Startups are like wine - Week 19

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If you missed the Berkshire Hathaway Meeting last week, here's Warren Buffet take on Bitcoin: "It's probably rat poison squared." Find 13 more quotes of the Master and more venture capital brain picks in the VC Academy group on Facebook

Startups are like wine

Pitchbook released their 1Q 2018 Venture Capital Valuations Report that made us think of tech startups as wine: the more mature they become, the more expensive they cost. Here are the main takeaways:

• The most significant valuation increase was at the late stage, where the median pre-money valuation as of the first quarter of 2018 went up to $75 million, which is a 19% increase from 2017. The main reason for this is tons of dry powder we talked about earlier.

• The shift toward funding more mature companies was especially present in the angel & seed stage in Q1. At those stages, the median age for companies receiving financing pushed to three years, which is twice as old as a decade ago. The reason? Lots of alternative funding options such as accelerators, equity or product crowdfunding, and a greater ability to bootstrap.

• The median time between venture rounds remains extended, sitting at 1.4 years for angel & seed and early-stage rounds, an increase from a long-term average of 1.2 years. For late-stage, it sits at about 1.8 years compared to an average of 1.5 years.

• It doesn't seem that VC valuation increases are driven by an increase in investor protections. For instance, the percentage of deals with cumulative dividends — as well as those with participation rights — has fallen steadily over the past decade. Learn more about these terms and their significance to investors and entrepreneurs

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In other news:

  • Endowments keep their money in alternative investments regardless of unimpressive performance, or even add to holdings. Last year, alternative investments accounted for an average of 52% of endowment assets, and over 60% in the largest endowments. But besides that, they also back their own entrepreneurship programs to get an early access to future unicorns. As students increasingly pursue startup path, more universities are creating accelerator and incubator programs to support them. Why does it matter? Universities become a stronger source of potential deals. If you're an early-stage investor, make university campuses your priority: become their advisor, hold informal meetings with students, build your network there.
  • What is a successful exit? Walmart's acquisition of 77% stake in the Indian e-commerce company Flipkart is the biggest news of the week. Walmart's shareholders aren't very happy about this deal that cost the company $16 billion, because Flipkart is expected to generate meaningful losses for at least the next few years. While Walmart shares were falling as low as 4.2%, some venture investors across the street were opening champagne. Tiger Global Management, a New York-based, low-profile investment firm, made about 3x return. While the firm first invested in Flipkart only $9 million back in 2009 and put total of $1 billion over the years, SoftBank joined the investor pool with roughly $2.5 billion less than a year ago, and its stake is now worth about $4 billion. That'd be a pretty quick good return, if only Softbank didn't have to hand over about $600 million to the Indian taxman out of it due to the steep 40% short-term capital gains tax. Finally, Accel, a Palo Alto based venture capital firm, has been holding on its share for 10 years. The firm invested $800,000 back in 2008 when Flipkart was operating with an 8-person team. (It now employs more than 30,000 people, and it is the largest e-commerce company in India.) Accel invested approximately $160 million over several rounds, and its position in the company is now worth about $1.1 billion. That's a staggering almost 7x return! Lesson learned: be patient and make your term-sheet strong. 

Recent Industry Reports And Studies (free instant access):

1Q-2018 MoneyTree Canada by CB-Insights

2018 Private Markets Due Diligence Survey by eVestment

1Q-2018 VC Valuations by Pitchbook

Reroute

From the DeLorean and New Coke to the Newton and Google Glass, here's a list of the biggest product flops from corporate giants.

Bond, Junk Bond - Week 17

Sequoia Capital has sued the founder of the largest cryptocurrency exchange for allegedly violating an exclusivity agreement for the upcoming funding round (i.e., a term sheet provision prohibiting negotiations with other investors after agreeing in principle with Sequoia). This doesn't happen often in the VC-land, so the case is important to study. Learn why a term sheet isn’t exactly a non-binding agreement — as they say — in our next weekly VC lesson


WeWork gave us a lot to think about this week. It's been a little over half a year after the most recent massive venture capital financing round of $4B lead by Softbank’s Vision Fund. As a rule of thumb, every VC investment round should be sufficient to keep the company afloat for 18 months on average. However, WeWork has been burning cash like crazy and raising money every year. Even though the last Softbank injection was more than 4 times larger than any previous round, it will still be insufficient for this disruptor in the near future.

Because there’s hardly anyone else left to turn to for money at this point, WeWork decided to raise new funds through a junk bond. "Junk bonds" are so called because of their higher default risk in relation to investment-grade bonds. Knowing that, WeWork offered a pretty high seven-year yield — 7.75-8% — and managed to raise 40% more than they asked for: $720M instead of $500M. Higher interest rates is one of the reasons why investors purchase risky junk bonds. Some investors, however, buy them to speculate on potential price increases, which may happen if WeWork does well and grows its valuation further. No guarantees, of course.

WeWork said the proceeds, together with the money left from SoftBank's last funding, will give it over $3B of cash to finance its expansion. Let's see where the problem is.

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How Are Things, WeWork?

Due to the bond offering, WeWork had to disclose some financials, which allowed the broad public to guess how venture capitalists are feeling about this portfolio company.

Good news: the revenue of the office-space management company more than doubled between 2016 and 2017 — from $436M to $886M. Nearly 93% of revenue ($822M) is tied to membership. WeWork revenue in 2017 totaled $886M in cash.

Bad news: the net loss more than doubled compared to 2016, which totaled $933M. But the worst news is that WeWork has $5B of lease payments due through 2022, and another $13.2B in 2023 and beyond. The annual lease payments for all WeWork's real estate is roughly around $1B. Current revenue is close enough to pay for the rent. However, all other expenses are or will be close to that $1B mark, so if WeWork is planning to become profitable in its current state, the company needs to at least double the revenue. Not easy at this scale.

According to the financial statements and newly raised bond money, WeWork has somewhere around $3B in cash. This money is kinda emergency funds to cover three years of the company's operations, excluding the rent (which can be paid for by the membership should it remain the same or grow). However, unless the company cuts expenses significantly or doubles the revenue, its future after 2020 is uncertain. Although IPOs of unprofitable companies are common today, the amount of public finding WeWork could possibly raise wouldn't cover it anyway.

"Community Adjusted EBITDA"

WeWork decided to put a new face to its extreme spending and invented a new measure called “community adjusted EBITDA”. The classic plain-vanilla EBITDA — or earnings before interest, taxes, depreciation, and amortization — is negative at $769M, according to the documents. However, WeWork’s "community adjusted EBITDA" subtracts not just these costs, but also ordinary expenses for things like marketing, design, administration, all tenant fees, rent expense, staffing expense, facilities management expense, and even executive salaries.

WeWork's intention is to best quantify its unit economics as it continues to prepare for an IPO. Since many of the expenses listed above relate to growth efforts, the company insists that the approach to EBITDA should be different from the one traditionally applied.

