Unicorns and Cycles
It’s interesting sitting here at the beginning of 2016 in the midst of what everyone is saying is another cycle for the venture space. For the first time in my career I am experiencing real time a new cycle with the benefit of having lived through a prior one. This provides a context for processing current events.
I began work in the startup world in 2004 and while there were still many wounds and PTSD from the Bubble bursting . I heard the stories of Webvan and the like but had not lived through it personally. It was different in 2008 as I was a banker working with a number of NYC-based VC-backed companies and funds. We navigated the uncertainty together — the feeling initially that the venture space was largely insulated from the broader pain and suffering to the infamous Sequoia “RIP Good Times” deck. There was worry that VCs would broadly abandon their losing bets in their portfolios and, from a bank perspective, that the shifts in the equity markets would massively impact the credit quality of the underlying portfolios of VC-backed companies. It was a cycle, but without the historical experience, personally I could only hang on and try to take in bits of data that would help me for next time.
With the benefit of hindsight, a few things are clear from the last cycle. Times were tough and in my world, credit losses did spike. Yet, VCs did not abandon their companies en masse and the most active banks were able to adequately manage the risk and we didn’t see a complete breakdown of the venture debt lending model. And, by the way, some of the most successful companies of the last 8 years were founded during the darkest days of the last cycle. As Andrew Parker pointed out, Sequoia themselves remained remarkably consistent during this time, making 31seed or Series A investments including throws into AirBnB, Greendot (IPO), Dropbox, yCombinator and OpenDNS.
It’s fairly well established now that we are in a new cycle, which I’m choosing to call the Post Unicorn Hangover Cycle. We’ve all been on one big party for the last couple years, fueled by the taste of seemingly never-ending valuation increases for fast growing businesses. The astute crew at First Round Capital eloquently recap this phenomenon in their q4 letter to LPs:
“The data shows a change in the market and calls into question the implicit bet that many founders have made over the past few years. Founders (and their investors) have assumed that their ability to access follow-on funding will remain fairly consistent and that the sole metric that matters is growth…For the last several years, these assumptions have been a fairly safe bet. Many founders have been able to raise venture capital, increase their burn rates to fuel growth, and then raise future financings at a higher valuation as a result of that growth. Over the course of the fourth quarter, we have seen signs that the core assumptions driving the late-stage funding market are starting to shift.”
This perception has been pervasive in the last couple months, and amplified by the carnage in public SaaS company stocks, the poor performance of tech IPOs, and mark downs in private portfolios by Fidelity and others.
The question on everyone’s mind is this: trends indicate change is coming but how will this cycle be characterized vs. the last two that we’ve seen? If the Tech Bubble cycle is known for hype with the absence of business model and the Financial Crisis cycle is seen as a bunch of collateral damage but survival amidst the maelstrom in the broader economy, what will the story be from the Post Unicorn Hangover cycle?
Only in retrospect will we really know, but here are a few of my observations based on what we’ve seen before and some of the factors I think will impact the cycle as it plays out.
- 1. There will be blood, but casualties will be less than expected.
Of the many changes in the world over the last 20 years, perhaps none is as meaningful for the overall tech startup market than the rise of the cloud/Moore’s Law and the resulting reduction in overall cost to start and grow a company. Paul Graham noted this in December 2008 at the beginning of the Financial Crisis Cycle:
“VC funding will probably dry up somewhat during the present recession, like it usually does in bad times. But this time the result may be different. This time the number of new startups may not decrease. And that could be dangerous for VCs.
When VC funding dried up after the Internet Bubble, startups dried up too. There were not a lot of new startups being founded in 2003. But startups aren’t tied to VC the way they were 10 years ago.“
This trend has only continued and every day we see SaaS businesses that have been able to get to single digit millions in recurring revenue with little to no outside investment. There are operators in all corners of the country who are able to build these businesses — and often it is in these tertiary regions where capital is less available that you find these bootstrapped ventures.
There are more healthy businesses today than in either of the other cycles. However, to grow these businesses at venture scale, outside capital and cash burn is usually required, and this is why there will be blood.
Growing software businesses with $1–2MM in annual recurring revenue have, over the last couple years, been able to secure venture rounds at increasingly aggressive multiples of their ARR. This is largely tied to the froth in the top end of the market where the fastest growing unicorns are getting valued at multiples that defy reasonable explanation. The trickle down effect on valuations is real, if a bit inefficient and hard to quantify. We will likely see younger private companies raising at reduced valuations from the recent past. Again, the First Round team expects this to happen, stating:
“We believe that starting in 2016, private and public companies will (once-again) begin to be valued in an increasingly consistent fashion. This change can (and will) be painful for many private companies. Companies that need to raise additional capital will have to price-test in the capital markets — and many will raise at lower prices than they previously did. And we worry that many private companies may unfortunately find that there is no market-clearing price at which they can obtain additional investment.”
The price-testing will be painful — but ultimately I think that most of these businesses will find clearing prices. This is due to the fact that many will be able to persist through lowering burn until the cycle turns and also because of my next point: the VC overhang.
2) The VC overhang is real, and it is spectacular.
VC overhang refers to the amount of capital that has been invested into venture funds by Limited Partners but which has not yet been deployed into private companies. Pitchbook recently released year end 2015 data which shows there is more than $79B in dry powder sitting in venture capital funds. This represents the largest amount of overhang since 2010. Further, more than 65% of this VC overhang is sitting in funds with 2014 or 2015 vintages.
This is capital which needs to be, and will be, invested. General partners are paid (quite handsomely!) to allocate this capital. And these folks are smart enough to realize that many of the best bets of the last cycle were made precisely when the market was seen as the bleakest. Further, the allocation of this capital is a necessary action before the partners can go out and raise their next fund.
Given the uncertainty in the market and the large chunk of the capital which is from recent vintage years, it would be no surprise to see a 6–9 month slow down in investing activity. But the 1–2 year outlook suggests that funding levels will remain healthy, and strong companies that can post positive performance can expect to find funders who are willing to invest in their growth — for the right price of course!
3) As always, getting through the cycle requires old fashioned basics
Perhaps the great output already in this cycle is the endless stream of Medium posts and smart Tweet tips from VCs and founders about how there is a great need to focus on the basics. What this means from a financial sense is stepping back from the alluring aroma of growth at all costs to really understand concepts like cash runway vs. burn rate, unit economics, and the value of sustainable, healthy growth. These are the basic building blocks of long term enterprise value and will ultimately lead to healthier outcomes for entrepreneurs and investors. They are also concepts that every business — no matter what size — can evaluate for themselves. The reality is that running a business in a cycle that is Unicorn centric, while fun due to valuations being higher, can be demoralizing too. As I tweeted the other day:
Rather than worrying about what is going on with the unicorns, I think this cycle has the potential to produce a cohort of scrappy entrepreneurs who figure out how to persist and can build scalable business models with great unit economics. The near term valuations for these ventures may be lower than in the last year. But the opportunity exists for the successes to be meaningful businesses with large enterprise values 6–8 years from now. Because of this, VCs will fund these businesses that pass the business basics test and could end up being the characterization of the Post Unicorn Hangover cycle when we look back on it in 2025.
