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Unicorns Distract Us from a Graveyard
Venture capital’s reliance on unicorns provides cover for the huge failure rate of startups, and investors make no effort to reduce it
Venture investing is fundamentally uncertain. You’re making big bets on people, ideas, and markets that might never work out, and there are more ways to fail than succeed. As a result, investing has to take into account the likely failure of many efforts. If your financial model assumes each of your investments will be a success, you will have a short career indeed.
Many investors have written about how they need some companies to win big in order to cover for other companies failing completely. As a simple example, Fred Wilson at Union Square Ventures tells his investors to expect a third of his investments to fail, a third to return their capital (which is also failure—they sell for a small enough amount that investors just get their money back, and in most cases the founders and employees get nothing), and a third to “succeed,” where his definition of success is that they return five to 10 times the original investment.
Wilson says his actual record is a bit better than that, but like Warren Buffet, he’d rather set achievable expectations.
Let’s use some concrete examples. Remembering that most companies raise more than three rounds of funding, and keeping in mind that investors usually get about 20 percent of your company through each of those first few rounds, here’s what needs to happen to deliver that 10x return:
- Your seed round is $500,000 at a $2.5 million pre-money valuation, so you have to sell for $25 million. The investor gets $5 million, and the founders split $20 million.
- Your A round is $5 million at a $25 million pre-money valuation. Now your company has to sell for $250 million. Each investor gets $50 million, and the founders split $150 million.
- Your B round is $15 million at a $75 million valuation. Your target exit price is now almost $750 million. By this time, the founders own less than 50 percent of the company, but hey, if you can exit at that price, everyone is pretty happy. Notice also that while this is a solid 10x win for the last investor here, it’s delivering close to a 300x return for the first investors (not counting pro rata costs). It’s nice work if you can get it.
Beyond three rounds, investors usually have smaller return expectations (for example, 3x to 5x) but also have a shorter time horizon. That growth-round investment of $50 million is only expected to turn into $150 million or so, but it needs to do it in three to five years instead of seven to 10.
Tripling a $750 million valuation ends up being pretty hard in any time horizon.
It’s worth noting that if the company sells for $20 million after that B round, then the founders get nothing. According to the preference stack (where the later investors all have priority over earlier ones), even with the cleanest term sheet, the B and A investors get all their money back, but the seed investor, founders, and employees get nothing. In practice, the buyer will usually negotiate something for the employees and founders — you rarely buy a company without wanting some kind of golden handcuffs on the people who work there — but it’s basically a pittance. You always have to manage your downside, even while you build toward the upside.
Note how quickly the exit price for the company escalates as you raise money. Realistically, it’s only once you’re around a billion dollars in valuation that you can consider going public, so if you’re smaller than that, your only choice is to sell the company.
This model helps to explain the industry’s fetish for unicorns. The returns you get from a billion-dollar exit swamp all the failures. And if those unicorns hide a lot of ills, the really big ones overwhelm even the successes. WhatsApp returned $3 billion to Sequoia on around $60 million invested for a 50x return, which means every other investment in the portfolio could have failed and they’d have still made a ton of money.
You can see how the unicorns make or break a firm. How does this affect how they treat the rest of their portfolio?
When you know that a small percentage of your bets end up mattering, you don’t worry much about any individual one, and that plays out in the world of venture capital.
Obviously investors don’t actually ignore the other companies; after all, they don’t really know which ones will win big. Equally, though, there’s no evidence they care whether any given startup succeeds.
Of course, investors would say otherwise: They’d say they work incredibly hard to help their companies, they work massive hours, answer the phone late at night, etc. Sure. I mean, they don’t put in nearly as many hours as the founders they’re helping, or even as much as a typical financier does (just thinking of the hours bankers put in these days makes me shudder), but I do believe they work hard. I have a couple anecdotes, however, that show it’s not as hard as they’d lead us to believe.