By its controversial new financial metric, WeWork reported an adjusted EBITDA of negative $193M and a loss from operations of $932M.

Although the interest for WeWork’s bond was strong, let’s not forget that just a month ago Tesla’s notes plunged to a low of 86 cents on the dollar, showing that creditors aren’t totally sure the company will be “money good”. Netflix’s stock slipped down  5% after the streamer announced new $1.9B junk-bond offering. As of March 31, Netflix had $6.54 billion in long-term debt and $17.9 billion in streaming content payment obligations, but the company is at least profitable.

What Were VCs Thinking?

WeWork’s soaring membership exploded from 7,000 members four years ago to 251,000 as of March 1, 2018. Its occupancy rate increased to more than 80% on Dec. 1, 2017, from 76% a year earlier, according to the documents. As we recall, it was fashionable at the time to invest in growth rather than actual profits. However, some industries — and real estate is one of them — are tougher than others.

Lease flexibility, a major perk for potential WeWork tenants, also poses one of the company’s biggest risks. The company is subject to "mismatched terms" when it takes 10- or 20-year office leases from landlords, and then offers companies month-to-month rental options.

Selling WeWork for the current company's valuation of $21B wouldn't even be enough to cover its existence with all the liabilities. However, we all know that what happens to a company after a venture capitalist exits. It’s no longer their concern. Keeping that in mind, the long-term future of WeWork from the financial standpoint is worrisome.

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Pitchbook surveyed its readers if the co-working giant's business model and $20 billion valuation will hold up long-term. Here's what we've heard. Some responses have been lightly edited for length and clarity:

* * *

"WeWork has effectively built an aura around itself that allows it to borrow money cheaper than everyone else. If it can do that faster and reach profitability faster than the economic cycle shifts to the downtrend, it will be fine. If it cannot, it will be toast."

"Without a clear path to sustainable profits, there is no clear path to sustainable value."

"To me, the business model does not look much differentiated from serviced office companies like Regus—other than how they arrange the spaces they rent and sublet to their tenants. Their costs per square foot must be about the same; ditto for the rents they collect. So...how can they sustain their valuation? What am I missing?"

In other news:

To add some brighter colors, let's put Docusign in the limelight. On Thursday, the company went public at $29 a share, and the stock rose 37 percent in the first day of trading on Friday.

The biggest winner investor is a venture capitalist who has never appeared on a Midas List, and whose firm isn’t one of the venerable investment firms on Sand Hill Road in Silicon Valley. Nevertheless, he made a bet on the startup that lets people securely sign contracts online 12 years ago. Pete Solvik was so sure of the idea that he kept buying shares over the years for his firms, Sigma Ventures and San Francisco-based Jackson Square Ventures, where he’s a partner.

To accumulate a 13% DocuSign stake for his funds — which is now worth $687M — Solvik spent only $17.5M of venture money. As you can see, patience gets rewarded by an almost 40 times return.

Recent Industry Reports And Studies (free instant access):

WeWork Teardown by CBInsights
HALO Annual Report on Angel Investments by Angel Resource Institute
2018-Q1 US PE Breakdown by Pitchbook

Reroute

Europe’s first national government-backed experiment in giving citizens free cash will be terminated. Since January 2017, random 2,000 unemployed people aged 25 to 58 have been paid a monthly €560, with no requirement to seek or accept employment. The idea aimed primarily at seeing whether a guaranteed income might incentivise people to take up paid work, but two years will not be enough to make a reasonable conclusion for the experiment.

Occupy Silicon Valley - Week 16

Do you measure your life in billable hours? There’s another metric you may want to add to your system: Cost Per Reasonable Decision (CPRD). Find instructions at the end of the e-mail.


Occupy Silicon Valley

Merrill Lynch, the wealth management division of Bank of America, issued a report called “Occupy Silicon Valley”. An investment forecast with the catchy title addresses the bank’s clients — traditional investors in the stock market. However, we can’t miss it because it summarizes recent events occurring in the tech community and describes a broader social phenomenon. Here’s why.

A decade ago, the tech industry in general, and Silicon Valley in particular, had an image of bold innovators advancing the entire world. Since early 2000s, they’ve been accused in creating too many meaningless mobile applications and social networks, and too few real breakthrough technologies. Today, the tech industry draws attention by public scandals, increased regulation, and taxation, all of which makes it vulnerable. Privacy breaches, institutionalized sexism, and jobs in jeopardy are only a few of the worries of common people. Venture capitalists are no longer knights in shining armor. Instead, they have become enablers. 

Merrill Lynch’s forecast of a backlash against the industry is based on the spicily valued tech giants whose market values surpass the gross domestic product of some major US cities. “Google is bigger than Chicago, Amazon is bigger than Washington,” wrote Michael Hartnett, chief investment strategist with Bank of America Merrill Lynch. Google and Apple have a combined market capitalization of $1.45 trillion, greater than the combined $1.31 trillion market value of euro zone and Japanese financial stocks.

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All those negatives and increasingly concentrated wealth of Silicon Valley feeding the gap between tech capital and human capital may spark a backlash against the industry similar to that one against the banks of Wall Street. That’s why the report's title draws parallels to the 2011 "Occupy Wall Street" protest against the wealth of the largest US financial institutions that arose from the financial crisis. Because more and more people feel left behind, Silicon Valley is on the edge of becoming a new punching bag.

But it’s not only the common people who are unsatisfied with tech. It’s also politicians and regulators who have started taking actions against the tech frenzy. A new EU privacy law and digital advertising tax, tougher antitrust enforcement, the US Senate bill to form a new Commerce Department Committee to grapple with the impact of AI and automation of workers, or South Korea’s world's first "robot tax" to reduce automation incentives, let alone severe regulations against cryptocurrencies and tokens — are only a few measures currently being implemented by the world governments.

Altogether, it may slow down the growth of tech stocks, even though Merrill Lynch is still expecting it to continue rising in the near future. Nevertheless, it advises its investors to start adding out-of-favor sectors — such as gold, natural resources, and banks — to their portfolios.

So what does it all mean for venture investors and entrepreneurs? Besides potential redistribution of wealth and power, the current environment will definitely require updating the values of technology companies. People will want more jobs created, more taxes paid, and better working and living conditions offered in the geographies most exposed to the tech gold rush. For some companies, this will mean cutting the profits, for others it will open new opportunities. At the end of the day, current technologies can address all concerns of the unsatisfied.

