise describe the situation of oversaturation, such as, for example, “fully placed investments” or “planned level”.
This form of rejection among large investors has created, indeed, bizarre and unprecedented activity in the world of unicorns. Upscale investors, already with large capital, began to conduct telephone companies with an offer to take part after them under their own names. However, insatiable unicorns need even more capital than these gentlemen can provide. Oddly enough, if you look at the great historical victories of this class of investor, there is no information about sending invitations to other investors. But now they “need” others who must warn of the risk to all parties involved. More about this later.
Investors are also worried about the growth of their next fund, which may lead to unusual behavior that does not depend on the situation of each individual company.Do you support a deal agreement containing “dirty” terms because it allows you to keep your paper tag and not scare your investors? Even if you know that it can be bad for the company in the long run? Do you feel the need to raise more capital quickly before prices go further and lower your IRR? Do you feel the need to have more money to continue to feed the hungry companies you have already invested in?
Companion partners such as trust funds and other funds are significant sources of capital investing in venture capital firms, hedge funds, etc. They represent real capital that systemically works in the market. Companion investors (LP) evaluate the effectiveness of different investors in the economic system and make investment decisions. This is hard work because feedback cycles are quite long - especially when it comes to investing in illiquid assets such as startups (and unicorns).
Another big problem for affiliate contributors (LPs) is that they are required to measure the effectiveness of these illiquid assets, although this is extremely difficult and the result may not be indicative of a future actual return on funds. In this case, many contributing partners (LPs) included the high efficiency of unicorn cost estimates in their overall results, which created a very significant increase in venture capital categories. In a sense, they have already “capitalized” this profit. The problem here, obviously, is that the absence of any material liquidity in the market, together with the latest correction, creates the risk that, in fact, there may not be any money for the paper profit that they have already capitalized.
In addition, as noted earlier, they may face increased pressure from venture capital firms who want to speed up their process of attracting funding in this highly disturbing environment. A recent WSJ article, “Venture Capital Firms Rush for New Money,” shows that venture capital firms, using affiliate contributors (LPs), raise new funds to the highest level in 15 years while cash liquidity is at its lowest level over the past seven years. It is useful to reproduce several excerpts from this article:
• In recent years, venture capital firms have invested heavily, encouraging companies to spend in the struggle for market leadership. This left some of these venture capital firms without funds and required them to raise money faster than in previous years in order to continue to receive their remuneration and make new investments.
• Some venture capitalists say the surge in funding is designed to show that paper-based returns on startup investments still look attractive.
• The distribution of funds will be sometime later, but for now, large paper profits are still a good bait for financing.
In addition to these problems, there was also an increase in the “internal rounds” when investors invested in companies where they were already investors, eliminating the “market check”, which may have led to a potential decrease in the cost estimate. This activity, which has an obvious conflict of interest, makes the actions of contributing partners (LP) in evaluating the effectiveness of venture capital companies even more difficult.
Against this difficult background, many firms offer their partner investors (LP) to take on new early investment obligations to their next fund at the very moment when the valuation is the most difficult and the concern may be at the peak of the cycle. In fact, at heart most of the affiliate contributors (LPs) know that the venture capital sector is countercyclical to the amount of money raised by venture capital firms. With over-financing of the industry, total profitability falls. Huge investments in overblown multi-billion dollar venture capital funds can easily exacerbate problems that already exist.
One of the reactions from the community of contributing partners (LPs) could be the requirement of obligations from new funds to prohibit intra-round and cross-financing investments. This can help ensure that new capital is not invested in trying to save previous investment decisions - an activity known as throwing in good money after bad money.
If this is not enough, then some investment partners (LPs) are required to participate in SPVs (specialized financial organizations), often from the very funds that they supported. As mentioned earlier, some investors reach the stage where they are bound by excessive obligations with a particular company in a particular fund (“at the planned level”). Nevertheless, these investors want to continue to provide capital to their unicorns and to support the priority of growth rather than profit. To do this, they create a one-time investment special-purpose mechanism (persistently offering to invest). And this mechanism (SPV) carries an added risk, consisting in the absence of any portfolio diversification or the option “looking back”, which allows to protect against losses.
Obviously, contributing partners (LPs) can simply say no to participating in the SPV (even though they may feel pressure from the fund). And this is most likely reasonable. First, someone asks you to invest, exactly at the time when everyone else is overly bound. Hey come, help us out, we're drowning here! Secondly, you already have a sufficient impact on this company through your initial investment. And finally, it is extremely unlikely that someday historical research of your involvement in the SPV peak cycle will show good returns.
