Matt’s point of view: from unicorns to reality

Today’s guest post is from Matt Weeks, a serial entrepreneur and longtime friend of NTR.
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From Matt:

I saw a great article in BI about Postmates CEO Bastian Lehmann’s attitude towards hypergrowth.

For years, venture capitalists have been pushing hypergrowth over profits, at least though the initial phases of investment rounds. Investors told Lehmann to reinvest the company’s money in pushing more growth over building a sustainable business.

That advice didn’t go far with the Postmates CEO. (…) Lehmann argues that it’s the CEO’s fundamental job to have looked at the margins and made decisions early on.

“Companies that run for the last two years in hyper growth are now wondering how to make money.”

I completely agree — hypergrowth without a hope of unit economics that lead to profitability has always been a fool’s errand with precious few exceptions, and even those “superstars” eventually had their “come to Jesus” realization moments when investors got nervous and were anxious for at least a hope of a repeatable, profitable set of unit economics. It’s okay to use early capital to explore and iterate to figure out the product-market fit and pricing/monetization formula. But at some point there must be a path to profitable and repeatable unit economics.

There has been a sense that pushing the bidding of sequential funding rounds at ever-increasing valuations would create a kind of de-facto “momentum” and crowd-out 2nd and 3rd and 4th place contenders, or at least amass a large enough war chest to drive marketplace pricing down as much as needed to push competitors out of the running (usually also by creating such a huge and dominant brand that customer acquisition in a noisy market is too expensive to make progress to catch up with the so-called leader).

Absent profitable unit economics this is ultimately as silly as the Texas and Miami and Las Vegas housing bubbles, that depended on “the next fool” to buy-in at a higher valuation, depending themselves on having a subsequent investor bail them out at a higher valuation, and so goes the escalator.

The problem is, the escalator gets to the top at some point and there must be a “destination” where value exists and with it, a hope of profitability. Otherwise the risk is that the dominant brands, regardless of their financial model, may crowd-out other entrants (perhaps with more rational economics) and we’re left with hugely overfunded behemoths that must go on crash diets while they flail violently to discover a path to revenue within reasonable unit economics.

This is disturbing to the market, as previously celebrated darlings of investors and pundits must lay-off double-digit percentages of workers, founders are forced out, valuations wobble and otherwise-smart people on boards wail “how could this happen?!” as they see their unicorns run towards the mean, in terms of valuation and stumble as the analysts start to pay less attention to the “cool kids” on the board and exec team and more attention to the basic economics of the business. And at about that time we see bloggers, analysts, and some nervous investors jumping on the “this is the end of Camelot” “the bubble has burst” “RIP prosperity” gloom and doom bandwagon.

It is embarrassing to see this. People outside of the venture and startup community must think we are a bunch of carnival hucksters or naive dreamers, have short-term memory problems, or just plan reckless. The reality is that most startup entrepreneurs are pragmatic, thoughtful and work brutal hours at great personal risk and personal cost to follow an inspiration to fix a problem or improve a condition or re-invent a market or process. And most investors “want to be” seen as just as thoughtful and insightful. In my experience most are.

Only a few startups attain the notoriety and attention that these unicorn billion dollar valuations command.

And that’s the problem. Even the investor community seems to get predictably hypnotized and sucked-into the trap of using these outliers to define the entire market – and therein lies the problem… Institutional money pours bad money after good money into self-created unicorns (some that lack sustainable models, others that may be on track to find one). Market momentum creates a fear of missing out (FOMO) in other investors who feel they must find their own unicorn or be shunned by their limited partners (their investors) in favor of the “Midas” investors that have them in their portfolios.

But the process is sometimes circular–these unicorns are created by the institutional investors that consciously inflate valuations so that they can expand their “social validation” among additional investors without diluting their interest. Usually by expanding the set of rational investors, an investment becomes somewhat less risky and volatile because there are presumably more sets of rational eyes examining and helping the business, and success and progress is usually rewarded by additional bumps in valuation. But this is not what we have been seeing. It’s not exactly “pump and dump” exuberance but it does kind of smell a little bit like collective self-serving “pump.”

The irony is that this increases investment risk and makes the valuation more volatile as exits narrow, and profitable exit scenarios get jacked up to extremely high figures. This happens so quickly that the exec team and founders often have no time to catch up with this flattering largess and they’re trapped in a situation that leaves them with very few options:

  1. Find another set of FOMO investors eager to participate in this unicorn to run-up the valuation even further (and put off the day of reckoning even further with more cash to feed the burn rate) or
  2. Find an acquirer to bail everyone out (but the larger their unicorn valuation the fewer suitors there become), or
  3. IPO and let the market take on the risk.

The continued stagnation of the IPO exit market this year has effectively called-out the “top of the escalator” and there are no more “next fools” (i.e. large enterprise buyers at the >$1 Bil level for unprofitable over-valued beached whales) and as mentioned a diminished IPO appetite from capital market leaders that demand value and cash flow and a hope of profits).

So now, once again we are back to reality.

The great news about being back to reality is two-fold.

  1. Sub-billion dollar valuations are no longer an “embarrassment” to VCs; and institutional investors
  2. Entrepreneurs can reasonably weigh a variety of capital structures that include bank and trade debt, customer financing and strategics, as well as investment equity and debt structures, all supported by revenue –and that means free cash-flow.

With this in mind, the VCs and the investment community in general must return to their roots and away from headline-grabbing sensational announcements in their day to day work helping entrepreneurs build sustainable, successful large businesses.

This is because they are suddenly back where they started- in the traditional broad capital markets and again have to compete with other capital sources and structures for the hot deals. This is where venture started.

They’re also facing nervous investors themselves and are quickly scrambling to re-set the expectations of their limited partners about return and “rationality.”

