There is a constant theme in the business world: Some enterprising individual uncovers a new way to make money and makes a fortune. Other people look at what they are doing and say, “That doesn’t look so hard, I can do that too!” If they are early enough maybe they make some money as well, but over time we end up with too many copycats and too much money chasing too few returns. Greed is a powerful motivator, but as more money pours into an idea, it becomes harder and harder to make money. There is an inevitable collapse in prices that causes the later entrants to suffer a major loss.
I think we are seeing this phenomena occur in the venture funding industry as everyone has become enamored with the idea of chasing unicorns (companies who have a valuation over $1 billion). Everyone wants to invest in the company that will be the next unicorn.
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Before Cowboy Ventures founder Aileen Lee coined the term “unicorn” in a November 2013 TechCrunch blog post, venture capitalist Mike Maples, Jr. was talking about “thunder lizards.” Mike is a smart guy who analyzed the returns from VC investments over many years. He found that in each year there was often one company that achieved exceptional returns compared to all the other companies that raised their initial funding in the same year. Often the results were so skewed that the one high performer was worth more than all the other companies combined! Also, the second best performer produced huge returns compared to everyone below them.
Being a smart investor, Mike recognized that finding the one thunder lizard each year should be the obsession of a VC. All of this makes perfect sense…at least until it doesn’t. There are a couple of underlying assumptions under this analysis that are beginning to be proven false. The biggest is that building a huge company means investors get tremendous returns. This was true in the past when the total venture funding raised by a company before going public was relatively small. If you build a company worth $2 billion, whether you raised $30 or $50 million doesn’t really matter much. The investor is going to be happy with the returns.
As the amount of money available to startups has increased, both because of larger VC funds as well as the entry of more late stage sources (private equity, sovereign wealth, pension funds, etc.), a billion dollar exit does not necessarily guarantee investor happiness. In the extreme case of Uber, which has already raised almost $6 billion, any exit short of probably $20 to $30 billion could leave early investors without a good return. No longer does being the top gross performer in your year guarantee a great return.
I think many in the startup community are losing sight of the goal. Venture investors want a great return for the large risk they take. They understand that many of their investments are going to be total failures, but some will be huge winners. Historically, a great return was defined as a 10X exit. Having a 10X exit should be the goal of the exercise, not hitting some random number of a billion dollars just because it sounds cool.
As entrepreneurs and investors are focusing on unicorns, they are failing to consider this changing landscape. My suspicion is that sometime within the next couple of years, limited partners may begin to realize that they don’t have as many winners as they thought they did. When that happens it will be really hard for many firms to raise another fund. My advice for entrepreneurs is to raise money now if you can, because it may not be available at nearly the same levels in just a few years.
Related article: Something is rotting under Silicon Valley (Fortune)
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