Jul 21, 2015 ยท 11 minutes

Much of the debate over the surging crop of some 84 (or 87 or 118 depending on who is counting) unicorns (and don’t forget the nine decacorns!) has been limited to why they’ve suddenly appeared in such quantity.

People debate how meaningful that $1 billion number is, or is not, to the actual health of a company. Some with horns even argue it’s “arbitrary as fuck.”  And pundits stress about whether or not those lofty valuations-- which in aggregate have quadrupled in 2015 to an insane half a trillion dollars-- will ever— ever— amount to a publicly tradable price in the same range.

It’s lead to handwringing about IPOs as “the new down rounds,” and some pretty alarming stats have gained currency. Like the one pointing out that 23 companies raised more than $40 million in growth rounds in 2014. That sounds great for entrepreneurs until you consider that only 240 venture capital-backed IT companies have gone public in the last 10 years. And that’s before you consider the pre and post-IPO valuations of those companies.

Now there’s a new reason to fear the ‘corn: They are insanely capital inefficient. And over the last year, they’ve gotten even more so at an alarming rate.

Bill Gurley— a proud investor in the biggest decacorn of all, Uber— has publicly railed against high burn rates, and Fred Wilson has warned against them on his blog too. So this isn’t entirely new. But there are multiple new data sets published in the last week showing just how bad it’s gotten in the last year alone.

First, CB Insights published a report saying that from 2012 to 2014 the capital efficiency ratio for companies that exited for more than $1 billion has been cut in half. Note: CB Insights isn’t talking about all those paper unicorns-- it’s talking about the ones who exited. Exits in the $100 million to $500 million range were also less capital efficient than in the past, but not by nearly as extreme a ratio.

Think about that: The “winners”-- the very companies that VC Aileen Lee herded together as “unicorns” because they were so vital to even a modest venture fund winding up in the black-- are half as capital efficient as they were a year ago. Every VC is happy write off losers, but this is actually a problem with the returns of the winners.

And that’s with a few massive outliers skewing the numbers to make the unicorns look more capital efficient than they might otherwise:

Veeva Systems (which raised $4M prior to a $4.4B exit), Whatsapp (which saw $60M invested by Sequoia, prior to a $19B acquisition from Facebook), and Indeed (which raised $5M before being acquired by Recruit Holdings for $1B+).

As Josh Kopelman wrote in his letter to LPs:

We don’t have a crystal ball -- and we can’t forecast the future -- but we do have a calculator. The simple math of venture investing says that only two numbers determine an investment’s return: the entry price and the exit price. And while 2014 showed a slight uptick in total exit values for the industry (mainly due to the $19B acquisition of WhatsApp), total exit values have not increase anywhere near the pace of entry values. Indeed, the total value of M&A exits in 2013 was less than it was in 2007, and public markets still remain relatively closed to technology companies.

And this past weekend, Lee herself posted an update to her original unicorn analysis on TechCrunch, joining in on this specific concern, calling the capital efficiency of unicorns “surprisingly low.”

Lee pointed out that just 19 companies have gone public for an average public market valuation of $8.9 billion, and 14 have been acquired for an average $1.5 billion valuation. Not bad. But the bulk of the unicorns out there are choosing to stay private longer, delaying the inevitable reckoning.

As they kick the problem further down the road, they are raising shit loads of money: Half a billion on average over more than six rounds-- a 103% increase from Lee’s study a year ago. And even in a time of insanely high valuations, the valuation vs private capital raised for these companies is a mere 8x. And that’s before they are welcomed with thorny arms into a far less forgiving public market. These are the good times for these startups.

Lee writes: “Unless these companies ‘grow beyond’ their valuations at exit, this will likely drive lower than historical profits at liquidity for founders, employees and investors.”

It’s a cliche for a CEO who has just taken his company public to downplay the event by posturing and saying things like “Oh, it’s just another day for the company” or “We still have to work just as hard tomorrow to achieve our goals.” At this rate, such rhetoric will actually be true in the future, because almost no one will be getting rich when they stand on the podium of the NASDAQ cheering.  

As CB Insights noted in its newsletter: “Venture capital LPs - you paying attention to this?  Don't let the logo chasing fool you.”

Already, Lee points out the expectation of a “good” return has been altered:

Ten years ago, the best investors were praised for achieving a 20x return on their $15 million investment = a $300 million return. Many venture investors and their LPs now invest later, which is perceived to be less risky – and hope to achieve their $300 million by getting a 6x return on a $50 million later-stage investment.

This is why there was such an allergic reaction to VCs returning to growth rounds again after the dot com bubble burst. And yet, here we are.

Many apologists for the recent investing mania would argue the world has, again, changed. That the mobile Web, the global opportunity through emerging markets, and the emergence of the on-demand economy have made the opportunities so much greater that the influx of valuations and cash are warranted.

These bulls have a point: Entire new previously unsexy categories are being upended, unlocking new pockets of a consumer’s wallet. Honestly, could anyone have predicted that a logistics company would be the highest valued private company in Silicon Valley in a raging private capital bull market? Or that a celebrity-backed organic diaper company would have a $1 billion valuation?