In other news:

  • This is the time of lists. Forbes released its Midas List, and CBInsights updated their Top 100 Venture Capital Partners of 2018 list. Seeing new faces is very encouraging, while losing some regular actors — especially due to sexual harassment accusations — proves that one mistake can cost a career even in venture capital.
  • As we’ve reported, the US Securities and Exchange Commision is on a hunt for different players of the cryptocurrency sector: startup fundraising through ICOs, their marketers, and now, cryptocurrency exchanges. You know it’s getting serious when investors step in. Andreessen Horowitz, Union Square Ventures, and other venture-capital backers of digital-currency firms met with the SEC to argue that severe regulations can slow down innovation based on blockchain technology. Let's see how that goes. While, the crypto community showcases Switzerland as an example, which has issued guidelines for initial coin offerings (ICOs) where it classifies cryptocurrencies into three types: payment tokens like bitcoin, utility tokens that provide access to a service, and asset tokens that represent participation in hard assets, companies, or profit or capital flows. The guidelines also recognize hybrid coins that serve multiple purposes.

Recent Industry Reports And Studies (free instant access):

2018 Marijuana Trailblazers by CBInsights
2018 Global Startup Ecosystem Report by Startup Genome
2018-Q1 US PE Breakdown by Pitchbook

Reroute

How to make reasonable decisions reasonably quickly? How would you estimate the direct cost of some recent decisions in your companies? What about the opportunity costs of all that time/energy that could be spent elsewhere? Read here.

Investing With Love - Week 15

How many hours a day do you typically spend answering emails? Find out how to reduce the stress that your mailbox causes you, at the end of this newsletter.


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Investing With Love

This week, we noticed that many investment professionals in our LinkedIn community are interested in impact investing. It's a well-known fact that the millennial generation cares about impact far more than any of the other generations, but it's always amazing to see it happening right in front of your eyes. Coincidentally, this week brought with it a handful of important insights about impact investing, so we decided to dedicate our newsletter to this subject.

The Ford Foundation, a globally-oriented private philanthropy organization, pledged $1 billion to mission-related investments last year, and following on from this, Switzerland’s Partners Group announced a $1 billion vehicle this week, that will seek investments focused on alleviating poverty and back companies developing affordable and clean energy technology. These are impressive amounts for impact investing, considering that there are still many people who doubt it can guarantee market returns.  

Target returns, overall and by geographic focus

As you can see in the image above, up to 71% of impact investors generate “risk-adjusted market rates” for financial returns. They keep in mind the social and environmental impact of their investments, but they do not sacrifice financial returns by making impact investments.

This makes total sense from a strategic marketing standpoint. "If a company is doing something very important in the world, customers are going to want to buy more of it, employees are going to be more committed, and investors are going to want to be very involved in helping that company succeed", explains Alex Pitt, the co-founder of Mustard Seed, a London-based impact investment firm. "We see these dynamics at work across our portfolios every day. This means these companies will have very strong long-term commercial returns, in our view." This has been confirmed by different surveys - see the first image above.

Where Do I Take The Money?

What is equally important is that institutional investors see this trend too, and they are becoming more and more interested in impact investing as well. A 2017 study by BNP Paribas shows that 20% of institutional investors intend to increase alternative allocations to ESG (Environmental, Social, and Governance)/impact assets.

Of all the different types of limited partners, development finance institutions (DFIs), e.g. investment banks, institutional investors, advisors, and managers, show the strongest aggregate commitment to impact funds, with almost 9% of all commitments to PE and VC funds being impact funds. However, their check may be too heavy for smaller impact investors - this is where high net worth individuals (HNWIs) and family offices step in. ("Family offices" is the next topic of our Weekly VC Lesson per our students’ request — subscribe here to receives it.)

More than 90% of HNWIs globally — particularly those under 40 — believe that driving social impact is important. Asset managers have increasingly adopted impact asset offerings in order to serve this demand. A 2017 family office survey reports that 28.3% of family offices utilized impact investing as a strategy and 40% of surveyed investors expect to increase commitments to impact/ESG investments in 2018. Read the analyst note on sources of impact capital prepared by PitchBook.

This trend has been out there for some years now, and last year we published a free "Impact Measuring Framework" course authored by the brilliant impact investor, Cynthia Ringo of DBL Partners. It's not too late to jump on this impact investing train yet, so enroll today!  

In other news:

Theranos, "the latest indignity for the once fabulously rich blood-testing company that’s become a parable for Silicon Valley hubris", is at risk of a foreclosure sale to private equity firm Fortress, which, if this happens, will be entitled to a 300% return on its investment before other investors are paid out. There is no hope for the latter, who were asked by its CEO Elizabeth Holmes to invest more (you read it right) in order to avoid this scenario. While some of the company's employees were laid off, others were playing a home-made crude version of the classic “Space Invaders” video game, in which players shoot at a likeness of the Wall Street Journal reporter John Carreyrou, who was the first to break the story of the company’s troubles in October 2015.

In addition to replacing the game’s titular aliens with Carreyrou’s face, the programmer replaced the canon with Theranos’ proprietary miniLab testing kit, and swapped out the bullets for the company’s “nanotainer” blood vial. The WSJ reporter didn't waste time while Theranos was sinking, and wrote a 300-page book titled “Bad Blood: Secrets and Lies in a Silicon Valley Startup”, where he paints a damning portrait of the culture of dysfunction and deception overseen by CEO Elizabeth Holmes. People like drama after all.

Theranos is a unique case where the company made so many of the mistakes that a Silicon Valley company can make, including suffering the irreparable damage caused by media revelation.

Recent Industry Reports And Studies (free instant access):

1Q 2018 Venture Monitor by PitchBook-NVCA 
2018 Cyber Defenders by CB Insights
Q1-2018 Venture Capital Funding Report by PWC and CB Insights

Reroute

You thought Slack or Telegram would set you free from hundreds of emails and remove the stress? Didn't work, huh? Here are some thoughts about why emails are so stressful for busy people like you. Spoiler alert - each “yes” leads to more work.

Wall Street is losing it - Week 14

Silicon Valley may not need Wall Street anymore

The news of the week is, of course, Spotify’s direct IPO. A lot has been said, and we’ll try not to repeat too much of the media. Let’s focus on the underlying reasons that could explain why a direct IPO today is such a big deal.

First, the main differences

In a traditional IPO, a company issues new shares to sell them to the outside investors (primary sale). In a direct IPO, a company sells the shares that the company or its shareholders already own (secondary sale).

In a traditional IPO, the money from selling these newly issued shares remain on the company’s bank account and can be spent on the further development of the company. In a direct IPO, whoever held a share gets money for which it’s sold — whether it’s a CEO of the company, its other employees, or investors. So unless the company itself sells the shares it holds, no money from a direct IPO remains on the company’s bank account.    

In a traditional IPO, the main goal is to sell newly issued shares. That’s why the company’s current shareholders are limited to selling their shares for a certain period of time by a lock-up period. They can sell a little portion of their shares at the beginning of IPO, and the other shares later on. That’s why a traditional IPO is almost never a full exit for investors. In a direct IPO, there’s no lock-up period, therefore, any shareholder, including investors, is allowed to sell their entire share and fully exit the investment.

