Every day I read about how a company raised “X Millions” from a VC, and it is broadcast across all media outlets. The round of funding varies depending on the stage of the company. The early-stage companies have either no revenue or minimal at best, and most of these companies are selling a vision that, in today’s marketplace, venture capitalists don’t want to miss out on. There are many VCs that may have passed on Uber or Facebook or LinkedIn and feel that they definitely don’t want to repeat that mistake.
These early-stage companies are getting valuations that are astronomical in any historical sense. I recently read an article where a company that is still pre-revenue received a $200 million dollar plus valuation. These early-stage companies are typically raising $1+ million, and lately it seems like that amount has increased to $10 million+.
The next batch are growth-stage companies that have $1-$10 million in revenue and strong growth rates and have raised a round or two and are now raising more funding to support the growth to the next tier. These companies are usually incurring large losses but have a very strong year-over-year growth. The growth could be measured in terms of revenue, users, hits, or any other means that attracts an investor willing to write them a check. Traditionally these checks were between $5-$20 million, but in today’s marketplace you are seeing funding range from the traditional $5 million to $50 million+. The decision of how much funding can be raised relies on how the company compares to others in a similar market and is more an art than a science.
The late-stage companies are ones that are around or over $20 million in revenue and continue to see high growth. Again, the “high growth” is defined by the beholder and doesn’t necessarily mean growth in terms of purely revenue. These companies in prior years would have looked to leverage the public markets to raise capital to support growth. Today’s world is different and affords them the ability to raise private rounds of growth from venture firms, private equity companies, or strategic partners. These companies are nowadays doing a round D/E/F or even G. What is surprising is that most of these companies are not only operating at a loss but do not forecast profit for the “foreseeable future.”
When I read some of the valuations that companies garner today, regardless of stage, I wonder if I wasted money getting an accounting and finance education at NYU. There we were taught about P/E ratios (Price to Earnings) and EBITDA multiples (Earnings Before Income Tax Depreciation and Amortization), as well as discounted free cash flow, as a means for valuation. None of those metrics seem to matter in today’s world, at least not based on the funding that start-ups are raising.
I am by no means questioning what the funding has provided, as we would not have the likes of Tesla, Google, Alexion Pharma, Regeron, and many many others without the investments they had in their early stages. We definitely are in an era of innovation, and investments in new technologies will revolutionize our and future generations’ lives. These new creations will add millions of new employment opportunities and drive trillions of dollars of potential global economic growth. But I am concerned with the fact that we may have reached a level of “irrational exuberance,” as ex-Fed Chairman Alan Greenspan was famously quoted as saying.
Capital has always been a “must have” for companies to kick-start, survive, and thrive, but too much capital also leads to excesses, and many times outright waste, if not managed and controlled. I believe that companies today have lost the focus on profitability and cash flow as they look at the ability to raise the next round of funding as their means to fund losses. Each time a capital round is raised, it does not come free! It comes with having additional members in the boardroom to scrutinize management, the dilution of founders’, management, and employees’ equity holdings, and the cycles and time spent on pitches to raise funding rather than running a business.
I love watching Shark Tank, as it truly is a great way to understand how raising capital works. Every week new ideas are pitched, and if one of the five investors likes the idea, they make an offer. What you find is that there is no metric to the offer in terms of consistency in valuation. The valuation is purely based on instinct — what the investor is willing to take in equity against the risk(s) that he or she envisions. I find that one of the angel investors in the show, Mark Cuban, to be fantastic at assessing a company. He keeps harping on the need to focus on ensuring a product is fully ready to be taken to market, on how the entrepreneur has to have sales to show scalability and is now looking for capital to support growth, while ensuring there is profit or foreseeable profit.
Although this may sound basic and somewhat like common sense, it is something that is forgotten with most new companies looking to raise capital today. Going beyond the early-stage companies, raising capital may be required to support growth, but ensure you raise “smart capital.” Don’t raise money to fund losses — or, worse yet, to get more users and clicks without any financial metric associated to it — but to truly support growth. Raise funds to build scale and ensure that the focus is on profitability and not just an increase in the topline. The idea that continuing to accelerate revenue will one day lead to profitability is a recipe for disaster, as most times the revenue numbers don’t hit projections, and now the losses that were expected end up being far greater, leading to lack of adequate cash and in turn another funding round. What a vicious circle! If your company can generate profits while maintaining strong revenue growth and market traction, then you as CEO and management control your own destiny.
The media also needs to stop writing only about how much a company raised but rather focus on how much a company makes. If you look at the billionaires list, those on top didn’t create loss-making companies but rather were focused on capital efficiency, driving strong, free cashflows in their businesses and ensuring that they were delivering value in the marketplace which would lead to longevity for their companies. There is a lot to be learnt from the likes of Buffet, Gates, Ellison, and Walton, as there is a reason those names are known by all.
Then again, I may be completely off and should ask for my $100k back from NYU! 😊