For the last 12 to 18 months, the private technology market has seen sky high valuations and a significant disconnect from the public markets. Recently, much talked-about startup Slack raised $120M at a $1.12B valuation with just $1M in monthly revenue. My friend, Danny Crichton, wrote a really insightful piece on TechCrunch regarding this new trend of “fundraising acceleration”.
Crichton outlines the factors that have created such a fundraising strategy and also carefully points out the disadvantages of raising too much at too high a price. Namely, he highlights the increasing bifurcation of the have’s and have-not’s (high and low-growth companies, respectively), as well as consequences with equity compensation for employees.
Here are some pitfalls I see with this kind of investment strategy:
- High risk of a down round: Macro conditions are nearly impossible to predict. Unless the mega round is meant to fully fund a company from one bull cycle to another, it’s likely that the next funding round will be a difficult one.
- Capital inefficiency: This type of fundraising strategy is also counter-intuitive to the lean startup philosophy. Raising such a large amount of capital creates negative incentives to be capital efficient, and in the hands of an un-experienced team, can lead to higher burn rates.
- Increased execution pressure: With a valuation so far beyond fundamentals, management teams will and should feel an increased pressure to perform. It’s no longer enough strive to deliver on a vision you’ve sold because you’ve already committed to deliver it. Traditional “Plan B” options, such as acqui-hires, will become harder to sell to the board.
- Diminishing returns: The reason that market leaders are often rewarded by an order of magnitude is that idea that in a networked world, winners take most (if not all). With funding acceleration, VC’s are not only increasing the risk of betting on the right horse, but also driving down their own gains. As the adage goes, capital flows into an asset class until returns revert to the mean. When that happens for the VC asset class, it’ll be a painful day for those holding such over-valued assets in their portfolios.
Crichton also writes,
The person who most popularized this notion of investing was Marc Andreessen (who ironically also happens to be one of the earlier investors in Slack), as well as Peter Thiel, whose experience with Facebook’s growth encouraged his investment thesis for Founders Fund.
While I’m a big fan of both, we should also consider the fact that neither of these two investors have long enough tenures as VC’s to have experienced a downturn in the markets, and more specifically, a downturn within the technology sector.