Finally, a traditional IPO is managed by underwriters from drafting it to selling all the offered shares. The underwriters can get paid for different services, and their fee on total proceeds from an IPO can be the largest income sources for them. A direct IPO involves underwriters on an à la carte basis, and the job they perform is mainly consulting and preparation of an IPO, but they’re not involved in sales of the shares, therefore, earn significantly less than in a traditional IPO.

Much ado about what?

Almost all the media wrote that if the direct IPO of Spotify is successful and becomes popular among tech companies, it will dramatically change the power balance between Silicon Valley and Wall Street, benefiting the former. Judging by comments on articles and blog posts, we’ve seen that the role of Wall Street for tech-IPOs isn’t quite clear to people who have never dealt with public offerings. We decided to dedicate one of the following Weekly VC Lessons to a detailed explanation, but will try to briefly explain it now too.

A traditional IPO never happens without the participation of Wall Street investment banks that play a role of underwriters with relevant IPO specialists on staff.  

Besides handling IPOs, investment banks serve a number of purposes in the financial and investment world, and their clientele invests a massive amount of money in public markets. As such, these clients can become purchasers of a company’s stock at an IPO. Therefore, an investment bank becomes a middleman between a company that wants to sell their shares in IPO and prospective buyers of such shares.

The work investment banks perform includes, but is not limited to bringing other investment banks to the table and coordinating the activities of the underwriting syndicate, conducting due diligence and evaluation, leading pre-IPO marketing and a roadshow, meeting with institutional investors, gathering information on institutional demand, building a book of potential buyers, pricing the securities for an IPO, buying all or part of issued securities for an IPO, preparing all the documentation and filing it with the SEC, and selling the securities they purchased among their clients and to other investors at an IPO.   

As you can see, this work covers pretty much the entire traditional IPO process and is paid accordingly. Besides all the underlying expenses such as legal, accounting, printing fees, roadshow expenses, and registration costs, the company pays investments banks a 3-7% fee of the raised capital amount. Depending on the size of the offering, this particular expense can be the largest the company bears at its IPO (see image above).      

However, direct listings need little from this list and are mainly limited to regular consulting services such as due diligence and evaluation, preparing all the documentation, and filing it with the SEC. This results in a much cheaper cost of going public. Although underwriters still charge a fee from the gross proceeds of the IPO for their consulting services, it’s smaller than usual, and unlike in a traditional IPO — where they have considerable leverage by controlling the sale of the securities — in a direct IPO, they don't have any control over such securities. We’ll be describing the underwriters’ job in greater detail as well as how they can manipulate the market and play against the companies they help become public — subscribe now not to miss this VC lesson.

In other news:

Venture capitalists add ICO-related language into term sheets. Raising funds through Initial Public Offerings hasn’t existed until recently. However, if we’ve seen newly established (and non-existing) companies raising crypto funds in 2016 and early 2017, it’s only within last six months that US venture firms got really anxious about their portfolio companies pursuing the same route. Several VCs anonymously confirmed that they’re requiring companies they back to provide investors with certain rights should the company eventually launch an ICO. Some investors require veto right over ICOs, while others insist that this decision must be discussed and voted for by the board. We’ve updated our course on designing a term sheet accordingly.

Recent Industry Reports And Studies (free instant access):

2018 State Of Startup Accelerators Worldwide by GAN
Q4-2017 Venture Monitor by PitchBook-NVCA
Identity and Blockchain by CBInsights

Reroute

The largest Chinese funeral home offers guests the opportunity to experience the entire process of dying in virtual reality, whether from having a seizure at work, a failed paramedic rescue, or your heart stopping.

$1,000,000,000,000 Of VC And PE Capital Is Out There - Week 13

More Than $1 Trillion Of Capital Is In The Market

Well over $1,000,000,000,000 in committed capital sits in the accounts of private equity and venture capital funds worldwide. This is almost equal to the recently approved spending bill of the United States. We'll give you a minute to wrap your mind around this figure.

The unprecedented amount of dry powder "is a testament to how much PE and VC have evolved as asset classes, and how much further they have to go". We're dedicating our upcoming VC lesson this week to the difference between venture capital and private equity, which is critical to understand in order to become good at managing either of them.

Let us remind you that “dry powder” is the amount of cash available to a venture or private equity firm to deploy as new or follow-on investments. Dry powder should ideally be spent over a fund's lifetime, so fund managers are obligated to invest this cash sooner rather than later. This, however, creates a whole bunch of different issues.

The most worrisome of these issues — even though old — is the problem of “too much cash chasing too few deals”. It is now too big to ignore, and means fattier checks of later-stage funds and higher competition for startups among early-stage investors.

As a consequence, the valuations of investees can be inflated deliberately (as happened with Softbank's investment in Wag) or not, which generally results in the market being at its least healthy (this type of situation is where we start talking about another tech bubble). It also creates pressure for fund managers, who now have to adjust their current strategies or design new ones, so that they don’t disappoint their limited partners.

Source: Pitchbook

Why Did It Happen And What's Next?

In venture capital, this situation has happened mainly because more and more venture firms are raising funds of over $1 billion in order to compete with each other, or with the behemoth of the market — the $100 billion Softbank Vision Fund. There are also rumors circulating about them rising another similar giant.

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However, with reaching record dry powder figures, the industry entered uncharted territory, where new game rules need to be established. To illustrate this — five years ago, after achieving a certain maturity and valuation ceiling, a tech company would have already been listed at an exchange. Instead, because so much capital is available in the market, such companies, aka "unicorns", are electing to stay private and are raising venture capital dollars instead of going public in order to continue fueling the company’s growth. This situation certainly demands new approaches by fund managers.

A record dry powder amount is not only a result of the evolution of private markets but is also an accelerating factor in that evolution. Let’s take a look at an example of this:

The VC mega-fundraising boom is led by Sequoia Capital, which is raising between 6-8 billion dollars for its new global growth fund — the biggest among other top-tier venture capital firms — which will focus almost exclusively on late-stage rounds for existing portfolio companies.

It seems like the firm would benefit a lot from the carried interest and management fee of such a fund. Not to scare limited partners away, however, Sequoia offers unprecedented for a top-caliber firm LP-friendly terms. The firm is not going to charge any fees on committed capital, there is only a 1% fee on called capital. The 20% carried interest remains typical for the market, although the firm has charged higher than that in its smaller funds. Still a good bonus on already existing portfolio, but this is how market has changed.

In other news:

This month, the Securities and Exchange Commission (SEC) called the blood testing startup Theranos a “massive fraud” and charged it for raising more than $700 million from investors through “an elaborate, years-long fraud in which they exaggerated or made false statements about the company’s technology, business, and financial performance.” Instead of going after the company — which is private, so all the available cash would come from investors who the SEC is protecting — the regulator went after the CEO, Elizabeth Holmes, and Theranos's former president, Sunny Balwani. Ms. Holmes paid a $500,000 penalty, was stripped of her controlling shares, and was furthermore barred from serving on the board of a public company for 10 years.