If you have serious money and you have not yet been offered to invest in a unicorn, then this is simply because people do not yet know where to find you. There are three types of people who are likely to come into contact with you now; everyone should be handled very carefully:
1. Founders (agents) of the SPV (special purpose investment mechanism). As mentioned in the Contributing Companion (LP) section, investors have also expanded their SPV marketing more broadly, including family capital management companies and other capital funds. Lures usually contain phrases such as “you are invited to participate in an opportunity” or “you will be provided with access to an opportunity” to invest. Such an invitation “you are very lucky with such an opportunity” is an ominous warning of widespread fraud. And remember: such persistent offers come from investors who actually have money, but who already know that they are bound by excessive obligations.
2. Brokers and third-rate investment banks offering secondary shares for sale in unicorn companies. If you ask any big family money management company, they will tell you that they are simply bombarded with calls and emails offering secondary positions in unicorn companies. Such baits often sound like “a 20-40% discount on the price of the last round”.
3. The increasing round of the unicorn. You may also be asked to simply add capital to the standard unicorn round. Being with many investors “at the planned level” due to the already accumulated amount of capital, some companies look “under every stone” where else to get dollars.
One of the shocking facts in many of these “investment opportunities” is the relative lack of financial information relevant to the case. One would think that these “opportunities”, which often sell as “pre-IPO” rounds, have something close to the data that could be seen in S-1. However, financial information is often quite limited. And when it is contained, it can be presented in a form incompatible with GAAP standards. As an example: most CEOs of unicorns still have no idea that discounts, coupons, and subsidies are negative income.
If the audit is included, it may have numerous “reservations”, where the auditor lists all the reasons why this particular audit may not meet GAAP standards and why the situation can change significantly if you look deeper. Investors should be clearly aware that this is not an IPO. Companies were not trained properly, and the numbers in a PowerPoint presentation are not necessarily correct. Here's a recommendation: if you intend to invest several million dollars in the growing investment of the unicorn, then talk to the auditor. Find out exactly how thorough the check was.
New potential investors might also be very surprised at how few heads of unicorns really understand the economics of their field. Such executives can easily be seen by the fact that they obsessively focus on the “gross revenue of all sellers of the site” or “long-term forward orders” and try to talk without considering such things as true net income, gross profit or operating profitability. They will continue to claim that they are a “profitable company,” even when everything they really do is stopped due to negative gross margins. These companies will one day need real income and real profit, and if the company has not worried about it in advance, they should not be given millions of dollars at a late stage of financing.
Perhaps the biggest mistake made by uninvested investors is to assume that since the company already has titled (brand) investors, the new investment opportunity should be of high quality. Here the reputation of other investors is used instead of checking the reliability of the financial condition of the company. And such a “shortest path” creates a lot of problems. Firstly, such investors are “wholly devoted to the company”. They have invested for a long time, and without your money there is a danger for their investments. Secondly, as mentioned above, they are already "full" and nervous. They did not contact you before when they built their reputation. Why are they so friendly now?
The main information for investors with whom such contacts are now taking place is as follows: this is not the first or even not the twenty-first pitch in a volleyball fight of many hours. You are not invited to any special dance; you are contacted only because you are the last creditor in a critical situation. And considering all of the above, breaking up with your dollars will now be an extremely dangerous move. Let the buyer be careful.
A few weeks ago, on March 31, 2016, the chairman of the Securities and Exchange Commission (SEC) traveled to Silicon Valley and delivered a speech at an event at Stanford University Law School. For those who are involved in investing unicorns, or for those who are considering investing in them, it would be useful to read it in full (see here ). An interpretation of this presentation by Bloomberg is set out in Silicon Valley Must Corral its Unicorns .
Chairwoman Ms. White seems to fully understand the problems and impacts that could disrupt the process of financing unicorns:
Almost all venture capital assessments are extremely subjective. But one must ask whether advertising and pressure aimed at obtaining a unicorn rating are similar to those experienced by public joint-stock companies putting forward a promising assessment on the market with the associated risk of financial reporting problems.
And then it gives out something important for all past and future investors regarding the need for increased verification of the reliability of the financial condition of the company:
As I will discuss, the risk of misrepresentation and inaccuracy is heightened because startup companies, even fairly mature ones, often have much less reliable internal controls and management procedures than most public joint-stock companies. Vigilance on the part of private companies in relation to the accuracy of their financial results and other information is therefore particularly important.
It would be unfortunate that unicorn investment promotion activities will lead to increased SEC involvement and rules regarding private venture startups. But if those involved believe that “not being public” also means “not being responsible,” we will quickly find ourselves in that exact place. We will be deservedly invited for a closer look.
Perhaps the biggest mistake in judgment for everyone involved in this process is the assumption that if we can just stand the “one more round”, then everything will be fine. Founders began to think that the more money, the better, and the volatility of the recent funding environment has led many to believe that heroic fundraising is a competitive advantage. The irony is that just the opposite is right. The best entrepreneurs acted more successfully precisely in times of insufficient capital. They can raise money in any environment. Free capital allows less competent participants to work in every market. Such a less competent player brings with him more risky operations, which draws even a good entrepreneur to careless actions.
