From Pieter Welten – Prime Ventures (@pieterwelten)
The perception is that venture capitalists invest in relatively young, fast-growing technology companies that are deemed to have great growth potential. Moreover, these companies are supposed to disrupt and challenge incumbents in their existing markets. Considering this, it shouldn’t surprise you that the definition of the word ‘venture’ is as following:
- Noun: ‘an undertaking involving uncertainty as to the outcome, especially a risky or dangerous one’
- Verb: ‘to take the risk of’
I have written about the ‘unknowns’ and risks involving Venture Capital before (you can find it here). I very much like the fact that it is less of a number crunching game in our industry compared to Private Equity. A venture capitalist must have the ability, from an early stage, to believe in management, in their execution skills, the quality of product, the market potential etc. These young, fast-growing tech companies don’t have a permanent seat at the table; they are easily unseated when the right challengers put the pedal to the floor. Yes, we understand. But from an investment perspective, the risks associated with these companies tend to stick around for a longer time than we sometimes might want to believe. Other than ‘business risks’, investors also have to deal with the risk of ‘buying high, selling low’.
Let me explain myself. As you can see in the graph below, as companies mature they tend to be able to deliver more predictable growth and get access to new sources of capital when they work their way up. Although each step up the ladder requires sustained high performance (growth), at the same time the company generally carries lower risks and therefore offer ‘smaller’ rewards to the investors. But then you might remember Fidelity’s recent revaluations of some of its portfolio companies including Zenefits, Dropbox and Cloudera? These established names took big hits despite their ‘lower risk profile’.
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So, at each stage, not only the seed and early stage, we can find plenty of examples of companies that unfortunately didn’t live up to (the investors’) expectations. Some other examples include:
- Seed / Early: We can all recall hundreds of start-ups that have ‘failed’, since 90% of start-ups are estimated to fail within the first three years.
- Growth – companies raising significant amounts of funding: Simply Hired (established in 2004, raised $34 million, subject to numerous acquisition rumours, now closing down); Rdio (raised $125 million, valued $500 million, acquired for $75 million); KnCMiner (raised $32 million, recently filed bankruptcy ahead of July’s mining reward halving).
- Down round IPO – companies that took haircuts in their IPO: Square (30% discount to last private valuation) and Box (30% discount to last private valuation).
- Post-IPO – companies that struggled after getting listed: GoPro (share price down c.80%); Fitbit (share price c.70% down all-time high) and Pure Storage (share price c.30% down IPO price).
Maybe it has to do with the fact that today there is a lot of capital in the markets coming from various sources that promising tech companies can tap into, but what we see is that private companies want to raise relatively large amounts of capital at company valuations that tend to exceed public valuations (in terms of multiples). At the same time the same major (business) risks remain involved for tech companies of all sizes. Nothing changed in today’s environment. So even though more mature and well-funded companies can better anticipate and deal with bumps in the road on their path to success, apparently it takes a long time before a company has actually outgrown the ‘venture adventure’. Especially from an investment perspective. Risks might diminish, but it remains challenging to every investor (angel, VC, PE) to realize handsome profits.