Confessions of Venture Capitalists: How to Milk a Unicorn

Those who wonder what the hell is going on with the accelerating number of startups getting billion-dollar valuations and above, please raise MY hand.
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Those who wonder what the hell is going on with the accelerating number of startups getting billion-dollar valuations and above, please raise MY hand.

According to my favorite source on this one - CB Insights, which keeps updating the full list in real time - there are, at the time of writing, 133 start-ups each with a value over a billion dollars for a total value $492 billion. Based on my research, this is a sum that is ten times larger than the whole amount of VC investments in 2014.

Nicknamed "unicorns" such companies were supposed to be as rare as Google (NASDAQ: GOOG) which set its IPO for $2.7 billion almost a decade ago. Now they seem to be everywhere, with the likes of Uber ($51 billion in valuation) and AirBnb ($25.5 billion in valuation) leading the herd. Their valuations are mysteriously higher than the market capitalization of the majority of companies in the Fortune 500 - publicly traded companies that are supposed to enjoy a sizable premium in valuation for their liquidity.

As someone who advises entrepreneurial ventures on financing strategies and teaches Entrepreneurial Finance for pre-MBAs, I am fully aware that when it comes to valuation, we move to the inexplicable world of perception. The classic valuation methodology got disrupted - sorry McKinsey - by what is called the Venture Capital Method, where venture capitalists are looking for an exit within 3 to 5 years and from an expected exit price calculate backward to the post-money valuation today, taking into account the time and the risk they bear.

And this is when it gets really interesting. I wrote in my previous piece that, fundamentally speaking, the "pump-and- dump" theme is the very nature of quite a few pre-IPO high-tech companies' offerings. Now, what if there is no "dump"?

In other words, now as companies are staying private much longer enjoying as so-called "private IPOs", VC-backed private market valuations exceed public market valuations by 100% to 200% in many cases, making it more difficult, if not impossible, for these companies to have an IPO in the current environment.

Without bringing up a "B" word, are you thinking what I am thinking? Shouldn't unicorns have gone public long ago? Why are VCs playing at such late stage financing rounds - do they really believe that unicorns will eventually become cash cows? Since it is a brand new phenomenon - how will it all play out?

Most importantly - how are VCs feeling about it - are they concerned?

I reached out to several VCs as well as David Weild, a former Vice-Chairman of NASDAQ and someone who is considered to be "the father" of the JOBS act, and realized their responses would require a much bigger article. Or a novel. For now I am squeezing in below, some of the answers I received.

Tim Draper, venture capitalist, Draper Fisher Jurvetson

"Yes, I believe we have a problem. Public offerings are being regulated out of existence, so companies would rather stay private, but private companies have few buyers and no trading so there are big liquidity issues, which in a down market can translate to business failure and people losing their jobs.

"There was an opportunity created when congress passed the JOBS act for private companies to be tradeable, but regulators have added so many restrictions that they have made it so it makes no business sense to use it.

"I expect leadership in securities trading is going to go to the country who frees up financial markets the most. This used to be the USA. Countries become rich when their regulations are clear and make sense to business. Ours aren't and they don't.

"A lot of this has been under the auspices of protecting widows and orphans from losing their nest eggs. Instead of just widows and orphans, our regulators have set up a system where we all lose our nest eggs."

Andrew C. Romans, Venture Capitalist, Rubicon Venture Capital

"I do not agree with (your point). These unicorns are successfully raising amounts of cash equal to or greater than the amount one might expect them to raise in an IPO. Because they offer a senior liquidation preference to the new investors, the new investors can support unusually high valuations, because the newest investor knows that she will get 100% of her capital out of the deal prior to any other investor getting their money back.

"I am not concerned. IPOs are expensive, time consuming, a huge distraction from growing the business and ongoing compliance is a drag for a high growth technology startup.

"Capital that used to go into an IPO started to go into later stage pre-IPO financings. We witnessed Fidelity and Carl Icahn investing in financing rounds of $100m+ or in the case of Lyft, $630m. That is enough money to achieve many of the core objectives of an IPO without the unattractive burden of an IPO and ongoing compliance. These huge financing rounds provide founders, employees, angel and VC investors with liquidity."

Rick Smith, Venture Capitalist, Crosscut Ventures

"I think it's tempting to try to view venture valuations through a strict economic prism, since it "feels" better if there is some rubric or formula that is applied. The reality is there is still a fair amount of art that goes with the science in venture investing. A VC needs to consider the dynamics of the team, the growth of the market, the entry of competitors, the change in the rate of customer adoption, potential exits and timing, etc. All of those factors are important, and the identification and weighting of those is not easily reduced to a formula. That said, the later in a company's lifecycle the more that traditional financial models can provide more meaningful input on valuation (discounted cash flow, discounted price to expected IPO, etc.)."

Will Bunker, Venture Capitalist, GrowthX

"I think VC's deliberately over valuing a portfolio company will end up being suicide. One of life's great moments of truth is: what do you do when you think no one is watching? I know everyone thinks that the management fees drive behavior in this game. If that is the only upside you care about, you won't be here in 10 years. I will keep doing this even if I am my only LP, because I want to help startups succeed and change the world. One of my criteria is: do I want to live in the world the entrepreneur is building?"

David Weild, Chairman & CEO at Weild & Co, the "father" of JOBS act

"It totally bears out my point that venture capital is starting fewer companies and moving up market (later stage). When is venture capital no longer "venture" capital anymore? Isn't the name "venture" misleading? Doesn't the industry need to come up with a different, less confusing name? Isn't it really "mezzanine" finance?

"(But) I don't get too upset about the "venture" capitalists. The regulators created a market structure that gutted the small IPO market. That meant that "venture" capitalists would now eschew singles and doubles (the small IPO model of first and second bases had been taken away) and were forced to focus on home runs (or selling companies out early to corporate buyers) - massive markets with massively scalable business models that would now be required to eclipse the now ridiculously high IPO thresholds that the SEC had caused.

"I don't begrudge venture capitalists for evolving in ways that allow them to profit. I do lament, however, the tragic impact that this has had on our broader economy."

What do you think? Please put your comments below, reach out to me directly or join our discussion on November 6th, 2015, Los Angeles, at the 4th annual Global Alternative Funding Forum I am producing.

Victoria Silchenko, Ph.D. is an alternative funding expert, Founder & CEO of business consultancy Metropole Capital Group and Creator and Producer of the Global Alternative Funding Forum set to be in Los Angeles on Nov 6th this year. She is also an Adjunct Professor on "Entrepreneurial Finance" at CalLutheran University and is on the Board of Los Angeles Venture Association.,
Twitter @MetropoleGlobal

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