The reason we are all in the mess now is the excessive amount of capital that poured into the venture startup market. This excess of capital led to the following: (1) record-high combustion rates 5-10 times higher than those that were approx. in 1999, (2) most companies operate very far from profitability, (3) excessively intense competition driven by access to named capital, (4) deferred or non-existent liquidity for employees and investors, and (5) persistent collection methods described above funds. Increasing the amount of money will not solve any of these problems - it will only aggravate them. The most healing process that could possibly have happened,
WHY THE MARKET FINANCING THE “UNICORNS” HAS BEEN SIMPLY DANGEROUS ... FOR EVERYONE INVOLVED IN IT.
April 21, 2016
Last February, Fortune magazine authors Erin Griffith and Dan Primack proclaimed 2015 the “era of unicorns,” pointing out that “Fortune has more than 80 startups, each of which are valued at more than $ 1 billion by venture investors.” By January 2016, their number soared to 229. One of the determining reasons for such an increase in the population of “unicorns” was the remarkable ease of mobilizing capital to create such a beast: state a new estimate of the company's value much higher than the last one, come up with a representative headline, demand proposals - and watch the flow from hundreds of millions of dollars to your bank account. After twelve to eighteen months, you “set sail” and do it again - amazingly simple!
Although it is not visible on the surface, a fundamental transformation has taken place in the investment community, which has made increasing investments in “unicorns” a significantly more dangerous and difficult practice. All participants in the unicorns — the founders, employees of the company, venture investors, and their investment partners (LPs) —are seeing their conditions under threat from the very nature of the unicorn phenomenon. The pressure created by extremely high paper valuations, a significant rate of combustion (and the subsequent need for more money), and unprecedented low levels of IPO and M&A created a complex and unique situation in which many key executives (CEOs) of unicorns and investors are poorly oriented .
Many people point out that the aggregate stock market value created by all such startups far exceeds the losses from their inevitably bankrupt brothers. This seemingly commonplace is based on the clear success of the qualitatively new companies of this generation (AirBNB, Slack, Snapchat, Uber, etc.). While this circumstance could give some sense of comfort, most of these startups are not represented in the basket of “unicorns”, and there is no sign that they can be bought. To some extent, the majority of participants in such an economic system can influence the specific effectiveness of the company and is responsible for this, which explains exactly why it is important to understand the changing landscape.
Perhaps a notable “bubble collapse” event was an investigation by Theranos by John Carreiro and published in the Wall Street Journal. John was the first to show that the mere ability of a company to raise money from a handful of investors at a very high price does not mean that (i) everything in the company is going smoothly or (ii) the value of its shares remains at the value of the last round. Ironically, Carreiro does not specialize in Silicon Valley affairs, and the success of his publication served as a call to action for other journalists who may have been struck by the “unicorn fever.” Next came Rolf Winkler’s in-depth analysis, “High-priced startup Zenefits is random.” We can expect the appearance of similar materials in the near future.
At the end of 2015, many public information technology companies saw a significant reduction in the price of their shares, primarily as a result of lower valuation ratios. A highly efficient, fast-growing SAAS company, which was previously estimated at more than 10 annual revenues, suddenly began to cost 4-7. The same thing happened with many Internet companies. This massive reduction in the ratio naturally affected what investors were willing to pay for more established private companies.
The end of 2015 also brought a "reduction in the price of the mutual fund." Many "unicorns" took private attracted dollars from mutual funds. These mutual funds re-evaluate securities daily based on current quotes, and fund managers periodically receive compensation on this basis. As a result, many firms have independent internal groups that periodically analyze company valuations. When public stock markets went down, these groups began to lower the cost of the unicorns. Once again, fantasies began to fall apart. The last round does not mean a fixed price, and being private does not mean that you will receive any concessions when carefully considered.
At the same time, we also began to see an increase in startup problems. In addition to high-profile companies like Fab.com, Quirky, Homejoy, and Secret, numerous venture capital firms have begun to hide behind. There were so many of them that CB Insights began to maintain a list. Suspension has also become more common. Mixpanel, Jawbone, Twitter, HotelTonight and many others made the difficult decision to reduce the total number of employees in an attempt to reduce costs (and, apparently, the rate of combustion). Many modern entrepreneurs have limited the impact of the concept of a malfunction or suspension of activity, because this has long been common in industry.
In the first quarter of 2016, the late-stage financial market has changed significantly. Investors became nervous and were no longer ready to invest new funds in unicorns without hesitation. Moreover, before ambitious startups began to fight for fundraising. On the board of directors of Silicon Valley companies, where "growth at all costs" for many years was just a mantra, people began to imagine a world where the cost of capital could grow substantially and profit would again become commonplace. Anxiety began to slowly enter the world of everyone.
