The ‘Too Rich to Succeed’ Challenge Facing Start-ups

startup cash

For start-up companies, there may be such a thing as an embarrassment of riches. In these heady times of high valuations, some have started to suggest that fledgling firms need to be more wary about how they raise capital.

Among those sounding the alarm is prominent venture capitalist Marc Andreessen. In a series of recent tweets, Andreessen warned that “high cash-burn startups almost never survive down rounds. VAPORIZE. Further, to get into this position, you probably had to raise too much [money] at too high valuation before.”

It’s weighty advice in 140-character bites, but timely in a year when stories of start-ups worth billions have dominated the headlines. Uber, Airbnb and Dropbox were all valued at more than $10 billion recently. In fact, in the first half of 2014, there were 14 venture-backed technology companies valued at more than $1 billion, double the number for all of 2013, according to CB Insights.

Start-up companies are “raising astounding amounts of capital,” says Doug Collom, vice dean of Wharton’s San Franciscocampus. “It’s a gold rush, and everyone wants to get in on it.”

Are the seeds being planted for another tech bubble? “I think that Silicon Valley as a whole, or the venture-capital community or start-up community, is taking on an excessive amount of risk right now, unprecedented since 1999,” venture capitalist Bill Gurley told The Wall Street Journal. A partner in Silicon Valley-based VC firm Benchmark, his company has invested in Uber, OpenTable and Zillow.

“The venture capital community in the San Francisco Bay Area is awash in capital. If you’re a founder, you don’t need to have a viable idea to get funded.” –Doug Collom

‘Awash in Capital’

These days, founders are “arguing (often persuasively) that their disruptive start-ups will one day be as valuable as the current technology giants trading on the stock markets,” according to a PitchBook report. Recently, mobile messaging service WhatsApp was acquired by Facebook for a whopping $19 billion. At the recent Internet.org conference in India, Facebook head Mark Zuckerberg said he was “clueless” on how to monetize it, according to Business Standard.

Once 2014 closes out, the WhatsApp deal will set a record for capital exited following the 2008-2009 recession and is the largest purchase of a company backed by venture capitalists.

Raising capital for start-up ventures has changed significantly in the last five to seven years, says Collom. Not too long ago, “financing was simple. There were three sources of financing: the first was family, friends and fools. The second was angel investors with excess cash in their pockets, having achieved success in another field. The third was the institutional venture capitalist road,” explains Collom. In today’s world, financing is much more complex with sources ranging from angels, superangels, crowdfunding, corporate investors, incubators, accelerators and hedge funds.

“The venture capital community in the San Francisco Bay Area is awash in capital. If you’re a founder, you don’t need to have a viable idea to get funded. You just have to sell the pitch persuasively,” notes Collom.

In the current climate, capital is relatively accessible, and software companies, like WhatsApp, Snapchat (valued at $10 billion) and Pinterest (valued at $5 billion) are often being measured by eyeballs, not profit. In fact, in the first half of 2014, venture capitalists invested $22.7 billion in the U.S., which is 71% more than the same period last year, according to PricewaterhouseCoopers and the National Venture Capital Association.

“Non-traditional investors like hedge funds, mutual funds and private equity firms have entered the picture … competing vigorously for these investments, pushing valuations up higher,” according to PitchBook. The outcome is high valuations that haven’t been seen since the dot-com bubble days of the late 1990s.

“High valuations can be worrisome for exits because of the assumptions venture capitalists have to make,” says Alex Lykken of PitchBook. “If an investor makes a Series C investment, for instance, the rule of thumb is [to expect] two to four times return, just to make the math work for their funds. If those windows contract over the next few years, which is the concern, they may be seeing smaller exit amounts than they’re currently hoping for.” He adds that most start-ups and investors, though, would “much rather see higher and higher valuations so they can goose their own stakes come exit time.”

Certain sectors, like software, do command higher valuations than other industries, including health care and science start-ups. According to the National Venture Capital Association, software companies garnered $11.2 billion in venture capital funding in 2013, which is 85% more than in 2008. Software businesses are “stickier” in that they are less likely to get dumped and have higher recurring revenue levels, notes Lykken.

Gurley warned in the Wall Street Journal article that the risk in the software-as-a service sector is “potentially among the highest.” While start-ups are seeing public companies lose money every month, they’re still valued at a billion dollars, Gurley said. At the same time, start-ups are being offered more and more money, leading to more risk.

Looking at the $10.3 billion valuation of Airbnb, which is worth more than the Hyatt and Wyndham hotel chains, you have to question whether the valuations are inflated, says John Mullins, an entrepreneurship professor at London Business School. “When you’re in the middle of a bubble, you wonder: Do you have a little more time in the bubble, or will it burst?” he asks.

Rainy Days Ahead?

According to PitchBook, start-ups have a much healthier pre-IPO outlook than the days of the first Internet bubble. “One of the byproducts of that change has been few post-IPO pops in stock prices, at least compared to 15 years ago,” PitchBook reported. “In effect, professional investors have captured more pre-exit value in start-ups, propping up later-stage valuations in the process.”

