Friday, October 16, 2015

When The Tide Goes Out - Bad Stuff Version




When The Tide Goes Out - Bad Stuff Version



The "is there or isn't there a bubble in venture" discussion has mostly focused on whether the momentum behind venture financing is showing signs of weakness, whether valuations are (way?) over extended and when, how and why this might unravel. Some say yes, some say no. But most bubbles are only evident after the fact so time will tell on this one. (If it is one ...)
Much of the the debate been couched in terms of the fate of the 150 or so $1bn+ unicorns. (Unicorpses to come?) As I noted recently, whatever the size of business, if you are a startup founder this is the time to make sure you are wearing swimwear.
Some unicorns are definitely getting sick, and not just for lack of revenues. Caroline Fairchild wrote on Linkedin that "Theranos, the Silicon Valley startup known for its blood-testing technology, is now in the spotlight in the wake of a deeply damning report out by the Wall Street Journal ..." Neatly she called it a "wounded unicorn".
As we digest the troubling news about Theranos here is something else to worry about: extended periods of loose money and exuberant investment are typically associated with some high profile incidents not just of mis-valuation but misrepresentation, or worse. (I am not commenting specifically on Theranos in that regard, but the allegations there have set alarm bells ringing.)
10 years ago I was the second witness for the US Government in the trail of Worldcom CEO Bernie Ebbers. Worldcom was a darling company that rode the 90s/early 2000s "TMT" bubble to huge success but ultimately to ignominy. Mr Ebbers was convicted and sentenced to 25 years in goal for an accounting fraud in which costs were understated and thus profits overstated ... and which led to the bankruptcy of the company. Worldcom went bust in July 2002 with $107bn of assets making it the biggest in history up to that point. (It ranks #3 now, behind Lehman and Washington Mutual, taken down by the 2007/08 financial crisis after an epic housing bubble burst.) 
So, for anyone concerned about the more extreme things that become visible when the loose money tide goes out, what did I learn from the last tech/telecom bubble? What are the warning signs that, with the benefit of hindsight, folks should have payed more attention to ahead of the biggest failures of the last tech bubble?
While nothing more than my own anecdotal observations, here are some red flags today's tech investors might care to look out for:
1. A very controlling CEO (and likely CFO too in a public company context) who has close oversight of all operations to the extent that only a very few people at the heart of the company have a full picture of what is going on. (That was the story at Worldcom.)
2. A CEO with massive ego (and paranoia) - although of course this goes with the territory in many cases so not very distinguishing. But taking aversion to criticism to extremes points to someone who can go to extremes in other ways - in their own self defined reality.
3. Sycophantic media coverage - which dulls sensitivity to any adverse issues and results in self censorship. That is ... until someone does the work and calls the company out ... and gets heard.
4. Opaque "trust us" business models that "just work" ... where mere mortals on the outside are not to be let in on the secret. (Recall the acclaim for "asset lite" Enron. It took Bethany McLean in Fortune to point out that the Emperor seemed to be lacking clothes.)
5. Vanity Board i.e. a Board of directors populated with "very important people" ... but who lack and domain expertise in the area of activity of the company and hence can't provide effective oversight, and likely don't have the time to commit either.

