There is a lot of chatter about valuations and round size recently – a sure sign things are getting a bit frothy again. It’s the entrepreneur’s choice relative to what the market will bear for how much to raise and at what time/valuation. This post is about a cap table limitation in a high valuation and large capital venture round of financing.
Valuations were most recently escalating to higher levels in the first half of 2008. There were plenty of what I call “beach muscle rounds” of financing being raised – you know the kind where the entrepreneur brags he raised some excessively large amount of venture capital in a diligence-averse short period of time at a startling valuation. Once Lehman Brothers crashed in September 2008, everything stopped cold. We saw a high percentage of deal flow evaporate out of the VC system, the vast majority of which were a welcome good riddance to “sub-prime” entrepreneurs who realized they would not be able to raise money and promptly reverse-commuted back to a day job. Most of the remaining entrepreneurs, many of whom were seasoned vets in venture backed technology companies or truly dedicated up-and-comers, chose to bootstrap the new venture and wait to raise capital. They realized that very few VCs were funding anything new, and even if they did get a term sheet for their venture, it probably wouldn’t be on terms they would find very attractive – we’ll call that a “sand-kicked-in-your-face” round of financing.
Start-up financing fell to record lows, valuations dropped, and this crop of entrepreneurs became the most capital efficient class by necessity. These founders narrowed focus, reduced expenses and expedited time to market for revenue generation to offset capital burn. Deja-vu, it was just like 2002-2003 all over again after the mighty Bubble 1.0 burst. Key strengths of that 2003 crop of capital efficient companies were that they had lots of options and could operate from a position of strength (low burn, low valuation, revenue producing and often profitable) when deciding to either raise additional capital or sell the company for a valuation that produced an excellent return for shareholders including the entrepreneurs.
A mere 18 months ago everyone saw the Sequoia Capital‘s “R.I.P. Good Times” presentation, a great marketing piece on the sudden push for capital efficiency, especially the part about “plan that you will never raise capital again”. It was great timing for it, perhaps only better if many funds had promised similar investment strategies when initially raising capital from their LPs. I remember saying to my partners David and Marc, “You can try to make a company capital efficient, which is operationally difficult enough, but you can’t make a cap table capital efficient” meaning, the investors paid the price they paid upon investing their capital, which is not reversible. In fact, changing a company from one that has been funded on a capital intensive plan into one that is capital efficient creates a cap table that is suddenly incredibly inefficient and often fatal. Why?
The company transitioning from capital intensive to capital efficient will reduce its top layers of executives, reduce much of the middle management and admin staff, and generally reduce salaries. Vendors and 1099 contractors with be terminated or cut back on fees. The company, with far less resources working for it, must then narrow its product and focus to hone in on producing sales to paying customers quickly, so the company can generate revenue and offset burn. The original growth projections on which the company raised money get reduced dramatically and most likely stretched out over a much longer time horizon. This may be more healthy and reasonable for building a business, but the company is still saddled with the original capital intensive aggressive growth valuation.
Worse, that original aggressive growth plan came not only with a correspondingly high valuation but also a VC expectation of a 10x return on that valuation as an investment goal. Very few companies grow well enough so as to achieve that 10x goal in the first place, so how is one that is now scaled back ever achieve it? Or more realistically, how will the company ever even attain its post-money valuation in any reasonable period of time? It probably won’t, which is why in part the Sequoia advice to never expect more capital may be correct even if/as the markets come back – because the cap table itself impedes potential future investment without dramatic restructuring to the company, its key people and all shareholders based upon greatly lowered growth plans and elongated timeframes. This often makes it virtually impossible to raise more capital and leads to a high mortality rate for such companies, a damaging result for everyone involved.
How many entrepreneurs who once flexed mighty beach muscles are now merely avatars for dead men walking? How many great entrepreneurs are chasing an exit burden like life after 30 in the carousel of Logan’s Run? To all entrepreneurs out there raising rounds of financing now as things get frothy again, just say no to the temptation of a beach muscle round of financing as you and everyone who relies on you will have to answer for it.