Lee echoes this point, noting that the big surge in unicorns wasn’t so much the “WhatsApp” moment as Pando argued before. Rather it was all about the golden moment when most of these companies were started: 2007, the year the iPhone launched. The second best year to start a company-- by unicorn standards-- was 2009, the year Android was launched and the bottom of the last economic downturn. Historically, the best times to start companies are during downturns or when there’s the beginning of a profound shift in technology. Win-win.

Still, the same startup math applies. Out of all startups who raise seed funding only 35% ever get a Series A, and the game of Survivor only gets harder the farther you go. Some 95% of the returns come from less than 5% of the companies.

The real goal here is investing in the so-called “Super unicorn” or a company worth north of $100 billion. Every major technology wave produces at least one, Lee argues, and it was Facebook in the 2000s. Indeed: Facebook now is worth more than all the other companies on last year’s unicorn list and all the consumer companies on this year’s list. There is hardly a price at which you could invest in Facebook and feel dumb. The problem is there was one Facebook in the last wave, and there are north of 80 companies right now hoping they are the next one.

Even if the average public market returns start to rise, “unicorpses” are simply inevitable.

Worse: Investors will have to be patient to find out. Unlike during the dot com bubble, the path to exit is still a punishingly long 7+ years. And that’s when things go well. Wall Street mostly isn’t buying what late stage Silicon Valley investors are selling— or at least not at the same prices.

But the fact that these bulls have a point only makes the concerns about the utter lack of capital efficiency greater. Just because you can raise more money and spend more money doesn’t mean every company should.

It’s not just that companies with more money will spend more money. Right now, excess capital at crazy valuations is absolutely dictating strategy in Silicon Valley. Uber is actually buying state legislatures for tens of thousands of dollars. Commerce companies have already flamed out for spending too much to acquire customers.

Startups are supposed to have a natural advantage because they do more with less. But in today’s world the unicorns are shooting dollars out of their horns while the traditional industries they are trying to disrupt simply don’t have the budgets to compete. The whole thing has been turned on its head. Few successful founders would tell you that zero constraints really build the best companies.

Listen to the concerns of Gurley-- an Uber investor-- as filtered through Business Insider’s rewrite of a WSJ article (that is behind a paywall):

Gurley thinks the burn rate for companies is the highest it's been since 1999. He also thinks that the number of people working at money-losing companies is the highest it's been since 1999. People think nothing of working at companies that are losing millions of dollars a year because there's an overwhelming feeling of optimism right now.
If a downturn suddenly hits the startup world, Gurley thinks it's going to take "massive" amounts of "gymnastics" for companies to readjust their businesses to cut down on the burn rate.
This is all being driven by the low cost of capital. It's relatively easy for startups to raise money right now.

Gurley continued in his own words to describe the problem:

That's really difficult because if you have a competitor that's going to double or triple down on sales and you just decide, "Oh, well I'm not going to execute bad business decisions, I'm just going to sit back," you lose market share. So, choosing not to play the game on the field doesn't work, so you're left with trying to advise someone to be pragmatically aggressive with some type of conservative backdrop or alternative strategy in case the world shifts. But it's hard.

Like, for instance, what Uber’s insanely expensive, $5 billion+, Gurley-approved growth strategy has done to Lyft and everyone else in the global on demand economy. Even the people raising red flags are complicit in the problem. And that’s how you know it’s going to get a lot worse.

Because here’s the thing: We can criticize a lot of things about Uber, but their strategy is perfectly appropriate to the market conditions. The problem arises when companies who have less golden business models than Uber follow it. As Gurley notes, they won’t be able to adjust should market conditions change.

Capital efficiency is the biggest stat to watch when you consider the future of this class of unicorns.

If the companies were capital efficient, the number of billion dollar companies wouldn't portend cataclysm, since venture valuations are so arbitrary. I’ve written many times that a private company valuation is as much marketing as anything, and it’s actually an effective marketing tool for some companies in terms of hiring, press, funding and future acqui-hires. A billion dollar price tag isn’t that risky to VCs: If there’s even a standard liquidation preference — let alone any of the more onerous terms— investors aren’t really betting the company will be a $1 billion outcome. They are hedging it will exit for enough that they get their money back.

And the concerns that not all of these companies will actually become billion dollar winners isn’t that big of a deal either. They never do in the start-up world. A ton of founders are taking money off the table in these later rounds, and if these companies never go public, the carnage is pretty limited to private equity investors. The only real victims would be stock option-ed employees who never see a dime. Not exactly the Silicon Valley dream, but, then again, those employees likely made market-rate or higher salaries so there was no big gamble taken either.

But when capital efficiency plummets this fast, it is a thing because it potentially hurts everyone involved with a winning company. Not only does it limits the upside, as Josh Kopelman argued, it could eradicate the value in options for founders and employees even in the event of a “good” exit. Then factor in that if a change in the market hits, and startups are this far over their skis, thousands and thousands of people could lose their jobs, as Gurley warns.

But the thing that’s so hard to track in all these stats is it invariably makes even the best companies worse. It creates a fat, bloated organization that constantly throws money— not creativity— at a problem.

The venture world is organized to tolerate a lot of failure for a few outsized wins. But rapidly plummeting capital efficiency is essentially putting a tax on those wins.