Around the same time, journalists specializing in the venture capital industry noticed something fundamentally important. In 1999, record-breaking valuations coexisted with record-breaking IPOs and shareholder liquidity. The year 2015 turned out to be exactly the opposite. Record estimates of private “unicorns” were offset by an ever-decreasing number of IPOs. In 1999, the bubble was “wet” (well liquid), while in 2015 it was very “dry”. Everyone was successful on paper, but there was little to show from a position of net income. In the 1st quarter of 2016, there were no technological IPOs with venture capital at all. Less than a year after proclaiming the coming year as the “era of unicorns,” Fortune Magazine returned with a grim warning: “$ 585 billion Silicon Valley problem: end of takeoff.”
As we move forward, it is important for all players in the economic system to realize that the game has changed. It is also important that each player understands how the new rules apply to him. We will start by first examining several psychological factors that can irrationally affect the overall decision-making process. Then we will consider a new player in the economic system who is ready to take advantage of these aforementioned changes and developing factors. Finally, we look at each player in the economic system, and what they should consider when they enter this “brave new world,” as English writer Aldous Huxley put it in his dystopian novel in 1932.
PSYCHOLOGICAL FACTORS
When theoretical scientists study markets, it is initially assumed that market participants act rationally. But what if participants are in a state that is pushing them toward suboptimal and potentially irrational behavior? Many factors add irrationality to the funding environment for unicorns.
1. Founder / CEO. Many of the founders of unicorns and their CEOs have never had difficulty financing - they only knew success. Therefore, they have a strong belief that any sign of weakness (such as, for example, a lowering round) will have a catastrophic effect on the internal situation in the company (company culture), on the process of hiring employees and on the ability to retain them. Leadership is also a working factor; he has a fear - won't the lowering round seem to be the leader’s weakness to others? It is quite possible that it is difficult for us to imagine the level of fear and anxiety that may arise from a previously confident leader at such a transitional moment.
2. Investors. A typical representative of a venture investment company in 2016 is also exposed to psychological factors. Investors are likely peering at the stunning, paper-based gains that have already been recorded as a success by their own investor companion investors (LP). Everything suggesting a decrease in investment (lowering round) immediately raises questions about success indicators that have already been “capitalized”. In addition, many such price cuts could impede their ability to attract further investment. Thus, alarmed investors can have many incentives to defend illusions - to do everything they can to prevent a decline in investment (lowering rounds).
3. Anyone who has already “capitalized” the return of their investment. Whether you are a founder, leader, business angel, venture capital company or late stage investor, it is likely that you took the value estimate from the last round, multiplied it by your share of the property and told yourself that you are now wow! - stand so much! It is simply in human nature that, having done such a mental exercise and convincing yourself of the result, you will experience difficulties in rationalizing the decline in investment.
4. The pursuit of exit situations. As soon as the fear of downward price dynamics asserts, some players in the economic system try to quickly and desperately capture instant liquidity, guided primarily by their own interests. This happens in every transitional situation on the market and can create quite a lot of tension between the various participants in each company. We have already seen examples of founders and managers who received liquid assets before investors. And there are also modern examples of investors who kicked founders and employees out of companies. Obviously, providing simultaneous liquidity is the most suitable option, but the fear of lower prices, as well as an increase in the duration of the conversion of assets into money, can force both parties to choose the “I'm the first” course.
SHARKS ARRIVE WITH TRANSACTION AGREEMENTS CONTAINING “DIRTY” TERMS
What does shark mean here? These are sophisticated and unprincipled investors who instinctively understand the effect of the above factors on participants, know exactly how to deal with investments, and can use the situation. They wait for the occurrence of such situations, licking their lips at the thought of the opportunity to profit.
Transactional agreements containing “dirty” or “structured” conditions are such proposed investments, where the main part of the economic profit for the investor does not come from the announced valuation, but rather through a series of “dirty” conditions hidden deep in the document. This allows the shark to meet the “question” of the entrepreneur and member of the VC board about the cost assessment, all the while knowing that excellent profits will be obtained even with outputs that are much lower than the coverage estimates.
Examples of “dirty” conditions are guaranteed IPO profits, retetches (or, otherwise, “ratchet”), PIK dividends, a series-based M&A veto, and exceptional preferences (privileges) or liquidity rights. A typical Silicon Valley transaction agreement does not contain such conditions. The reason that these conditions can make a profit on their own is that they lay the foundation for rebuilding the capitalization table at some point in the future. Therefore, the founder and members of the board of directors of a venture company can continue to think for a long time that everything is going fine. Correction will not occur now, it will be done sometime later.