“When you’re in the middle of a bubble, you wonder if you have a little more time in the bubble, or will it burst?” –John Mullins

On the other hand, some start-ups are taking the money they’re raising and banking it for when capital may be harder to come by in a possible future market correction. Wharton finance professor Luke Taylor advises companies: “Don’t be embarrassed to put a bunch of money in the bank account and sit on it. Economies have good times and bad times. In bad times, it’s very hard to raise money. You never know when you need to save it for a rainy day.”

Netflix is an example of a company that did just that. Right before the dot-com bubble burst in early 2000, Netflix received $50 million in financing when its main business was renting DVDs out by mail. “Even though our business model was working quite well, we would not have [had] access to capital and we would have had to close the company if we hadn’t raised the extra money,” Barry McCarthy, Netflix’s former chief financial officer, told The New York Times.

However, delving into hefty capital markets also comes with other risks. One such hazard is a high burn rate, or how much cash a company spends.It can encompass anything from spending on bloated head counts to 10-year leases on pricey real estate to gourmet cafeteria food, while not turning a penny in profits. “It takes discipline. You can really start throwing money around when you have too much,” notes Xenios Thrasyvoulou, founder of start-up ventures PeoplePerHour.com and SuperTasker.com in London and New York.

“Hiring too many employees before you really need to increases your cash burn rate,” adds Taylor. “Now the company is paying lots of salaries every month, and that’s not an easy cost to get rid of. Companies don’t like firing people.”

Thrasyvoulou warns of the perils of growing a company too fast too soon. He went from a lean company of six employees to 50 employees in one year. “It’s tough when you have to do downsizing,” he says. It’s important to be transparent and open, especially when you have to tell someone they have to take a 60% salary cut or make a sensible decision to leave, notes Thrasyvoulou.

Wharton management professor David Hsu adds that a downturn in the markets could lead to a huge drop in valuations. If a company has burned through all its money, and if investors think there has been non-judicious use of funds, it will be difficult to raise capital in the next round.

Whos Got Control

The good news for founders is that high valuations also mean that investors are open to taking smaller stakes in their companies. For example, in the past, Series A rounds meant entrepreneurs would give up roughly 33% of their company. This year, the average is around 27.7%, according to PitchBook.

“Whatever you raise, investors expect something in return and will own part of the company,” explains Taylor. “The founders’ stake will get diluted. So the more cash you raise, the more of the company you have to give away.” If a company is worth more money, the founder may get a thinner slice, but the pie has gotten bigger.

Timing is important as well. “Most entrepreneurs will become more valuable over time,” Hsu notes. “If you think next year that you’re going to be worth double what you are now, you don’t to want to give up too much ownership too soon. Diluting much faster than you need to” is one thing to watch out for.

“Money comes with a lot of baggage. Investors will not own a majority of the firm, but they will have a degree of control, including the ability to get the entrepreneur fired.”  –John Mullins

Founders generally want to keep as much control of their companies as they can. “Don’t give away too much, and stay in control of the board so they can’t remove you,” Thrasyvoulou warns. He also points out that investors want to make money quickly. In his case, venture capitalists expected his company to grow five times in 12 months. Though he viewed his firm as having a healthy, sustainable growth rate, it didn’t meet those expectations, and he was forced to hire an expensive and large management team. Eventually, Thrasyvoulou regained control of his company, but he reminds other entrepreneurs that “sanity is more important than vanity.”

Mullins adds, “Money comes with a lot of baggage. Investors will not own a majority of the firm, but they will have a degree of control, including the ability to get the entrepreneur fired.”

If things go wrong, “investors are compelled to tell a company to do certain things to protect the company,” says Hsu. An early stage company that sells a significant number of shares in the firm to others also gives up control. Investors might demand more board seats and more oversight, Hsu warns.

Lean and Mean

The best start-ups are the ones that are scrappy and stay scrappy Twitter ,” says Thrasyvoulou. Collom adds, “Most founders and investors learned to run lean and mean. That lesson was reinforced with the recession of 2008-2009.”

When an entrepreneur approaches investors, he or she should have a number in mind about how much is needed to last 12 to 18 months. This calculation affects which type of investor the company should approach, explains Collom.

Hsu adds that asking for money is a balancing act — companies’ don’t want to ask for too little, but they also don’t want to ask for too much. There should be funds available to “handle a number of unanticipated things, like scaling or logistics, but you also don’t want to needlessly dilute control.”

Collom recommends thinking of capital in terms of benchmarks. An entrepreneur may want to want to hit three benchmarks, but investors may be willing to only give enough money to hit one. Once an entrepreneur reaches that benchmark, however, it’s easier to go to the investors to ask for more money.

At the end of the day, it’s the “uber” high-valuation success stories that are making the headlines. “There are thousands of founders who collect money and go sideways and flame out,” notes Collom.

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