Lawsuits against portfolio companies have been very unusual in Silicon Valley. The first big precedent with the intervention of the SEC took place last year, when it fined insurance company Zenefits and its co-founder Parker Conrad for deceiving investors. That “unicorn” paid a penalty of $980,000.

We already know that the SEC also announced it had opened “dozens” of investigations relating to cryptocurrency and “initial coin offerings”, and are taking a hard look at one of Silicon Valley’s hottest obsessions.

All this means that more investors and shareholders will be prepared to go to court when their loyalty is betrayed. This also means that one of the long-standing informal Silicon Valley principles "fake it until you make it"  will not just work anymore. Even if companies find a way to stay private, it won’t help them avoid scrutiny and they’ll be charged according to the lies they have told. Investors on the other hand, still ought to do their due diligence properly, and not just read through the list of current investors and advisors, which was pretty much the case with Theranos.

Elizabeth Holmes is the daughter of Christian Holmes IV, a former member of the George H.W. Bush administration, whose wealth is reportedly connected to the Fleischmann Yeast company, which was financed by J.P. Morgan himself. Expectedly, the company's board was filled with a bunch of Washington VIPs who had lots of connections, but little relevant experience, and Tim Draper was very certain about Theranos's technology back then...

Would you invest in Dropbox? - Week 12

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5 Things to Know About the Bumpy Start of Dropbox

  • Dropbox can be included in the "anti-portfolios" of many investors. "Dropbox impressed investors in Boston. It just didn’t impress them enough to write a check. Boston investors had an entire week before any Silicon Valley investors saw Dropbox, and not one of them made a move." Jessica Livingstone, partner @ Y Combinator, first investor in Dropbox
  • In the application to Y Combinator batch in 2007, when asked about the lowest offer he'd take to sell Dropbox three months from then, its co-founder Drew Houston wrote, "I'd probably have a hard time turning down $1m after taxes for 6 months of work."
  • See the first Dropbox investment deck that served its purpose to receive another check from Sequoia Capital, and anything but a smooth public product launch on stage at TechCrunch’s TC50 startup event in 2008. 
  • In his keynote in 2009, Steve Jobs vowed to kill Dropbox with iCloud. Read the full story.
  • Y Combinator sold half their Dropbox shares and used the money to fund YC operations approximately 7 years ago. That was the only time they’ve done something like that, but YC would’ve made more money if they hadn't.

Why We Like This Story

Dropbox IPO is a good example of venture capital math. While we all know that most of the risk falls on early investors' shoulders, this case illustrates how later stage investors can also lose. We dedicate our One VC Lesson a Week to later rounds valuations. Subscribe now to get it or reply to this e-mail for a special discount.  

So. Dropbox Inc. raised money from venture capitalists at a $10 billion valuation in 2014. It filed for an IPO last week at a humble valuation range of about $6.3 billion to $7.1 billion, which is a down round for investors who participated in the latest rounds. However, the demand was better than expected, and Dropbox ended up going public at a valuation of ~$12 billion as of yesterday.

If its last round C lead investor BlackRock were lucky to sell all their shares for the current $29.90 price per share, their profit would amount to only ~4.5% of their initial investment -- a return much lower than 2016 S&P 500 (roughly 12.25%) or 2016 NASDAQ (11.28% return with dividends reinvested). Why bother?

Big winners, on the other hand, are Sequoia Capital and Accel Partners, who invested in the company very early at less than $1 per share. 

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See full infographics

Clearly, the company was overvalued for quite some time: experienced investors such as BlackRock bet poorly. The bankers who underwrote the IPO were also mistaken by filing the papers for a valuation lower than the market expressed in the first days of trading.

The latter, however, isn’t a reason to buy Dropbox shares today. First, the company's revenue growth is slowing down. Dropbox valuation is now worth 10 times its current sales, while the average cloud software company currently trades at only 4.7 times revenue, according to Bessemer Venture Partners. It's also unclear whether Dropbox CEO Drew Houston will be effective at managing Wall Street expectations. 

That said, Dropbox has a larger size, stronger cash flow and attractive growth rate. See for yourself:

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In other news:

  • More than $687 million was invested in nearly 160 companies in 2017, both decade-high marks, according to a report on Pittsburgh technology investment. These numbers echo the recent (and ongoing) notion that “Silicon Valley is Over” and “Everyone Hates Silicon Valley”. Well, not really. 
  • First, most of the technologies first appear in California. Even though it creates a bubble distancing Silicon Valley from rest-of-the-world market realities, think about it as tech's first focus group.
  • Second, a myth has been spreading for a couple of decades that Silicon Valley monopolizes venture capital. A study shows that it actually doesn't, therefore, there isn’t much to be “over”. As the costs of starting technology companies have lowered, the time required to bring products and services to market has also shortened. This makes Silicon Valley totally unnecessary for launching a startup. Following this trend, different regions started offering  lower costs of living, lower operating costs, access to talent pools comparable to East and West Coast universities, as well as alternative funding sources. All these trends forced venture capital firms to innovate their own business models.
  • It's not other US states that threaten the kingdom of Silicon Valley (although they attempt to do so). It’s other countries and global regions.
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P.S. We actually wanted to run more stories from this week news. Will follow up in the next newsletter. Subscribe now

Recent Industry Reports And Studies (free instant access):

2018 The Top 20 Reasons Startups Fail by CB-Insights
WeWork Teardown by CBInsights
2018 The Venture Capital and Private Equity Country Attractiveness Index by IESE Business School

Reroute

You might need one literally if the rumors are true: Attorney General Jeff Sessions declared war on the State of California

Initial Coin Offerings Are a Mess - Week 11

Massive ICO Fundraising Is Under Fire

Following Facebook’s decision to block all ads related to сryptocurrencies and ICOs, Google announced last week that it will do the same by June 2018. The threat is real. Instagram, also affiliated with Facebook, blocked a promotion of our mascot dog's account whose name is Bitcoin. We appealed, but they didn't change their decision. These measures were best explained by Scott Spencer, Google's director of sustainable ads: "...we've seen enough consumer harm or potential for consumer harm that it's an area that we want to approach with extreme caution", he said.

Initial Coin Offerings appeared on a large scale out of nowhere during the middle of last year. This new way of raising money had been known before, but nobody really took it seriously.

It was the end of 2017 when the investment industry ― from Silicon Valley to Wall Street and beyond ― started scratching their heads. $5.6 billion was raised through "initial coin offerings" in 2017, which was shy of 10% of all venture dollars invested in the US. The big question ― will ICOs replace venture and private equity capital?

The Security and Exchange Commission wasn’t supportive of this fundraising tool, and unlike with crowdfunding, it made no effort to develop a new legislative framework. Rather, it simply equated ICOs to IPOs with all the draconic restrictions and requirements.