Transactional agreements containing “dirty” conditions are a serious problem for two reasons. One is that they are “unpacked” or “exploded” at some point in the future. You can no longer just look at the capitalization table and measure your profit. After the “dirty” offer is accepted, the payment in each potential future cost estimate requires a complex analysis, where the profit of the “shark” is calculated first and only then the remainder is divided among all the others. The second reason why they present a serious problem is that their complexity makes future financial investments almost impossible.
Any investor who will be asked to follow a “dirty” offer will look at its complexity and, most likely, refuse. This greatly increases the risk of either loss of money, or complete recapitalization, which will destroy previous shareholders (equally all - founders, employees, investors). Thus, while such a maneuver may seem safe and solve your short-term psychological difficulties and problems, you can put your whole company in a much more dangerous position, without even realizing it.
Some late-stage investors themselves may be tempted to become “sharks” and begin to include structured conditions in their own agreements on the basic terms of the transaction. Successful adherence to such a strategy will lead these investors to truly become sharks. It will be convenient for them to know that their interests contradict the interests of the founders, employees and other investors in the capitalization table and conflict with them. And it will be a pleasure to them to know that they will win, and others will lose. This situation is not for the faint of heart and, of course, is completely different from the typical investor behavior in the past few years.
Now let's take a deeper look at what this new medium for attracting investment means for every participant in the economic system.
ENTREPRENEURS / FOUNDERS / DIRECTORS GENERAL
Today's entrepreneur working with a unicorn gained his experience in an environment that could be radically different from what lies ahead. Take a look at the history of the process. Money comes in easily. The market prefers growth rather than profit. Competitors also have access to capital. Therefore, in order to win, one must grow extremely quickly in size and be super-ambitious. It is necessary to capture the maximum possible market share.
Never in the history of venture capital did startups at an early stage have access to so much capital. In 1999, if the company reached $ 30 million before an IPO, then this was considered a great historical success. Now private companies exceed this value ten or more times. And, accordingly, the combustion rate increased tenfold compared to what it was then. All this creates a monstrously hungry unicorn. He needs capital again and again (if he intends to stay on the current trajectory).
Perhaps for the first time in their lives, these entrepreneurs may face a situation where they will not be able to keep their net rising funding at the proper level to ensure investment growth. This is uncharted territory. There are several alternatives here:
1. The first opportunity many unicorns have is a deal agreement containing “dirty” terms. As discussed above, these conditions can cleverly fool an inexperienced player, because they are able to “meet the question” regarding coverage assessment; the founder accepting these conditions simply does not understand what kind of "slaughter" awaits him in the near future. The only reason that such an agreement could be accepted is to support the illusion of a cost estimate, which, however, simply does not matter. Accepting an agreement with such conditions is like launching a watch on a time bomb. Your only salvation will be to go through the IPO window as quickly as possible (note: the Box and Square companies managed to slip through this needle eye successfully), otherwise the accepted conditions will eat you alive. The main problem is that after that you will never again be able to get an investment, since no new investor wants to sit on a volcano. And you will get bogged down in negotiations with a creditor who has already proved that he is smarter than you.
2. Conduct a round of cleaning (capitalization tables) at a lower cost estimate. This seems a serious failure for many modern entrepreneurs, but they must quickly change their minds. Reed Hastings at Netflix raised money in a resonant lowering round as a public CEO. Each public general manager had days when the stock price fell - this is a common and common phenomenon. The only thing you defend is your image and pride, but, ultimately, they have no meaning. You should be more worried about the long-term valuation of your stock and minimizing the likelihood of losing everything. And it is precisely the conditions mentioned above that Godzilla is worth seriously fearing. A dropping round is nonsense. We must go through it and move on. Clear,
3. Get down to business and do everything so that the cash flow along with the funds in the account becomes positive. This may seem like the most inappropriate choice, since your board of directors has advised you to do the exact opposite for the past four years. They told you that you have to be “bold” and “ambitious” and that now is the best time to capture a significant market share. Despite this, the only way to completely control your own destiny is to completely eliminate the need for additional capital growth. Achieving profitability is the most liberating action that a startup can accomplish. Now you can make your own decisions. It also minimizes future dilution. Gavin Baker“Create a free cash flow for 1 dollar and then you can invest the rest in growth, remaining on that 1 dollar in free cash flow for many years. I understand that you want to grow, and I want you to grow, but let's finance this growth internally from gross profit dollars, and not from dollars for new dilutive shares.
