A VC’s Guide to Bubbles, Unicorns, and Viral Cats

For the past few quarters, the innovation economy seems to be entering a new bubble. Capital is flowing rapidly and the apparent overvaluations of certain companies are turning the vague worry about a bubble into a legitimate concern.

Sean Foote, Managing Director at Cosmopolitan Capital, is in a prime position to assess the innovation economy from close range. Foote has been a venture capitalist for over 16 years and has been involved in high profile investments including Hotmail and Rocket Fuel. Meeting Sean Foote and hearing about his quite scientific approach to venture capital was enlightening and refreshing at a time when the innovation economy seems to become more chaotic.

This article will analyse the current state of venture capital and explore how Foote’s down-to-earth approach to venture capital investment can help investors avoid being trapped in bad companies.

Venture Capital Has Changed Since the Dot-com Bubble

Sean claims that venture capital (VC) is not the glamorous industry that the media portrays. In term of size and return, venture capital is a tiny industry. It gets press coverage not because of money but because of the impact of a few successful companies.

The average VC fund return has been zero percent in the 10 years through 2012. Only a handful of firms have experienced exceptional returns.

However, the amount of capital invested in venture capital is growing again. It recently hit an almost 15-year high. This raises the inevitable question of a new tech bubble that would be taking a different form than the Dot-com bubble.

“A Bubble Is Coming”

Many worry about a nascent tech bubble. Among them, businessman Mark Cuban published an article titled ‘Why This Tech Bubble is Worse Than the Tech Bubble of 2000’, explaining that the ‘bubble today comes from private investors who are investing in apps and small tech companies’.

Some investors take another stand. Naval Ravikant, CEO of AngelList, thinks that “overall [the tech industry] is all healthy and positive”. However, he worries that the likelihood of a bubble would be an 8 on a 10-point scale. Tech is fine. But “it’s a global liquidity bubble”. “Many of the central banks are still printing a lot of money, and that money is trying to find a home”, Ravikant said[1].

“It’s a global liquidity bubble.”

Andreessen Horowitz is also bullish on technology. The VC firm presented arguments against a tech bubble at their L.P. annual meeting. It explained that “earnings, not P/E multiples, are growing” and that the market size is real now, e.g. the US funding per Internet user has been roughly flat since the bubble.

What has changed is that more money is invested in privately owned tech companies. This is mostly because of “the megabucks being poured into a handful of late-stage companies that have become known as unicorns”.

The Inception of Unicorns

Indeed, Foote highlighted that since the Dot-com bubble, things have changed a lot. Large companies find that the private market is an attractive alternative to going public. Fewer companies want to go public because of corporate governance and Sarbanes-Oxley-type regulations.

There are a bit less than one hundred tech unicorns, which are private companies with more than $1 billion valuation. They follow the example of Facebook. They try to capture as much capital as they can before hitting Wall Street. The tech IPO market has almost evaporated. As long as money is flowing from the private market, why should these unicorns bother going public?

But these late-stage investments are inflated. Ravikant claimed that “the later stage valuation have really accelerated, i.e. 3–5x”. Foote provocatively told me that “investing in late-stage branded deals is the “cool kids” approach to investing — the press highlights the cool kids investing in cool companies. It’s the fear of missing out on a really great party”. This sounds bubbly, does it not? There is a risk for venture capitalists to invest in dressed-up cats or rather than in real unicorns.

“Investing in late-stage branded deals is the ‘cool kids’ approach to investing.”

Being trapped in a bubble not only happen to novices, it happens when investors try to outsmart the market, thinking that they can take advantage of crazy valuations, or when they tend to follow the trends adopting a herd behaviour. This is why VCs need to rely on carefully thought-out investment theses. It is certainly possible for VCs to navigate a bubble. After all, “we made a lot of money for our investors in the last bubble due to some good investments and lucky timing” Foote said.

How Venture Capital Can Profit in and After a Bubble

How does a VC investor choose companies to invest in? A good investor knows when to say ‘no’, and VCs do that all the time. Listening to hundreds of pitches per year, Foote says ‘yes’ only three or four times.

Traditional Answer to Overcome Market Inefficiency

The main reason VCs say ‘no’ often is that venture capital is a long-tail business — it is part of an inefficient market. While in an efficient market everyone can make informed decisions, venture capital has to deal with asymmetric (or scarcity of) information. So when you finally say ‘yes’, you need to make sure that you can leverage something that you know and others do not.

Because of limited information about the future, many venture capital investors adopt a ‘spray and pray’ strategy — a diversified investment strategy that can also be seen as buying options hoping that it will lead to a few extremely good deals.

