Not built to last
This recent article and diagram by JP Morgan inspires me to write about something obvious.
Unicorns (those hyper-growth start-ups which venture capitalists are hunting for), are not built to last, because their early years’ maniacal focus on hyper-growth forces them to avoid looking at building the key fundamentals which are the foundation of long-term, solid businesses.
A few things are at play here.
1/ The model of venture funding itself
Venture funding, looked from the vantage point of large Limited Partners, pension funds, and large institutional investors, is an asset class routinely seen as THE asset class which returns the highest possible return, with expectations in the range of 10% or above annually, on average.
This expectation setting started a while ago, when VC funding was invented to fuel innovative technology companies, in the then-nascent Silicon Valley.
I remember speaking with a first generation venture capitalist, in New-York City, around 2006. She had been a Venture Capitalist in that first wave of VC fund, and humbly remembers: “back then, the entire industry was returning good returns, consistently, and once a decade, one of us was stumbling upon a home run” (we call them unicorns, now). “We knew that it was a home run, a fluke of sorts, and we knew someone just got lucky”.
And then the YouTube acquisition by Google, masterminded by Sequoia Capital and Mike Moritz, changed everything.
Everyone started hoping for a home run — at every strike of the ball.
People started looking at the YouTube model: a few years of steady, but slow growth, followed by a hockey stick hyper-growth phase.
Today, it is not uncommon for venture capitalists to state that their SaaS companies metrics EXPECT a doubling of revenue year on year, for 2 to 3 years.
It is not their fault, though. They too, are part of a system larger than them.
A venture fund is a legal and investment structure with a life of 10 years.
3 years to invest, and 6 years to prune, nurture, and keep financing the survivors.
It is therefore a mathematical necessity for a venture fund to seek, demand, expect hyper-growth from its investees.
It enables a venture fund to paint a picture, or ride a wave of hyper-growth from their successful investment to would be buyers, maybe they be private companies (so-called “M&A exit”), or the general public (IPO exits).
It is only a handful of a VC fund portfolio which delivers the big returns, because the VC fund does NOT have the time to nurture more successes. Hence, it seeks the hyper-growth companies which emerge within 3 years. The VC fund does not have time.
The valuation at the sale, and hence the “valuation premium” is thus rewarding those companies on the basis of their hyper-growth, yet, completely artificially, since it’s known and observable that this growth is not sustainable post acquisition or post IPO.
In other terms, the venture capitalists short term model construction is optimized to serve them and their investors, while it hides a flaw in the expectation setting of the future acquirer, corporate, or public investor.
2/ Hyper growth expectation is un-natural — and toxic
Indeed, let’s look at the long term.
Let’s play a game.
Let’s compare the revenue growth of Google, Facebook and Apple, to that of a hypothetical unicorn company which would double each year through the rest of its lifetime.
Here is our core data set:
Our three favorite unicorns enjoy tremendous revenue growth after their IPO:
But when you analyze their year on year revenue growth, it becomes pretty clear that EVEN those behemoths of the Silicon Valley could NOT sustain a “hyper-growth” after their market establishment.
Let’s plot their growth against a “hypothetical unicorn”, which would enjoy a doubling of revenues every year.
A graphic is worth a thousand words, they say… Here, it puts in perspective how un-sustainable and impossible this doubling of revenue actually is.
The picture is even more striking (and fun to look at) if we take the time to look at the compounded growth of the revenues, brought back to index 0 on Year 1:
3/ Tracing a few lessons
So what the JP Morgan diagram and our analysis show us is that it is NEVER possible, to sustain a hyper-growth over the long term. Even worse: we should EXPECT revenue growth to slow down, EVEN for the companies which succeed at establishing a “virtuous cycle” of user to revenue acquisition.
Worse: the expectation of hyper-growth builds an un-achievable objective for the management of the start-up, then acquired company, that they will continue to function the same way after the acquisition.
Or that the promise of the IPO prospectus will be met after the stock starts trading at the Stock Exchange.
This sets the management team for failure, explains the decaying rate of entrepreneur CEOs over time, and looses the focus on what to build for the long term.
Worse, it actually “bends” the original vision of the company… “Pivots” are seen mostly as a valuable behavior, but sometimes, a pivot will denature the path to the original vision, which just needed a bit more time to develop.
Twitter, SnapChat are all arguably in that “re-correction” phase, and Uber is headed that way as well: unsustainable expectations of growth, while those novel, innovative new media formats need years, maybe a decade, to find their righteous place in the existing industry landscape.
In a world of unicorns, CEOs focus on user acquisition numbers, and end-up “feeding the beast” of those user acquisitions. Revenue derived from those numbers come second, at the risk of denaturing the original promise of the business.
4/ Is it time to rethink the model, maybe invent a new investment vehicle?
I posit that it is.
Predictability is good, and start-up valuations should begin to value and focus on revenue predictability, instead of hyper-growth.
The focus should be on usage, on building a long term value proposition, on taking the time to find the core use case.
Then transforming that usage into revenue, slowly, patiently, and without denaturing the promise of the brand, and the core vision for the business.
This is true for B2C companies, B2B2C companies, and of course for B2B, SaaS companies.
Large organizations, which are potential acquirers of the start-ups incubated in the Silicon Valley, should fast realize that they are not at hyper-growth companies which will magically solve their revenue growth problems.
Truly, Silicon Valley companies are, by far and large, groups of human beings who think differently, and have a way to help larger companies do things differently.
Incumbents should acquire Silicon Valley companies for their innovation value, and helping them think differently about the business and sectors they control.
In turn, they should relieve the pressure on the venture funds where they invest, and give them more room (i.e. more time) to nurture and incubate value.
It takes time to introspect, in order to “think different”.
It takes time to nurture behavior change in a consumer marketplace.
It takes time to assemble a team of trusted folks who can work patiently, for the long term.
So, I am calling for the creation of a new legal structure of venture funds.
A venture fund which would have an unlimited duration (or, if we have to compromise, a 20 years one).
A venture fund which would actually house, hire, fund, “operating relays” sort of EIRs, between its corporate investors, and the start-ups they invest in.
A venture fund which could return capital not only on the basis of investment exits and sales, but also on the delivery of corporate dividends, when their investees start generating profits.
A venture fund where some of those dividends could also be used to replenish the available capital to fund future start-ups, and thus reduce the capital calls required of the LPs, thus improving their return over the longer period.
A venture fund which would thus be less focused on short term decisions and more focused on long term value building.
This would change the dynamic and quality of the relationship between a CEO and his investors, his Board of Directors.
All would benefit, I posit, as this would ground companies in focusing on the long term.
Think I’m dreaming?
Well, maybe my dream is not as crazy as looking for unicorns, all the time.
“Today’s culture of quarterly earnings hysteria is totally contrary to the long-term approach we need.”
He’s of course focused on the publicly traded companies.
Bit I am adding that this call for long term view should also affect private companies as well, with a rethinking of the the venture funding model which fuels them.
Venture capitalists are fantastic people… but they are also driven by their own financial motivators, compensation models, and systemic constructs.
Change those, and you change the whole “value building” culture of the Valley, and you correct the “unicorn magical thinking” phenomenon and cyclical creation history.
True value building happens slowly, quietly, and over the long run.
“Built to last”… this should be what the Silicon Valley is capable of delivering.
I believe it is, but that, too, will require innovation in thinking.
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