Middle and nascent deals will have to become cash-flow generating, and for this reason they will also (wisely) become more reluctant to give up huge chunks of equity just to bring in working capital (at least not until the enterprise value pops to a higher tier by using bank debt, trade debt and other creative capital structures).

Larger growth rounds will have to demonstrate that they have a realistic path to profitable monetization and growth using simple unit economics, not just a cool popular service or celebrity exec team or famous Midas” investor on board.

Savvy entrepreneurs and founding teams will also be less excited about creating an early and dramatic bump in valuation just to bank extra growth capital, because a down-round will likely wipe out a giant proportion of their equity.

The giddy “we are a unicorn” has turned into “what happens in a down round?” reality check, that most people forgot about when the champagne was flowing and they could finally catch their breath and pay some bills.

Early institutional investors will have protected their downside with special preferred terms that founders and exec teams rarely consider or can demand. If this were real-estate, it might even start to look like over-aggressive venture investors that pump up valuations too high too early, only to have the market adjust to “reasonable” later, were being “predatory.” It is a sneaky nefarious way to wipe out naive founders. This is not unknown in the darker corners and chapters of institutional investing. It’s why reputation matters in this sector.

Predatory lending is an interesting parallel that will not be lost on founding teams, angel investors and early exec team members that hope to be rewarded via their equity stake. “Flatter me, but don’t think I can’t see why you are doing it.”

There is more good news for startups.
The reticence of many of the younger venture investors (those with fewer than 20 years of experience) having yet to bring in a 5X or 10X much less a Unicorn, to invest in early stage deals, is now counter-balanced by the abundance of crowdfunding and syndicate fundraising at the seed and angel level. This is a great organic re-shaping of the investment and capital markets in favor of the early stage company and entrepreneur.

There is also a growing suspicion that the early stage deals that do get picked up by venture investors have been in a long slow decline and “narrowing” of deals to known insiders and repeat successful (i.e. “brought a good exit to a venture fund’) founders. I think that this is based largely on common sense pattern recognition (bet on the horse that won the last race for you), and also based on the reality that it is a rare and elite breed of entrepreneur that can see an opportunity and execute a successful solution (and exit).

That said, a close examination of the venture deals that have been funded in favor of known founders pales next to the stats behind the successful new ventures that have been founded by first-time startup teams.

The difference is largely that part of the value-add from the venture investors is the addition of those “experienced” startup executives onto the exec team as soon as the big money comes into play in connection with profitably scaling the business. Thus the risk of execution is somewhat reduced. So The good news is that it’s really not a closed, insular “inside-pool” system.

Mostly.

But if you are female, or of color, or lack Ivy credentials and the accompanying network, or have not yet created a previous 5X or 10X return, it’s a brutal path. That’s just a fact.

And in this sense it’s very much getting back to a true meritocracy in that you must FIRST build a sensible and exciting startup business that has a hope of becoming very large, and THEN enroll investors in your story and team’s ability to execute and muddle your way to success. But it’s still far from fair. We have miles to go before it is a true meritocracy. As the father of a daughter, son of a female business owner and brother of a female business owner, I want us all to get there at a much faster pace.

What does that mean to today’s startups? It means that the old concepts of cash-flow, repeatable and scalable selling and service delivery models, the idea of managing customer acquisition, retention and lifetime customer value, are again in vogue.

As they should have always been. While there will continue to be many good reasons for companies to temporarily sacrifice cash flow and profitability for raw user or customer growth, the days of “just get 1 million users and we’ll figure out how to make money later” are – at least for the time being, gone. And we celebrate that.

Unit economics always wins. This goes back to the days of “the lemonade stand” cash-flow exercise. It’s what built the world’s greatest capital markets. And it will always remain the best place to start. Water, sugar, lemons, cups and napkins. And a sign and a cardboard box. “How many cups of lemonade must we sell at what price to pay for the supplies, time and sign?” Simple. One does not need an MBA or to be a dropout PhD candidate to start with those basic principles.

In another parallel with the real estate (mortgage) market, today’s startup teams should be asking themselves the same questions that prudent investors will be asking them (kind of like the new mortgage market, where everyone has to go through “full documentation” to get a standard mortgage loan):

How can I make money? How can I do it at scale? What is my selling process and is it repeatable? Who will pay for my service or product and what will they pay, and why? How much money do I need in working capital to find my perfect product-market fit and establish the right selling model and price point/margin? What are the unit economics of my business? What drives retention and churn? What prevents others from copying me and disintermediating my base? Is there a brand value that creates loyalty, or is this market driven by other values and factors? What are my logical exits? Who are the logical acquirers? Is there a realistic IPO path?

Yes, we are back to reality. It sucks for some people. And that’s okay. Those people should get with the program or get out of the startup business. Disrupt and question everything. Be bold, revolutionary, even bombastic and disrespectful of the incumbents and status quo.

But don’t ignore the fundamental rules of business that underlay the path all companies must tread to go from small to large, and startup to profit and successful exit. After all is said and done, you have to make payroll. Sell to a customer a second time. Own a brand people love and trust.

Reality only sucks because it makes you work harder to win, and forces you to confront inconvenient tasks and difficult questions. Short cuts are nice but when they don’t work you end up falling off of a cliff. Better to work harder than run headlong at a cliff you can’t see coming.

Seize the day!

Matthew Weeks is Co-Founder and CEO of HealthyOps, a Healthcare IT Informatics company serving hospitals, clinic systems and other healthcare service delivery organizations. He also serves as chairman of ZOOMPesa, a money transfer company, and advisor to several other technology companies. He is based in silicon valley, where he grew up, and where start-ups, innovation and questioning authority was the norm. Learn more about Matt at LinkedIn and follow him@mattweeks

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