Ultimately, internally funded growth is the only way to control your own destiny, and not be dominated by capital markets. ”
4. Get public. Ultimately, the best way for founders to take care of their property, as well as their employees, is to go public. Prior to the IPO, ordinary shares are preference shares. Many preferred shares have various types of management functions, and most of them have significant privileges over common shares. If you really want to release your own ordinary shares and the shares of your employees, then you should convert the preferred shares into ordinary and remove the privileges, both in management and in liquidation of your shares. To many founders, various misguided consultants have repeatedly said that an IPO is bad and that the path to success is to "remain private for as long as possible." However, an IPO is not only better for your company (see
The stock price fluctuates. There is not a single high-class public (open) joint-stock company that did not have time periods when their shares showed low results. The joint-stock company "Amazon" has gone from 106 to 6 dollars per share. Salesforce went down from $ 16 to $ 6 and stood below $ 10 for many months. Netflix slid from $ 38 to $ 8 per share for some six months. And remember Facebook in the first six months of its existence as a public company?
If you cannot handle lower valuation, then you should seriously consider giving up the position of CEO. Being a true leader means being able to lead both in good and bad times. Accepting a “dirty” agreement jeopardizes the future of your company solely because you are afraid to lead through difficult new times.
STAFF
The exact situation with the capital structure of a company is usually hidden from the average employee. You know that you work for this unicorn and that you have a certain number of ordinary shares. Perhaps you know your share of the property. And, unfortunately, you can assume that the result of your assessment of the cost of the unicorn and your share of ownership is all that you are worth. Of course, to be accurate in this assessment, it is necessary to achieve a liquidity event (IPO or M&A) with an estimate of the value equal to or higher than that obtained in the last round, without increasing dissolution from new rounds. But think about it: M&A gives obviously scarce funds (no large company wants to pay these prices or assume this burning rate), and many founders have been told more than once that an IPO is bad.
For the most part, employees are in the same position as founders (see above), except that they do not participate in the decision-making outlined in paragraphs. 1-4. But even so, they must ask the same questions related to management: Can we get to break even on the money we have? Should we continue to raise money? If yes, can we do this on “clean” conditions (not on “dirty”)?Employees, in fact, would like to know if the founder and / or CEO are going to enter into a deal with “dirty” conditions (or maybe have already entered into it), because the owners of ordinary shares are most at risk in such a situation . And you also need to know if your leader is an IPO opponent. If your CEO / founder enters a round with dirty conditions and is also an opponent of an IPO, then the chance that you will ever be able to get something remotely close to what you think they are worth now will be very, very low. You will probably be better off moving to another company.
INVESTORS
Explanation: It should be noted that the author of the article and his investment company belong to this category.
In most cases, early investors in unicorns are in the same position as founders and employees. This is because companies, after the early investors, raised so much capital that the early investor is no longer an essential part of the holders of voting rights or liquidation privileges. As a result, most of their interests coincide with those of the owners of ordinary shares, and the desired key decisions on compensation and liquidity are the same as those of the founders. Such an investor will also be wary of a deal agreement containing “dirty” conditions, which has the ability to take control of the entire company. Such an investor will also have rather strong fear due to the difference between paper and real incomes and due to the lack of general liquidity in the market. Or at least all of this should be present.
An exception is a late investor or a wealthy investor, who may represent a substantial portion of all the money raised. This particular type of investor may have protected its property with proactive or oversized investment. They may even have encouraged the aggressive “forward to victory” mentality, knowing that they could continue to write checks. And they act like an irresponsible gambler at the poker table.
There are two forces that at some point can begin to slow down this type of investor. Firstly, when difficulties begin, some really large amounts may be debited from the accounts of these investors. These impressive losses create insecurity not only for the investor himself, but - more importantly - for his partner investors. The second problem is that for many of these investors, a single block of shares may become too large for the entire fund. They basically cannot afford to put themselves at further risk in their own name. They begin to use euphemisms to otherwise describe the situation of oversaturation, such as, for example, “fully placed investments” or “planned level”.
This form of rejection among large investors has created, indeed, bizarre and unprecedented activity in the world of unicorns. Upscale investors, already with large capital, began to conduct telephone companies with an offer to take part after them under their own names. However, insatiable unicorns need even more capital than these gentlemen can provide. Oddly enough, if you look at the great historical victories of this class of investor, there is no information about sending invitations to other investors. But now they “need” others who must warn of the risk to all parties involved. More about this later.
Investors are also worried about the growth of their next fund, which may lead to unusual behavior that does not depend on the situation of each individual company.Do you support a deal agreement containing “dirty” terms because it allows you to keep your paper tag and not scare your investors? Even if you know that it can be bad for the company in the long run? Do you feel the need to raise more capital quickly before prices go further and lower your IRR? Do you feel the need to have more money to continue to feed the hungry companies you have already invested in?
DEPOSIT COMPANIES (LPS)
Companion partners such as trust funds and other funds are significant sources of capital investing in venture capital firms, hedge funds, etc. They represent real capital that systemically works in the market. Companion investors (LP) evaluate the effectiveness of different investors in the economic system and make investment decisions. This is hard work because feedback cycles are quite long - especially when it comes to investing in illiquid assets such as startups (and unicorns).
