Unicorn Indigestion Affects Smaller Startups, Too

By Jessica Floum
San Francisco Chronicle

WWR Article Summary (tl;dr) As the headline suggests, it’s not just “Unicorns” (startups valued at more than a billion) that are being questioned about growth and profits.  These days, far smaller companies may find their business plans/proposals under tougher scrutiny. For women in business who want to prepare for what may lie ahead, take a good hard look at your position, abandon guesswork and a “grow at all costs” mentality.

San Francisco Chronicle

Anthemos Georgiades, the CEO of San Francisco startup Zumper, consoled a friend and fellow entrepreneur visiting from New York two weeks ago. The company his friend had spent three years building was being acquired. It wasn’t a cash-out or a glorious exit. And it was far, far from the magical $1 billion valuation that grants a startup “unicorn” status.

The deal was a lifeboat — one known as an “acqui-hire,” where a larger company pays a small amount to grab a startup’s employees.

The New York startup, which had been living off its seed funding, couldn’t raise its first round of venture capital, despite having what Georgiades’ friend believed was a significant growth opportunity. A few years ago, evidence that its product was catching on would have been enough. Now, investors wanted to know how he would get profitable.

“That really made him struggle with investors,” Georgiades said. “They weren’t willing to bet without that piece of the story.”

While much attention has been paid to tech’s unicorns, private companies valued by investors at $1 billion or more, the stumbling herd of hornless startups has its own set of problems. Before one becomes a unicorn, a company generally receives several rounds of funding from venture capitalists.

If all goes well, its value soars from the millions to the tens of millions to the hundreds of millions and then off to the rainbow prairies. And if it doesn’t?

Funding falls
The number of deals where startups raised an initial round of funding, often called a Series A after the name of the class of shares issued to venture capitalists, fell for the first time since 2009, according to the MoneyTree report by PricewaterhouseCoopers and the National Venture Capital Association. The report, which draws on data from Thomson Reuters, showed that the number of early-stage deals dropped 23 percent from the first quarter of 2015.

Early-stage startups rarely have significant revenue, let alone profit that might allow for a conventional assessment of a business’ worth. The price that professional investors pay in an initial round of funding is a mix of guesswork, spreadsheets, greed, fear and envy. If they think other investors are racing to pour money into a company, they’ll bid it up. If they think their peers are shying away, down go the valuations. Everyone watches each other — and then makes moves as much based on the signals they see as any fundamentals.

“Valuations have risen to a point that they seem to many people to be unsustainable,” Blumberg Capital’s David Blumberg said.

“The future expected value of their continued growth is lessened. People are getting more realistic and skeptical.”

People should have been more skeptical sooner, Uber board member and Benchmark Capital partner Bill Gurley wrote in a blog post last week. He argued that a “grow at all costs” mentality and record burn rates have brought danger to the market for private tech companies, and that investment priorities will shift as a result.

“Today’s Unicorn entrepreneur has been trained in an environment that may look radically different from what lies ahead,” Gurley wrote, adding that some are finding “for the first time, perhaps in their lives,” that they can’t raise additional funds at a higher value than they had in previous rounds. “This is uncharted territory.”

Some accused Gurley of hypocrisy. As a board member of San Francisco’s Uber, which was valued in December at $62.5 billion, he oversees the world’s highest-valued unicorn. But his latest salvo follows valuation cuts in both the public and private markets. (A spokeswoman for Gurley said he was not offering comment beyond what he wrote.)

In the first week of February, LinkedIn’s shares dropped 43 percent after its revenue projections fell short of expectations. That same week, Tableau Software’s value plunged by almost 50 percent after the data analysis and visualization company’s revenue forecast fell short of analysts’ consensus by about $20 million.

“We know that this whole creation of unicorns this last couple of years was just an anomaly,” said SoftTech venture capitalist Jeff Clavier. “Some of the unicorns have raised capital in a distorted reality that doesn’t have any bearing.”

Warnings about overvaluation began in late 2015, making investors nervous as they went into an uncertain new year. Stock market drops and the lack of initial public offerings and mergers and acquisitions made matters worse.

“Without any bad thing happening in the market, people started saying ‘Let’s stop,'” Clavier said. “It’s a bit of a self-inflicted wound.”

Company founders’ fears of an unforgiving public market have prompted them to stay private for far longer than they might have in the ’90s, when companies like Yahoo and eBay raced to go public. Now, according to the MoneyTree report, venture capitalists have shifted their focus to later stages, where they can better assess companies’ prospects of one day turning a profit.

“There is still a certain amount of activity, but it’s going to be concentrated in the companies that have (positive margins) and great prospects,” Clavier said.

Slower growth
At Zumper, a service for renting homes and apartments through the Web or a mobile app, Georgiades’ board encouraged him to shift focus away from growth at all costs early on. The company, which is not yet profitable, makes money by charging application fees to renters and letting landlords pay to promote listings. It has raised $14.6 million and is operating with only 33 employees. While Georgiades said he will seek to raise more money in the next three months, he’s made sure that the company’s cash on hand will last it well into 2017. And he expects Zumper to generate a profit from operations by the end of the summer.

“It’s so obvious an entrepreneur should focus on a business model,” Georgiades said. “Growth models are sexy, but at the end of the day you don’t want to rely on venture capital funding.”

Still, there is plenty of venture capital money to be had, Clavier and Georgiades agreed. If we are in a bubble, it is one that has deflated rather than popped — which means startups will compete all the more fiercely for the funds that are available.

“To raise capital, it’s going to cost you a good chunk of the company, and it’s going to be Darwinian,” Clavier said. “Only the strongest companies will be able to raise.”

Being sustainable
The strongest companies will be those that can increase revenue with sustainable costs, Clavier said. As a counterexample, he cited Zenefits, the health insurance broker, which laid off 250 employees, 17 percent of its staff, in February, despite achieving a $4.5 billion valuation. CEO David Sacks wrote in a memo to employees that the company had grown “too fast, stretching both our culture and our controls.”

“You better have a model that puts you back in the black,” Clavier said. “Otherwise you’re just digging your own grave.”

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