Many venture capital investors adopt a ‘spray and pray’ strategy.

A firm like 500 Startups shows a successful version of such a strategy. Its founder and general partner, Dave McClure, summarises his strategy by saying that “a quantitative, high-volume investment strategy filtered based on reasonable assessment of team, product, market, customer & revenue along with domain-specific expertise, and selective follow-on investment with incremental knowledge of company metrics and progress CAN result in good outcomes”.

If one believes a bubble is about to burst, all those ‘spray and pray’ options will tend towards worthlessness, while focused investments made with ‘inside information’ have a higher likelihood of survival and success.

Strictly Respect Your Investment Thesis

Instead of buying options on future investments by adopting a ‘spray and pray’ strategy, Foote chooses carefully.

Over the years, Foote has built an approach that helps him find what he calls ‘bamboo companies’. According to him: “Bamboo is fast growing and hardy, nearly impossible to kill. The whole goal of venture capital is to find bamboo companies.”

VC investment is not rocket-science but it is not a random process either. You need to do your due diligence. How is the company performing compared to the competition? What is the market opportunity? Are there going to be any regulatory problems?

“Bamboo is fast growing and hardy, nearly impossible to kill. The whole goal of venture capital is to find bamboo companies.”

To counterbalance the constant inefficiency of the innovation economy, Foote’s approach is centred on adding value.

Some investors add value by leveraging external information — e.g. what they know about large companies’ M&A pipeline. Foote believes in actively helping portfolio companies. While traditional VCs only have monthly board meetings and occasional additional meetings with their portfolio companies, he wants to be involved. He needs to know that his contribution goes beyond the money that he is investing, i.e. contributes more than just providing cash.

“With a partner that has started 12 companies with multiple IPOs, it only makes sense to be more like a team member than a board member,” says Foote. “It’s the world’s best due diligence for both us and the company. Are we working well together in this staff meeting? Did everyone deliver on their commitments?”

Beyond the traditional criteria for identifying successful startups that seasoned venture capitalists like Terry Opdendyk have developed[2], some additional things Foote asks himself:

• What is the one thing that will make the difference between win and failure?
• Is this someone I want to marry?
• What are the risks that can I eliminate?

One of Foote’s decisive questions is: “Can we help the company?” Are there some information or skills that I can use to overcome the 90 percent chance of failure? Making sure that you are bringing something to the table is a good way to avoid herd mentality.

Finally, like all seasoned investors, Foote focuses on valuation. What is the investment price? What is going to be the exit price? To answer the second question, VCs commonly refer to later-stage investors. If you are a series A investor, you go to series B investors and ask them what they expect in term valuation and metrics.

A tricky part in estimating valuations is to make sure that the terms are understood. Are you going to invest in common stock, convertible preferred, or participating preferred stock? Terms are important and have an impact on the valuation. A VC friend, who invests in late-stage deals, told me: VCs often agree to boost valuation in exchange of complex terms that guarantee a certain return. This creates an “artificial valuation” that looks more impressive.

Conclusion

Risks of bad investments increase in a euphoric environment, where investors see rainbows, unicorns, and centaurs everywhere.

There is a growing feeling that the elastic is taut and that it might crack soon. Even The Economist dedicated a cover page to the “Empire of the geeks”.

This is a time where back-to-basics is the safest way to invest. Sean Foote’s approach is refreshing. It helps to keep the fundamentals in mind and to avoid being lured by mythical creatures.

At a time where capital is flowing to support innovation, raising money sounds appealing. If you are still wondering about whether you should raise VC money, Foote has a straightforward answer for you: “entrepreneurs should do everything they can not to have to raise money from people like me. But if you need money, and you are offered it, take it! Nothing prevents bankruptcy better than money.”

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[1] Naval Ravikant at PreMoney SF 2015:

“It does concentrate toward us [i.e. the tech industry] because people are look for risk assets but that said the tech industry is going through a marvellous phase where we are now attacking every industry reaching every consumer or user.

It is really that story of human productivity and GDP growth come from technology. So I don’t think that Silicon Valley is gonna go away or take a huge hit.

Overall [the tech industry] is all healthy and positive. I think that many of the central banks are still printing huge amounts of money, and that money is trying to find a home in return. It is a global liquidity bubble. I give it a 8 but I don’t think it’s concentrated with us. Unfortunately every asset classes is vulnerable right now.”

[2] Read Opdendyk’s theory for identifying successful startups

The LER would like to thank and acknowledge Sibo Wei (MIM 2015) for making this article possible.

Update: This article has been edited to correct quotations from Naval Ravikant.

Originally published in 2015 at www.londonentrepreneurshipreview.com.