Another big problem for affiliate contributors (LPs) is that they are required to measure the effectiveness of these illiquid assets, although this is extremely difficult and the result may not be indicative of a future actual return on funds. In this case, many contributing partners (LPs) included the high efficiency of unicorn cost estimates in their overall results, which created a very significant increase in venture capital categories. In a sense, they have already “capitalized” this profit. The problem here, obviously, is that the absence of any material liquidity in the market, together with the latest correction, creates the risk that, in fact, there may not be any money for the paper profit that they have already capitalized.
In addition, as noted earlier, they may face increased pressure from venture capital firms who want to speed up their process of attracting funding in this highly disturbing environment. A recent WSJ article, “Venture Capital Firms Rush for New Money,” shows that venture capital firms, using affiliate contributors (LPs), raise new funds to the highest level in 15 years while cash liquidity is at its lowest level over the past seven years. It is useful to reproduce several excerpts from this article:
• In recent years, venture capital firms have invested heavily, encouraging companies to spend in the struggle for market leadership. This left some of these venture capital firms without funds and required them to raise money faster than in previous years in order to continue to receive their remuneration and make new investments.
• Some venture capitalists say the surge in funding is designed to show that paper-based returns on startup investments still look attractive.
• The distribution of funds will be sometime later, but for now, large paper profits are still a good bait for financing.
In addition to these problems, there was also an increase in the “internal rounds” when investors invested in companies where they were already investors, eliminating the “market check”, which may have led to a potential decrease in the cost estimate. This activity, which has an obvious conflict of interest, makes the actions of contributing partners (LP) in evaluating the effectiveness of venture capital companies even more difficult.
Against this difficult background, many firms offer their partner investors (LP) to take on new early investment obligations to their next fund at the very moment when the valuation is the most difficult and the concern may be at the peak of the cycle. In fact, at heart most of the affiliate contributors (LPs) know that the venture capital sector is countercyclical to the amount of money raised by venture capital firms. With over-financing of the industry, total profitability falls. Huge investments in overblown multi-billion dollar venture capital funds can easily exacerbate problems that already exist.
One of the reactions from the community of contributing partners (LPs) could be the requirement of obligations from new funds to prohibit intra-round and cross-financing investments. This can help ensure that new capital is not invested in trying to save previous investment decisions - an activity known as throwing in good money after bad money.
If this is not enough, then some investment partners (LPs) are required to participate in SPVs (specialized financial organizations), often from the very funds that they supported. As mentioned earlier, some investors reach the stage where they are bound by excessive obligations with a particular company in a particular fund (“at the planned level”). Nevertheless, these investors want to continue to provide capital to their unicorns and to support the priority of growth rather than profit. To do this, they create a one-time investment special-purpose mechanism (persistently offering to invest). And this mechanism (SPV) carries an added risk, consisting in the absence of any portfolio diversification or the option “looking back”, which allows to protect against losses.
Obviously, contributing partners (LPs) can simply say no to participating in the SPV (even though they may feel pressure from the fund). And this is most likely reasonable. First, someone asks you to invest, exactly at the time when everyone else is overly bound. Hey come, help us out, we're drowning here! Secondly, you already have a sufficient impact on this company through your initial investment. And finally, it is extremely unlikely that someday historical research of your involvement in the SPV peak cycle will show good returns.
ALL EARLY DISABLED FINANCIAL SOURCES (FAMILY-CAPITAL FUND MANAGEMENT COMPANIES, PROPERTY MANAGEMENT FUNDS, ETC.)
If you have serious money and you have not yet been offered to invest in a unicorn, then this is simply because people do not yet know where to find you. There are three types of people who are likely to come into contact with you now; everyone should be handled very carefully:
1. Founders (agents) of the SPV (special purpose investment mechanism). As mentioned in the Contributing Companion (LP) section, investors have also expanded their SPV marketing more broadly, including family capital management companies and other capital funds. Lures usually contain phrases such as “you are invited to participate in an opportunity” or “you will be provided with access to an opportunity” to invest. Such an invitation “you are very lucky with such an opportunity” is an ominous warning of widespread fraud. And remember: such persistent offers come from investors who actually have money, but who already know that they are bound by excessive obligations.
2. Brokers and third-rate investment banks offering secondary shares for sale in unicorn companies. If you ask any big family money management company, they will tell you that they are simply bombarded with calls and emails offering secondary positions in unicorn companies. Such baits often sound like “a 20-40% discount on the price of the last round”.
3. The increasing round of the unicorn. You may also be asked to simply add capital to the standard unicorn round. Being with many investors “at the planned level” due to the already accumulated amount of capital, some companies look “under every stone” where else to get dollars.