That didn't stop entrepreneurs, however, and just by March this year, ICOs raised over $1.6 billion. This is when SEC switched their neutral defensive stance to an aggressively offensive one. Subpoenas started rolling in from the SEC, and while most of the enforcement actions have targeted clear cases of fraud, the industry is expecting the change.

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Wyoming Wants to Be a Safe Harbor for ICOs

The state of Wyoming has always been cutting edge when it comes to entrepreneurship and is known for an entrepreneur-friendly business environment. It remained the same toward the crypto market as well.

Over the last several weeks, Wyoming passed five bills related to blockchain and cryptocurrencies, which became the first step to clarify how cryptocurrencies should be regulated and get the US Congress to take the matter seriously.

The main threat for ICOs comes from the US SEC, which views them as traditional IPOs, because the digital assets offered by ICOs are treated as securities. Although, this approach makes some sense, crypto assets are definitely worth their own legal framework.

Wyoming sets such digital assets — also known as “tokens” — as a new asset class, which upon meeting certain criteria, excludes their “developers or sellers” from securities laws, or as the bill states:

“A person who develops, sells or facilitates the exchange of an open blockchain token is not subject to specified securities and money transmission laws… (provided that) the purpose of the token is for a consumptive purpose, which shall only be exchangeable for, or provided for the receipt of, goods, services or content, including rights of access to goods, services or content; and the developer or seller of the token did not sell the token to the initial buyer as a financial investment”.

So Will Initial Coin Offerings Replace Venture Capital?

Although traditional venture capitalists remain bullish about their position in the entrepreneurial community, many of them are also trying to stay relevant in the new market and invest in ICOs, or prior to them. With recent legislative developments, chances are high that you may also find yourself in these positions, so you'd better learn more about ICOs today.

Not only did Wyoming become the first state in the world to pass a bill that clearly defines digital assets, all five bills created and lobbied by Caitlin Long, co-founder of the Wyoming Blockchain Coalition, are meant to drive innovation in various ways.

Does it mean that venture capital investors will see less of worthy startups in their portfolio?

The classical approach of venture investors is based on the concept of “smart money”, which includes a valuable advice, broad network and investors' know-hows for strategic development in addition to cash. There is, of course, the opposing concept of “dumb money”, meaning that investors provide only financial support with no practical help.

Critics of ICOs equate them to the latter, completely forgetting the many cases when startups faded away or couldn't start developing due to lack of funding, which in turn occurred because of the investors' different bias. ICOis a key to financing for many underrepresented founders such as women or ethnic minorities, therefore, when venture capitalists remain unresponsive, it becomes yet another source of funding. There’s no argument here since it gives entrepreneurs another chance. We should also expect many innovative business-models built on blockchain and tokenomics.

In other news:

  • Famous rapper and entertainer Snoop Dogg has announced his debut venture firm, which just closed with $45 million. As we've been saying for some time, background is irrelevant to becoming a venture investor. Skills and knowledge are. This is why we built VC Academy. If others can do it, you can too. Learn how to be a better VC every day.

Recent Industry Reports And Studies (free instant access):

2017 Annual Unicorn Report by Pitchbook
2018 Private Equity Report By Bain'n'Company
FAMGA Earnings Call Analysis by CBInsights

CBInsights looked at which peers each FAMGA company talked about and found that Apple and Google are clearly on each other's minds. Amazon, on the other hand, has nothing to say about the competition.

Reroute

Are you promoted to the level of your incompetence

What Venture Fund Became a Villain in the Industry?

Intro first

In his recent blog post, Hunter Walk points out that first-time fund managers don't pay enough attention to basic, but fundamental components of a venture fund as an enterprise. The message to venture investors Stop being a rookie and become a professional fund manager if you want to be successful!

To uncover and explain all the operations of a venture fund — the backend work that you rarely hear of — is the goal of Venture Capital Executive Program, the first comprehensive course on building a venturefund as a business. We truly believe that startups and limited partners of a venture fund are its customers, and venture capitalists should serve them right.

Role of Softbank Vision Fund in the industry

The largest VC or PE vehicle in history, and even the largest of buyout funds, the Softbank Vision Fund has significantly and globally affected the venture capital arena. With assets $100 billion strong, this Japanese investor dictates its own rules the industry has never seen before. Although fellow venture capitalists call Vision Fund "a great partner" in the media, this behemoth has already forced many other prominent venture firms to revisit their plans.

Venture funds Menlo Ventures, Benchmark, and First Round sold their stakes in Uber during the last financing round with Vision Fund, which hadn't been a plan. This secondary transaction brought almost $1 billion in cash to each fund, but only time will tell whether this was the right move or whether the funds should have retained their stock.

If Vision Fund pushed Uber's valuation 30% down in this deal, in the case of dog-walking service Wag, the fund insisted on a minimum deal size of $300 million and higher valuation than the startup and its current investors envisioned. As a result, venture firms NEA and KPCB, who had both been eager to back the startup, dropped out of this investment round.

In both cases, the Vision Fund lost co-investors, but did the rounds anyway, flexed its muscles, and demonstrated that nothing could stop it.

Patricia Nakache of Trinity Ventures states that: "...the Vision Fund has created this layer of “super-haves” [among startups]. And the “super-haves” are almost untouchable in a way because they’re in a whole different stratosphere from a competitive perspective."

We all know that overvaluation and an excessive load of money hurts startups rather than helps them. We'll see. 

What is Softbank Vision Fund's dealmaking strategy?

For such a considerable amount of money, the Vision Fund has a surprisingly short investment period — only five years from its final closing, which took place at the end of 2017. The Fund started investing in summer 2017, and has already spent one-third of its $100 billion already. Its fundlifetime period of 12 years is typical for a venture fund, however, with that much capital to return, the outlook seems somewhat optimistic even for a PE or buyout structures. For some reason, we have little doubts that the Vision Fund will somehow pull it off. 

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From what we’ve seen to date, it would be fair to say that the Vision Fund invests in key sectors slated to emerge as future megatrends with a purpose of consolidating its stakeholdings and becoming an industry leader in each of those verticals. This is yet another strategy in your VC arsenal along with some others we've discussed

The fund management even found a way out of conflicts of interest with some of its limited partners' investments. For example, Saudi Arabia's sovereign wealth fund had invested in Uber before becoming the Vision's Fund LP, while SoftBank, another LP of the fund, had invested in Uber's rival, Didi Chuxing. Currently, Softbank undoubtedly controls the ride-hailing market holding, along with stakes in other players such as Ola and Grab, and has even considered a stake in Lyft.

Softbank is said to be aggressively headhunting young investors from top venture firms who haven't become partners yet. The quest for fresh talent became so widescale that people who received offers started joking about, “Who hasn’t been offered a job at SoftBank?” We’re certainly curious to find out why these offers weren’t accepted. You can try your luck with Russell Reynolds, the recruiting firm Softbank hired for the headhunting campaign, but don't forget about dozens of other VC job available in the market today. 

