Startups, Late-Stage Valuations, And Bull

Bill Gurley, a general partner at Benchmark, makes news mostly because he says what other venture capitalists will tell you while drunk, but does so while on the record. It’s refreshing in a way.

Most recently, Gurley made the point that the tech and investment industries are shoving nine and ten-figure sums of cash into startups while not enjoying a full dig into their financials. In the age of the mega-round, the issue isn’t a small one: Gurley thinks that some people are investing from the hip and not from the spreadsheet.

Here’s the quote:

“Pay attention,” Gurley said. “These companies aren’t going through a proper audit process. … We’re drifting from high-margin businesses to ever-increasing low-margin businesses in terms of what we’re saying are unicorns. Be careful. I don’t think it’s sustainable if you extrapolate that way.”

Placing the low-margin bit aside, the point about vetting companies is disturbing. If huge sums of money are going into companies that are not properly audited, there is more risk in the market than was perhaps understood. And more risk, in this case, doesn’t mean more potential reward — it means more un-hedged downside.

I talked with Gurley on the phone for a minute on the auditing point and he noted that some companies are raising massive rounds off of a Power Point deck, and not an S-1. The implication is simple: When you go public, you undergo a financial root canal, exposing your strengths and weaknesses alike. Massaged decks aren’t like that. And as the market remains flush with bored capital, it seems perfectly happy to shovel it into the maws of companies that report less than you might want before valuing them north of a billion.

(Before I hand the floor to others, I have to ask: Do any of these companies know how to GAAP their top line? I hear endless talk of run rates, and 18-month-away cash flow breakeven, but desperately little when it comes to material profitability.)

Is Gurley Full Of Shit?

Not really, it seems. I reached out to a number of venture capitalists that I think are not stupid, asking for response to Gurley’s point on a lack of auditing of firms receiving late-stage capital in large doses. Here’s what they had to say:

Matt Murphy of Kleiner Perkins told me that there are “definitely some rounds that go on where the entrepreneur doesn’t want to provide detailed data,” but that sort of behavior is a “red flag.” Murphy went on to note that if a company wants to work with a firm, “they will ultimately provide” the information. “Firms who invest without it,” Murphy concluded, “are playing a dangerous game.”

Jason Lemkin of Storm Ventures had some hot words for the current market:

I know many very successful VCs that didn’t do a single new investment last year because of valuations. Many. But, those that simply chase returns are doing very little diligence these days. They will get burned. And it’s not just VCs. Who does diligence on AngelList? No one. No one.”

Josh Felser of Freestyle Capital made a different point, noting that “FOMO has been elevated to a higher status than it used to be and that can’t be good long term.” FOMO, or the ‘fear of missing out’ is a general term for being terrified in the face of an opportunity passing you by — what if all the cool kids do it? And if you think that the cool kids are doing it, why aren’t you? And all of a sudden, $35 million in at a $1 billion pre-money valuation suddenly seems like a deal.

Ron Heinz of Signal Peak Ventures was blunt:

The ‘Unicorn Effect’ has permeated Silicon Valley and created lofty valuations that are likely unsustainable over the long-term. While we fully expect sophisticated investors to complete thorough due diligence, enthusiasm for exceptional upside is clearly driving valuations higher in some instances.


Aziz Gilani of the Mercury Fund feels similarly:

I generally agree with Bill’s warning on valuations. This scenario reminds me of the old maxim: ‘You pick the valuation and I’ll pick the terms’. Right now, some funds are giving in to founder desires for ‘unicorn’ raises and valuations in exchange for relatively onerous terms.

I presume that that is a subtweet of Box’s last round of private capital.

Continuing, here is Jacob Mullins, formerly of Shasta Ventures, and currently of Exitround, a company that helps unwind failed startups: [Update: Mullins noted to TechCrunch in an email that while his company formerly helped companies in trouble find exits, it now assists companies with 8-figure revenue get their M&A on. My bad.]

Today, with stagnancy in the public markets, we’re seeing a large inflow of institutional investors, hedge funds and large private equity with far less experience in VC who are piling money into late stage venture rounds in order to find Alpha. This is increasing the availability of capital and thus increasing valuations and size of fundraises. But these firms often don’t understand the true risks in venture, nor do they necessarily care because of their risk tolerance with respect to the capital they are putting at work. They invest on the backs of other big VC names assuming that its a safe bet; but in venture, companies rarely are.

It’s a vicious capitalistic cycle, because venture investors love having this deluge of easy capital and skyrocketing valuations because it increases the overall holding value of their portfolios.

Chris Calder of Epic Ventures noted that return is concentrated, and expensive:

I think the quality of diligence is there, but because private equity is illiquid, returns are concentrated in a few companies, and there are only so many opportunities to invest (I.e. illiquidity), people are willing to pay up to get exposure. [And] So validation growth becomes lumpy.

Summing the above, it seems, and I know this will shock some of you, that we are currently sunning in the glow of a general asset bubble inside of technology, the result of which is that many funds are willing to buy not just next year’s growth at today’s prices, but profits that are a decade hence. When money is that generous, why not take it?

Just keep in mind that the business cycle is just that: A cycle. And according to that one dead physicist, whatever goes up tends to come down a bit. It’s like the inverse of rent in San Francisco.