The past 6 years have seen a ton of start-ups in the infrastructure management space. There has been a flood of new companies created to address the massive challenge of managing the plumbing and underlying compute and storage that facilitates the growth of the Internet of Things, Public and Private Cloud and Artificial Intelligence. The ease of raising funding from Angels, Venture and Private Equity has provided entrepreneurs an easy source of capital. What a great time to be a start-up….or is it? I equate the existing start-up space like a gambler (in this case an investor) debating whether to bet more chips on another hand, double down on the one that exists or walk away from the table.
2017 saw almost 4 billion internet users, Gartner predicted 8 billion things would have connected and AI became more prevalent and started to make an impact in our daily lives. We truly are in an information technology renaissance with the world becoming virtually smaller, new innovations shaping our daily routines and transforming the workforce to meet the needs of a digital economy. Every day we see new technologies make front page news, from online shopping to self-driving cars to cryptocurrency to robotics and AI. Each and every one of these next generation innovations requires core/edge computing capability, tons of storage to keep data that can be mined and utilized and networks through which the information can flow across the globe. The underlying infrastructure is evolving with new innovations from legacy vendors and start-ups to meet the needs of the market.
This exciting era of technology has led to crowd funding, angels, super angels, venture capitalists for different stages of growth and private equity all pumping money into new ideas and companies. From raising thousands to raising billions, the opportunity to stay private and raise as much capital as required has been the mantra utilized by most start-ups, avoiding the scrutiny of the public markets and all that comes with it. Venture and private equity funds have raised tens, if not hundreds of billions of dollars to invest in the next Amazon or Alibaba! Nobody wants to miss the party and everyone wants ‘in’ on the 10-20-50x return that waits upon an exit! This is analogous to sitting at a blackjack table and everyone around is winning so the enthusiasm keeps building, players keep increasing their bets, doubling down as there are no signs of a losing hand. Investors see their other investments or their peers making multi-fold via a unicorn exit and the exuberance continues in stride.
Unfortunately most of the start-ups never think about profitability and focus solely on customer acquisition, top line growth or worse yet, number of users/clicks without any direct correlation to financial metrics. This focus on customer acquisition, top line growth is an essential component of a company’s growth curve but at some stage there has to be a means to profitability. Start ups in today’s world don’t worry about profit as they are more focused on raising the next round of funding and then the next and the next and before long the company has raised tens if not hundreds of millions without earning a dollar. What’s amazing to me is that investors continue to do round after round of investment despite knowing that throwing good money behind bad doesn’t make sense. The challenge is, once they are ‘in’, they have to keep on investing as they need to show their limited partners (LP’s) that the investments they’ve made are continuing to progress forward. Keeping the blackjack analogy in mind, think of the same table that is full of exuberance and a couple of the players lose a hand or two. The gambling mindset is one where the loss is a fluke, it won’t happen to me or it definitely won’t happen two times in a row. If the gambler keeps playing and maybe even increasing the stake, a win will yield rewards.
What you will see in 2018 is that a large majority of the start ups will end up closing or being sold for pennies on a dollar. The reason is not because the technologies are not good, it is because the companies are not profitable, they are not within site of being profitable and the investment dollars for new capital is drying up. There are several reasons for investors not willing or able to invest further. First, the investors have a time horizon that may be coming due. Most funds have a ‘life’ for each fund raised, typically 10 years from inception, so a fund is bound to exit from what it has invested in before the time horizon runs out. Secondly, to go public requires delivering on numbers. The public markets are rewarding companies that meet or exceed forecasts and just as harshly killing those that don’t. Financials do matter and the public market is clear that you must show profitability or a means to it, in order to continue to be supported with a strong share price. There are exceptions to this but even those exceptions face a crazy roller coaster ride to their share price. The other option is a private exit, an M&A to a strategic. The challenge to this is that most large companies are extremely smart and have fairly mature M&A processes, not to mention activist investors that are monitoring every major spend. They are not going to pay multiples if they know the company is going to run out of money and is on its last breath. In addition, they will not want to take on a transaction unless it is strategic and can be additive to their earnings, or has a diminutive short term negative earnings impact. Going back to my gambling analogy…the gambler has a flight to catch and needs to leave the table pretty soon and he/she must decide what to do, should they bet more chips and double down, take a new hand or simply walk away? My feeling is that many in 2018 will either take ‘even money’ or take the loss and walk away!
To my fellow entrepreneurs, we are the dealers of each hand, making the gambler win is in our best interest. Focus on profit and the analogy ‘the house never loses’ will definitely come to fruition. Best of luck in 2018!