In “Return of the Jedi” the rebel fleet drops out of light speed to attack what they think is a not-yet-operational deathstar. In what has become one of the most meme-ized lines from the Star Wars saga, Admiral Ackbar, a minor character, exclaims “It’s a Trap!”
This is how I feel about some of the sky-high valuations and huge amounts of capital being raised by companies in series B and series C financings right now. I understand the strategy of raising a lot of capital when you can (not when you need to), especially when valuations allow you to do it with little dilution. But I think doing so is a trap that is going to harm these mid-stage companies over the long-term.
I don’t consider myself a “bubble monger,” sounding the alarm that things are about to burst. We live in a time when a few massively disruptive technology trends are allowing enormously successful and profitable businesses to be constructed incredibly rapidly. A whole class of later-stage private companies have built enormous corporate and financial strength, disrupting legacy players with new nimble technology, and some justify what sometimes seem like astronomical valuations without context.
I am not too worried about the earliest seed or A-round financings of very young companies that are no more than an idea and some people. There is no question that valuations are rising early on. But outcomes are also completely binary—things either work or they don’t—and increasingly extreme. Things that work can be bigger than ever before because technology fundamentally lets things scale faster and bigger, so it is reasonable that at the outset risk adjusted net-present value valuations should rise, and more leverage and control of the cap table should reside with entrepreneurs.
But it is the financings in the middle that are giving me pause. These companies, typically 18-months to three years old, have a product and some traction for investors to evaluate. But the businesses are still pretty far away from being a runaway success.
These days it’s normal to see companies in this range raising at least tens of millions of dollars on valuations of $100 million or more. I worry that the market is forcing up valuations for these companies in a way that will ultimately trap many.
Why This is Happening
There are a couple of universal trends playing out. The first is rising competition from traditionally later stage investors moving into tech earlier: hedge funds and mutual funds like Fidelity and T. Rowe Price, which have historically swooped in just before companies go public to get to know the management teams early.
Second, as outcomes become more binary, VCs are increasingly terrified of missing the next Uber and are willing to overpay for anything they believe might show that type of a growth curve. Many, perhaps most, VCs are driven by FOMO (fear of missing out). When it appears as if the winners can get big quickly, investors can easily slip toward thinking that they are looking at their last chance to get into a deal before it “pops.” Even without new forms of capital becoming available, the increasing speed of the game is making people more competitive and less valuation sensitive.
As valuations go up, financiers can put more money in each deal. When you are trying to maximize dollar returns, you want to put the most money to work that is possible in any given deal. And higher valuations, ironically, frequently provide that opportunity. If a valuation is 5x higher, presumably the company can also take 5x more money. And it also doesn’t hurt to remember that VCs get paid more the more capital they deploy.
These dynamics create several risks mid-stage companies are particularly vulnerable to.
The first is that the company can’t effectively deploy the capital it raised. Despite the fact it has become common to say so, companies don’t raise money to “de-risk.” Businesses raise money to put it to use to grow. Startups used to include an important slide in presentations to investors called “use of funds;” it seems to have vanished in today’s runaway rounds.
It usually takes time and energy to build up the competency to spend money efficiently. Later-stage companies have learned how, but mid-stage companies typically haven’t. Early-stage companies are immune because they aren’t raising meaningful funds.
Entrepreneurs in the middle who raise big round of financing are left with two choices. They can spend the money they raise inefficiently, which leads to bloat and will force them to spend more money inefficiently in the future. Or they can just sit on it.
Hoarding cash as an insurance policy against a downturn might seem like a fine strategy. But I think it is a pretty costly way to operate. Even in low-interest rate environments, investors expect money to make money. If entrepreneurs raise and then sideline capital, they are effectively agreeing to pay their investors an internal rate of return on capital without actually using the advantage they have purchased from investors for their equity. They’ve diluted themselves for no meaningful return on the capital.
If you want to be cynical about it, it actually makes a lot of sense for VCs to be sounding the alarm about a bubble and telling entrepreneurs to prepare for a downturn. If companies can’t justify raising capital to help them grow, the only way investors can get and increase their stakes is to convince the entrepreneurs to take their money as bubble insurance.
Trapping the Team
The second part of “the trap” comes down to team. There is obviously a difference between the 409A price at which common equity is granted to employees and the preferred price that investors pay; however, the preferred price does impact the price of common.
If I were raising one of these monster B or C rounds, I would be acutely sensitive to how these rounds affected my current employees and my ability to hire.
It is true that people like to join companies that are hot and highly valued, and it is harder for companies to hire when their stock price is low. But making people paper millionaires dramatically ahead of reality can be demotivating if not handled well.
Even worse, if a company is valued too high too quickly, it crushes the upside for the next generation of employees a company needs to bring on board. Almost all successful companies hire more people in the future than the past. If the vast majority of the equity appreciation happens very quickly, the value of equity as a currency for everyone else declines dramatically. This would be less of an issue if more compensation was tied to cash, as I have argued it should be. But in the current equity-heavy system, companies end up dramatically over-compensating early employees at the expense of prospective employees.
Finally, seeing a big valuation number is great for a moment. But knowing that your revenue or growth is behind your valuation and that you need to climb out of a hole isn’t a great feeling. For early-stage companies this feeling is a given; it’s all potential. And for later-stage companies, ideally the business has started to catch up to the valuation. But B and C round companies are more likely to hit an unexpected corner and need to evolve their approach to keep scaling.
In the last few weeks I have seen several entrepreneurs out raising rounds that I fear are going to get caught in this exact mid-stage trap. Their businesses are doing well, and they have the ability to build great companies. But they are raising money they can’t deploy at prices they can’t justify. That will hamper hiring and morale for the next several years as they race to justify old valuation numbers. Some may climb out of it and build successful businesses. But I think at least a few will falter. They might consider the real cost of the checks they plan to cash before the wires hit.