In other news:

  • Travis Kalanik has announced his next life chapter and has become a venture capitalist. He's established a venture fund called "10100". Media isn't yet sure whether it's for real or not, since the fund's name is somewhat enigmatic. "10-100" is a known radio code used to signal a 5-minute break usually allocated for bathroom visits. If Kalanick is serious, it's unlikely he's planning to make a play to return to Uber and "Steve Jobs" it. He's also left his email for those who'd like to work with him at (ahem) "10100". Find vetted venture capital jobs here.

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One VC lesson a week

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Engaging articles showcasing venture investment tools and practices including exclusive comments from the industry professionals.

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An excerpt from one of the lessons

Innovative equity-based approach to determining a startup valuation

Often referred to as private tech unicorns, most of the Silicon Valley darlings grant their common stock as part of their compensation package for their employees (regardless of the form — whether it’s restricted stock units, option stock or additional options). If you amongst the proud shareholders of a Unicorn, you definitely hope that the company’s valuation will grow over time — along with the value of the stock you hold — due to your team and personal efforts and contributions to its success. However, the bad news is that even if you achieve this success leading the company to an IPO or M&A, there is actually a chance that you will not benefit much from your share in the company, if you benefit at all.

Rather than utilizing common metrics for determining a valuation, such as users or revenue growth, professors at the University of British Columbia and Stanford University actually discovered an equity-based approach to calculate the fair value of private companies. They proved in the course of their research that different types and classes of company’s shares may be critically different in value. Unfortunately, this fact often remains ignored by founders and investors until it’s too late to deal with it appropriatelyNot only does it lead to a company being overvalued, but, even if it is acquired or goes public, it can also drop the value of the employees’ shares dramatically. They calculated, as examples, that the common stock of Solar City, Good Technology and Nutanix was was overvalued more than twicewhat their company valuations showed at their most recent private financing round (before IPO or M&A). Common stock holders of JustFab, which is still held privately, was in a bit better position at the last round in 2014, with their shares being overvalued at 192%. Furthermore, the owners of common stock of Box should have been much more aware of their stock being overvalued by a staggering 269% (This, eventually, did not go well for the employees!)   

Silicon Valley definitely doesn’t like drawing attention to such failures — when founders and employees are left with little to zero return, while the investors receive at least partial return for their investments. How does this happen, and more importantly, how can we stop it from occurring? 

Let’s take a moment to refresh our memories. Shares can be what is known as common (which are usually issued to founders, employees and early stage investors) or preferred (which are generally issued to investors in later rounds), where preferred owners possess special rights and preferences that protect them from losing their investment in its entirety if the company fails. Therefore, the more money an investor decides to invest in the company, the more protection they will typically request. If the investor in question feels as if the company is asking for too much, overvaluing itself, the investor can still agree to pay the requested price, or a price close to the original amount, but in exchange for the security of absolute bulletproof protection.

What can such protection be?

To begin with, regardless of whether the company fails or not, most investors want the exact amount of their original investment back at the exit (liquidation preference). Some investors actually want their funds returned with a premium, which can often be as high as 100%. If, due to the protection right of seniority, such an investor is set to be paid off before all of the other shareholders, then they will receive 200% of their investment back, and the leftovers — if any — will then be distributed among the remaining shareholders.

Can it get any worse? Sadly, yes, there are even more volatile circumstances. After the initial investment amount (with any additional premiums) is returned to the senior investor, this same investor may also request the right to participate in the distribution of the remaining proceeds as a common shareholder, along with others (participation), acquiring even a little more for additional pocket expenses. These protection rights are most relevant for an M&A scenario. Yet, even if a company decides to go public, later stage investors can make the decision to block the IPO, get additional share compensation or save their preferential rights in the instance that the IPO doesn’t provide an acceptable return.    

Now, when you read in the news that new investors decided to back your employer at a price per share that is significantly more than the price in the previous round, you can imagine what they are paying for. You can probably start to recognize this as the point where things begin to go wrong.

These shares will, in effect, guarantee investors certain rights that will not be guaranteed to other types and classes of shares. However, to publicly announce the most recent valuation of the company, all the shares of the company, including the common shares that will have no protection rights like those described in the paragraphs above, will be multiplied by the exact price paid by the most recent investors. This is exactly the situation in which most of the current private Unicorns instantly jumped to an over $1 billion valuation. However, you can clearly see now why this math is, in fact, incorrect.

Rather than explaining the deal algebra, let me provide you with two other real-life examples to help illustrate how these rights can adversely affect the true value of your employee stock.

Example #1

In the last financing round (in 2014) before its IPO (in 2015), Square was proclaimed a $6 billion Unicorn, but not without the following strings attached: the investors were guaranteed seniority to other shareholders, with a payout of $15.46 per share at the time of exit, and a 20% return at the IPO. When this news appeared on its employees’ smartphone screens, they rushed to multiply their shares by $15.46. However, as these investors received such guaranteed preferential rights, the above-mentioned professors calculated that the fair value of the common shares at that exact moment was, in reality, closer to merely $5.62 — overvalued by $175%!

Triggering the protection rights of the latest investors, Square went public at $9 per share with a pre-IPO value of only $2.66 billion and had to grant those investors $93 million worth of extra shares, which diluted all of the other shareholders. Surely you can easily see how common stock could drop in value after these two events. Just as recently as February of this year, the shares of the company finally hit the last financing round price of $15.46 per share. Those Square employees, who had purchased employee stock options at $9 strike price, couldn’t have earned much until just recently, and most likely lost the money being not patient enough to wait for more than a year.

...

Collective wisdom for raising your venture fund

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What key challenges do venture capitalists face today?

Preqin released its survey of over 350 private equity firms globally to find out their views on the key challenges facing the industry.

Startup valuations remain the No. 1 concern facing venture capitalists, even in Europe and Asia, where valuations are noticeably lower than in the U.S. More than half of the surveyed investors believe that pricing for portfolio companies is higher than last year. As a result, many fund managers are raising much larger funds to get meaningful stakes when backing new startups and avoid dilution in the next rounds. We've talked about why this may be not a good idea in our previous newsletter.

What are the other important takeaways?

  • More than one-third of investors are planning for lower returns because of higher valuations in the market. Don't forget that venture capital indexes still underperform against or barely match the large-cap S&P 500 and the tech-heavy Nasdaq indexes over the 10-year period. Only 11% of fund managers are planning for increased returns. 
  • Thirty-nine percent of surveyed fund managers predict increased exit activity in 2018, compared to only 11% that expect activity to decline. Half of the surveyed investors expect more M&A deals to happen this year, and are split on the prospects for the IPO market. 
  • Alternative investment structures offered to LPs are growing in popularity. For example, 64% of surveyed fund managers offered co-investment option as of November 2017 (12% from 2015). They admit, however, that this structure slows down the deal-making process, requires additional expenses or resources, as well as creates some confusion due to possible different deal terms for co-investors.    