Friday, October 9, 2015

WHEN THE TIDE GOES OUT - HAVE YOUR SWIMWEAR ON


WHEN THE TIDE GOES OUT - HAVE YOUR SWIMWEAR ON

I was chatting with a founder recently and mentioned my trip to SF end September. OK my sample size is very small, but from VC to startups there was no avoiding the pervasive sense the startup funding environment was tightening, or going to tighten soon. I noted to my friend that this definitely seems like a time to raise early stage money quickly if you have good metrics and momentum, rather than wait for a better valuation or when you feel you really "need" the money further down the road ... because if and when the window shuts, or at least gets tougher to get through, valuations will surely come down and terms will become more investor friendly. (The "it's there, so take it" rationale was the one the Slack founder Stewart Butterfield gave back in April as to why they have raised much more money than they appear to need. Smart guy.)
Four points of angst as I think about this some more:
1. Investor side angst: Since my SF trip at an anecdotal level I keep hearing the same "its' getting tougher out there" vibe from people I speak to back in NYC and there have been some forceful public comments on the matter. e.g. Mark Suster calling out the obsession with unicorns and Caterina Fake melodramatically heralding the Age of the Cockroach. Obviously related to this mood music is the fact that the stock market has stalled (S&P is basically where it was a year ago despite a few good days recently) in no small part pending the Federal Reserve finally raising interest rates for the first time in nearly a decade. Plus we have global economic issues to content with, especially the China deceleration and related commodity price and hence broader Emerging Markets collapse. All that means a less buoyant IPO, read VC exit, outlook. Current data point: Pure Storage IPOed and closed 6% below issue price on its first day - so slightly below the last private market raise valuation. Importantly this is the first VC backed unicorn to IPO since Box in January, according to Dan Primark at Fortune. Also on the exit issue, many unicorns (150 now and counting according to Crunchbase) are simply too big to be acquired and there has definitely been a dearth of hope into reality cash exits for VCs. So VCs get more anxious. Are they holding back? Well Pitchbook just reported that VC Deal volume fell in Q2 (albeit with strong $bn invested, but that is biased up by larger late stage rounds and "VC tourists" like the big mutual funds). The Q2 numbers make for three quarters of consecutive VC deal volume declines ... for the first time since 2009
2. Corporate side angst: Brad Feld did an interesting post recently pointing out that a couple of M&A deals his fund has been involved with fell apart recently at short notice. This is the flip side of investors starting to get more cautious - corporate acquirers do to. Brad says:"In both cases, the explanation was vague." My hunch is that is because the reasons are indeed vague ... because they are typically emotional: "Do we really want to do this now?", "Is this a risk we want to take?" And crucially ... "Seems likes prices are high, so maybe we can buy this company later ... at a lower valuation." So all to do with confidence in the general environment and conviction in a specific deal. Those two things ebb together.
3. Startup business model angst: Also there have been some pretty specular high profile startup implosions (Zirtual, Quirky) or partial implosions (Evernote) recently that serve to dampen the mood too.Not all rocket ships get to the moon. All these cases have elements of individual corporate shortcomings, they always do. But in my view Evernote is especially interesting because it signals a point where investors start to worry more about business model/revenues relative to user metrics (which can be "monetized later, we just haven't worked out how yet".) When the little boy calls out that the Emperor has no business model clothes on ... and people listen ... then you are in big trouble if you are a company that needs sustained and substantial external capital to survive. 
4. Media angst: Regardless of more sophisticated considerations, you know a story is well baked when it hits totally mainstream media for general consumption. Nick Bilton's Vanity Fair piece "Is Silicon Valley in a Bubble ... and what could burst it?" answers its own question, the first one anyway. That was before the end of the summer. (When I was in SF another journalist I met dismissed it as ... "old news that could have been written months ago.") And NPR just covered the skyscraper bubble prediction hypothesis on the Marketwatch morning show with Exhibit A being ... the Salesforce Tower. (The thesis being that market peaks are correlated with building of "mine is bigger than yours" office towers thanks to cheap money and a lot of hubris.)

My bottom line advice to founders based on all of the above is to ignore the noise for the most part. Great companies are founded and grow in good times and bad. Compelling solutions to big pain points that encompass big markets will get funded if the team is awesome and the traction is there. So stay focused on what you are building. But for CEOs, one of whose three key roles is to make sure their company never runs out of money, then financing strategy does matter. Hence this CEO advice:
a) If you are raising money now do so as quickly as you can. Accept standard deal terms without a fight and definitely don't be greedy on valuation. And at the early stage consider a priced round as opposed to a note. Professional early stage investors really do not like notes (other than for a first small pre-seed round maybe) and only do them because they "have to". When they don't have to ... they won't. (Don't use very investor unfriendly docs like SAFEs for example.)
AND/OR
b) Hope is not a strategy. Have a Plan B for an immediate future where the external financing environment is irrelevant to you because you can manage to a very long runway or, better, get to cash flow break even so your runway becomes infinite! I met a founder recently who had done exactly that. Shifted the model somewhat to increase revenues near term and get to cash flow break even sooner. Now the founder has people saying "you are running a lifestyle business" because the company is no longer insanely maximizing growth (and taking in capital to achieve that). But the founder has taken back control of her future ... and is OK with that!