One of the shocking facts in many of these “investment opportunities” is the relative lack of financial information relevant to the case. One would think that these “opportunities”, which often sell as “pre-IPO” rounds, have something close to the data that could be seen in S-1. However, financial information is often quite limited. And when it is contained, it can be presented in a form incompatible with GAAP standards. As an example: most CEOs of unicorns still have no idea that discounts, coupons, and subsidies are negative income.
If the audit is included, it may have numerous “reservations”, where the auditor lists all the reasons why this particular audit may not meet GAAP standards and why the situation can change significantly if you look deeper. Investors should be clearly aware that this is not an IPO. Companies were not trained properly, and the numbers in a PowerPoint presentation are not necessarily correct. Here's a recommendation: if you intend to invest several million dollars in the growing investment of the unicorn, then talk to the auditor. Find out exactly how thorough the check was.
New potential investors might also be very surprised at how few heads of unicorns really understand the economics of their field. Such executives can easily be seen by the fact that they obsessively focus on the “gross revenue of all sellers of the site” or “long-term forward orders” and try to talk without considering such things as true net income, gross profit or operating profitability. They will continue to claim that they are a “profitable company,” even when everything they really do is stopped due to negative gross margins. These companies will one day need real income and real profit, and if the company has not worried about it in advance, they should not be given millions of dollars at a late stage of financing.
Perhaps the biggest mistake made by uninvested investors is to assume that since the company already has titled (brand) investors, the new investment opportunity should be of high quality. Here the reputation of other investors is used instead of checking the reliability of the financial condition of the company. And such a “shortest path” creates a lot of problems. Firstly, such investors are “wholly devoted to the company”. They have invested for a long time, and without your money there is a danger for their investments. Secondly, as mentioned above, they are already "full" and nervous. They did not contact you before when they built their reputation. Why are they so friendly now?
The main information for investors with whom such contacts are now taking place is as follows: this is not the first or even not the twenty-first pitch in a volleyball fight of many hours. You are not invited to any special dance; you are contacted only because you are the last creditor in a critical situation. And considering all of the above, breaking up with your dollars will now be an extremely dangerous move. Let the buyer be careful.
VISIT OF SILICON VALLEY BY REPRESENTATIVE OF SECURITIES AND EXCHANGE COMMISSION (SEC)
A few weeks ago, on March 31, 2016, the chairman of the Securities and Exchange Commission (SEC) traveled to Silicon Valley and delivered a speech at an event at Stanford University Law School. For those who are involved in investing unicorns, or for those who are considering investing in them, it would be useful to read it in full (see here ). An interpretation of this presentation by Bloomberg is set out in Silicon Valley Must Corral its Unicorns .
Chairwoman Ms. White seems to fully understand the problems and impacts that could disrupt the process of financing unicorns:
Almost all venture capital assessments are extremely subjective. But one must ask whether advertising and pressure aimed at obtaining a unicorn rating are similar to those experienced by public joint-stock companies putting forward a promising assessment on the market with the associated risk of financial reporting problems.
And then it gives out something important for all past and future investors regarding the need for increased verification of the reliability of the financial condition of the company:
As I will discuss, the risk of misrepresentation and inaccuracy is heightened because startup companies, even fairly mature ones, often have much less reliable internal controls and management procedures than most public joint-stock companies. Vigilance on the part of private companies in relation to the accuracy of their financial results and other information is therefore particularly important.
It would be unfortunate that unicorn investment promotion activities will lead to increased SEC involvement and rules regarding private venture startups. But if those involved believe that “not being public” also means “not being responsible,” we will quickly find ourselves in that exact place. We will be deservedly invited for a closer look.
MORE MONEY - MORE PROBLEMS
Perhaps the biggest mistake in judgment for everyone involved in this process is the assumption that if we can just stand the “one more round”, then everything will be fine. Founders began to think that the more money, the better, and the volatility of the recent funding environment has led many to believe that heroic fundraising is a competitive advantage. The irony is that just the opposite is right. The best entrepreneurs acted more successfully precisely in times of insufficient capital. They can raise money in any environment. Free capital allows less competent participants to work in every market. Such a less competent player brings with him more risky operations, which draws even a good entrepreneur to careless actions.
The reason we are all in the mess now is the excessive amount of capital that poured into the venture startup market. This excess of capital led to the following: (1) record-high combustion rates 5-10 times higher than those that were approx. in 1999, (2) most companies operate very far from profitability, (3) excessively intense competition driven by access to named capital, (4) deferred or non-existent liquidity for employees and investors, and (5) persistent collection methods described above funds. Increasing the amount of money will not solve any of these problems - it will only aggravate them. The most healing process that could possibly have happened,