Advice from collective wisdom

  • Start raising your next fund early. Data shows that fund managers start pitching LPs for the next fund in 2.5 years from closing the current one.   
  • Be creative and offer alternative structures to sophisticated investors who are looking to maximize their returns and reduce costs of backing traditional venture funds.
  • Although LPs' appetites have increased, the competition for their money is still very high. When raising a venture fund, spend more time working with Asian investors - they are willing to invest in venture capital like never before. 
  • Work harder on creating additional value to your portfolio companies as competition for attractive investments has grown significantly. "Smart money" has to become "extraordinarily intelligent" nowadays. Third of surveyed fund managers reported they are finding it more difficult to find attractive investment opportunities.

Good news: Seed-investors for venture funds

Unlike the U.S. limited partners, international investors are willing to support emerging alternative fund managers and put their money where their mouth is.

RPMI Railpen (one of the UK's largest and longest established pension funds), along with the Alaska Permanent Fund Corporation (APFC) and The Public Institution for Social Security of Kuwait (PIFSS) have committed a combined total of USD700 million (with potential to grow) to Capital Constellation, a new vehicle that is designed to provide the group with an "unmatched access to the next generation of successful alternatives managers, enabling us to deliver long-term returns that will help us achieve our mission". 

The most promising managers will receive reliable and sustainable capital funding and strategic support, which will enable them to attract follow-on investment from other institutional investors.

This is how Julian Cripps, Managing Director of RPMI Railpen, explains their goal: “As a major global institutional investor, we are committed to using the size of our assets to invest wisely and influentially. We are not afraid to think innovatively and act boldly, as this initiative demonstrates.”

Good luck!

Add to your risk management check-list:

  • Those U.S. startups (and their investors) that hope to be acquired by foreign companies one day, need to keep in mind that the government may become a barrier likely disregarded or underestimated when planning exit strategies. Last week, the U.S. national security panel has blocked the $580-million sale of the U.S. semiconductor testing company Xcerra Corp (XCRA.O) to a Chinese state-backed investment fund. That comes after two other deals with the Chinese companies not approved by the U.S. government lately: money transfer company MoneyGram International Inc. (MGI.O) and chip maker Lattice Semiconductor Corp (LSCC.O). (Reuters)  
  • Since we are at it, Millennials impose another threat to companies, especially public. A couple of days ago, a celebrity Kylie Jenner wiped out ~$1.5 billion of Snap’s market value in just one tweet. We wouldn't be surprised if one or two traders had timely shorted the stock. (Bloomberg)
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Bigger is not necessarily better: Larger venture funds don't really advance the industry

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Where does the money go?

More and more venture firms raise new funds with total capital commitments of one billion US dollars and above. Only this week, two U.S. venture firms flexed their muscles by announcing newly raised funds. Battery Ventures raised $1.25 billion, and Norwest Venture Partners announced $1.5 billion just days later. Rumors about Sequoia Capital aiming to raise more than $5 billion for a single fund — an amount which would be the largest ever raised by a U.S. firm — have been circulating since December of last year. So where does all of this money go?

Indeed, the round size at every stage has increased over the last decade. We've also seen a historic high number of mega-rounds in 2017. Under these circumstances, some VCs explain that more capital helps them to avoid dilution and keep their pro rata share in companies.

Will larger funds be more successful?

One of the best performing venture funds, Benchmark, has preferred to keep their fund’s size around a humble half a billion dollars for the last decade. Bill Gurley, the general partner at Benchmark, believes that a “systematic swelling of money” will do nothing for the greater good, and that larger funds won’t necessarily achieve proportionately large returns. Mr. Gurley rebuffs the argument that more capital helps venture funds avoid dilution, calling it a “rationalization”, and maintains that a slow and steady approach has not hurt Benchmark’s performance (WSJ). Keep in mind, however, that Benchmark is primarily focused on early-stage startups, with a $1M - $15M preferred investment amount.

According to the MoneyTree report for 2017, early-stage investment activity has remained constant for the last five years. While average round size grows, the number of deals is stagnating, therefore, all these billions must be directed at something else.   

Some of the billion-size venture funds have a stage-agnostic investment focus, while others are raising this money for growth investments specifically. We have yet to see how all these billions will work out for later-stage funds.

How does this affect the industry?

First-time funds suffer from the trend of established venture firms raising larger funds. They raise less money — from $36 billion in 2016 to $26 billion in 2017 — and the number of funds dropped as well, from 283 in 2016 to 226 in 2017, according to a report in RealDeals.

This, however, doesn't upset the LPs. They are happy to invest in established managers who come back to market at a faster pace — just 2.5 years from closing a previous fund, and sometimes with new products — rather than taking the risk of investing in a first-time fund. Moreover, the number of investors reporting a veto on first-time funds also increased in 2017. All that is happening even though first-time funds continue to outperform established managers, showing on average consistently higher net IRRs, as Preqin reports.

As one LP told Chris Witkowsky, from PE Hub Wire: “You’ve got no incremental upside. If [first-time funds] do well, they’re going to do well like a Fund III, IV or V, but if they do bad[sic], there’s a lot more downside. The risk-reward doesn’t seem to be there.”

In other news

  • Peter Thiel is distancing himself from Silicon Valley, reportedly being "frustrated with what he sees as intolerance of conservatism in tech industry", according to sources familiar with his thinking. He's moving his family from San Francisco to Los Angeles, and contemplating his resignation from Facebook’s board of directors — a company he was the first investor to back in 2004 and whose board he has served on since that time (WSJ).
  • "Rather than having their capital cannon facing me, I'd rather have their capital cannon behind me, all right?" said Uber CEO Dara Khosrowshahi, confirming an open secret that during negotiations, SoftBank was willing to invest in Lyft if the Uber deal did not work out.

Recent Industry Reports And Studies:

2017-Q4 Silicon Valley Venture Capital Survey by Fenwick&West
2018 Coinbase Strategy Teardown by CB-Insights

2018 Fintech Trends 2018 by CBInsights
2017 Annual VC Liquidity Report by PitchBook & Deloitte

Webinar: How to get that job in Venture Capital?

At our 30-minutes webinar, you will learn how to stand-out among all other applicants for the job you want! 

What are venture capitalists looking for in new hires?
How to get noticed?
What should you bring to the table?

Our advice comes from the personal experience, so you won't find it on the Internet. There is no straight path to venture capital industry - we'll show you how you can climb in from the window and land your dream job! 

We know that thousands of people with different backgrounds and from different countries are willing to apply for a job in venture capital. That's why we designed the webinar in a way so that every group could benefit from the advice. Get your questions ready - we'll answer them too! 

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