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The Hubris of Venture Capital

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Don't blame the founders for taking gigantic gobs of venture money -- often they don't even plan to spend it -- blame the funders.

A large part of the problem is that there are so few investable companies. 

Slack’s funding is a hedge against future instability and an investment in its own operation that comes with little risk. On the other side of the equation, venture capitalists are risking a lot. Marc Andreessen, of the highly respected venture capital firm Andreessen Horowitz, outlined his gamble:

We see about 3,000 inbound referred opportunities per year we narrow that down to a couple hundred that are taken particularly seriously. There are about 200 of these startups a year that are fundable by top VCs. About 15 of those will generate 95% of all the economic returns. Even the top VCs write off half their deals.

It’s venture capital firms, not necessarily start-ups, that are lighting money on fire in pursuit of the next unicorn investment. Hyping this risk has a way of exacerbating it, however. As more and more venture capitalists pile on, the product everyone is seeking isn’t so much an effective, profitable company as it is the idea of a sexy start-up itself. Getting a 100-percent return is boring. Being profitable, in fact, is boring, since it means a company might not be spending enough money to grow as large and as fast as it can.

It's a funders market. 

What does that mean in practice?

I did enjoy this story:

On a recent episode of the HBO television show Silicon Valley, the young start-up founder at the center of the story, Richard, finds himself in a dilemma. It’s the sort of quandary that many of us would dream of being caught in. When taking an initial round of investment, Richard has to decide whether his nascent compression algorithm company is worth $100 million or a fraction of that, figuring out how much investors will have to pay for a small slice of equity that thus far has only a very theoretical value.

Richard eventually goes with the fraction, deciding that it’s not worth the risk of failing to fulfill a massive valuation—becoming a unicorn, as Silicon Valley calls companies with a valuation of over $1 billion—and disappointing investors. Fact followed fiction last week as Stewart Butterfield, the CEO of Slack, a workplace chat environment, raised $160 million in funding for a valuation of $2.8 billion, a double-plus unicorn. The feat is almost unheard-of for a company less than two years old. The question is, is Butterfield falling into the TV show’s trap?

He clearly doesn’t think so. “This is the best time to raise money ever,” Butterfield told the New York Times. “I think it would be almost imprudent for me not to accept $160 million bucks [sic] for five-ish percent of the company when it’s offered on favorable terms.” In other words, if investors want to throw money at him because they think his company is the next huge thing, he’s not going to say no. After all, they just might be right. And if they aren’t? Their loss.

More about Slack's funding:

It make perfect sense for money to be flooding into VCs right now.  Any rudimentary understanding of markets with publicly recognized appreciating assets reveals why this is simply human nature.

Remember the Real Estate bubble... was that hubris when your hairdresser or cab driver was getting a real estate broker's license or simply a sign of being late to a well-established party?

People often confuse (or simply don't know) VCs' main fiduciary role of buying and selling underlying startup companies as assets by conflating that priority with picking out and preferring startups they can build into a profitable business: these are not the same things.

A startup company can be several things from the transactional points of view of an Angel, VC and entrepreneur, such as an immediate opportunity in any of the following categories expected to be:

1. an appreciating asset as ONLY THE IDEA of a business (untested, exciting concepts and markets);

2. an appreciating asset as NOT YET a business (funded concepts, no revenues);

3. an appreciating asset as NOT YET a profitable business (operating costs greater than customer revenues);

4. an appreciating asset as a going concern, profitable business (revenues greater than costs);

5. a flat or depreciating asset with # 1 above condition (dead business concept)

6. a flat or depreciating asset with # 2 (dead product concept)

7. a flat or depreciating asset with # 3 (dead market or outcompeted in getting to it)

8. a flat or depreciating asset with #4 (boring or dull company, industry and/or market...check out any publicly traded company for real world examples)

9. NOT an asset at all – (oops, somebody didn't do their due diligence, malfeasance or I forgot to sell it before the lawsuit was filed...)

Assets appreciate when people demand them and bid them up, regardless and sometime despite any  intrinsic value of tilting towards being a going concern business.  Asset values decline when fewer and fewer people, or nobody, demands them – again, regardless being a going concern business or not.

We can presume VCs consider startups as assets and that they value hanging on to only #1 through #4 above conditions in their portfolios conceptually, if they believe in future appreciation of the company's value.  If Marc Andreessen's comments are the norm, then operationally VCs' primary intentions are focused on filtering only the highest potential startups found in #1 and #2 above categories (if they play in later stage then perhaps #3 too) in hopes that they then can sell their ownership share of these assets at a later date after more demand is created for owning these companies – not necessarily customer revenues.  

And they will always sell these startup assets at a later date... as when their fund sunsets they are bound by fiduciary covenant to pay out all of their limited partners, typically in cash.

Every other startup that doesn't make these cuts gets to go to their bank of Dad and rich Aunt for a loan, or more likely just end up as a tear-stained pillow...

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