I had one investor tell me that he loved the transition from operator to investor because the lifestyle is so much better. Again, this is from an investor class that publicly derides “lifestyle” businesses that generate cash for its founders but don’t scale massively. When I asked him about the hypocrisy of him working nine-to-five but demanding his founders put in crazy hours, he defended it as their needing to lead from the front. Guess that tells you where the investors aren’t.
I also know a great investor who left a top-tier firm because he said he could not spend any more time working three days a week and being paid for five. Pretty honorable, if you ask me.
But mostly, yes, I do think many investors work hard. I just don’t think the work they’re doing helps their companies much.
Let’s walk through a couple of obvious examples.
Given the high probability of failure of a given investment, you’d think the industry would be great at reducing the risks for their companies and thus increasing the survival rate. Not so much. For example, many investors have told me that the most likely reason for a company to fail is the team. Okay. So what do they do to reduce the probability that a founding team will fall apart?
Ah…nothing. No coach for each founder, no coaching plan, not even a packet providing best practices. Nada. There are exceptions, of course — usually at the largest firms, like A16Z and NEA — but they’re few and far between.
Their explanation for this is pretty simple: Coaches are expensive, and the investor can’t afford to have them on staff because the measly 2 percent on their $300 million fund just can’t support bringing on staff to help founders. They could have the company fund it, but then that’s less money going to build the company.
This is the highest risk to your investment, and you’re literally not willing to spend any money mitigating it? Further, you’re tacitly recommending that your founders also avoid this easy bit of risk mitigation? Huh. Okay.
Investors will also tell you that the most valuable resource at a company is the founder’s time, and the founder needs to be laser-focused on building the business. It’s obvious they don’t actually believe that.
We’ve already established that founders will spend about a quarter of their time fundraising, rather than building the company. You could argue that this is the most valuable use of their time, but that’s only true in the sense that it has to be done and there’s no one else to do it. Most founders suck at fundraising and are tortured by their need to focus on that rather than building their business. Investors help a little with this, but not so much that it implies the founder’s time actually is a precious resource. There’s a pretty clear sink-or-swim attitude around fundraising, even though success at it has little to do with the ability to build and run a company.
You see this same disregard for the founder’s time when you look at what they end up spending it on.
A vanishingly small part of any business is truly innovative — maybe some part of your market definition or your solution itself — and everything else you do is disappointingly similar to what every other founder ends up doing. Great, so investors have figured that out, and as part of their investment, they deliver a playbook that uses the collective intelligence of their portfolio to help founders avoid having to make all the rookie mistakes, right? Hah! Nope!
The best firms enable founders to talk and work together, and there are a few great books in the area, but it’s all ad hoc, and let’s be honest, that’s pretty minimal help. Every founder is basically doing a random walk around the possible solution space for “how to build a great company,” taking on huge technical risk with untried platforms and experimenting with idiocy like holacracy rather than focusing on the most important parts of their business—the one or two bets that will make or break the whole thing.
It shows how little investors are willing to do to help founders mitigate the biggest risks in their business, thus improving its probability of survival. If they cared about their portfolio companies making it, investors would specialize in helping them navigate the different phases of the company, minimizing probability of failure at each phase, and especially when transitioning.
So now we see that it’s not just that investors are focused on unicorns, but also that the failure rate that those unicorns cover for is just irrelevant to investors. They know most of you will fail. (Again, investors expect two-thirds to at best return their capital, which is failure in their model, and even then only accomplished by a fire sale of the company.) Heck, if you don’t fail and instead just continue on being neither a big sale nor a failure, they’ll have to push you into one or the other to close their fund.
As I found when running a growth company, success hides many ills. One of the biggest problems in venture capital is how much they let the success of their unicorns hide their indifference to the rest of their companies. This fails their founders, their employees, and the whole market, for no reason other than that it’s easier this way.
I’m convinced that a firm that directly invested in reducing its failure rate would have as many unicorns, but it would also have more positive returns throughout its portfolio, and in the midst of building more companies and making more money, it just might do a little good at the same time. That would be a nice change.