This content was created by Tim Draper. This content was uploaded by Tim Draper. This is a YouTube talk titled "The Startup World Right Now | John Somorjai" (posted 2016-06-08) in which John Somorjai gives a presentation on the startup funding environment. He reviews trends and data — excess funding driving inflated private valuations, a sharp decline in IPOs (23 IPOs last year, one tech IPO so far that year), valuation disconnects between public and private companies, prevalence of down/flat and structured rounds, and M&A as the likeliest exit. He explains preferred vs. common stock and how employees can be left with little in many acquisitions (examples: Gilt, Fab/Goode), cites CB Insights cohort data on fundraising survival, and advises founders to control burn, focus on building businesses (not just features), and be valuation-sensitive for acquirers.
Chapters
Okay, so I'm gonna get into a little bit what's going on in the startup world because it's really changed over the last year, and this is information you guys should all know if you're about to start a company. So one of the things that has happened is that there's been too much funding. There's been sort of this massive overfunding of companies, that has really driven up valuations to levels that we haven't seen in quite a while. And companies are raising a lot of money that they use to spend on sales and marketing and product development, and they have huge burn rates and are really, it's unclear whether a lot of these companies are actually ever going to get to profitability. And the other thing we found is that as the public markets corrected, there's a disconnect a valuation disconnect between the valuations that public companies are getting and private companies in the same space are getting. The other thing that's happened is IPOs are not happening, and I'll share with you some data on that. There are fewer IPOs, there's this valuation disconnect, and what it's resulting in is it's just getting harder and harder to raise money. And a lot of the rounds that we've participated in recently are actually down rounds, flat rounds. They're rounds that have a lot of structure to them. And do you guys know what structure is in the VC context? So you have super rights. So basically any investor that will invest in your company gets special rights that no one else gets. that you might not have given to other investors that allow them to make more money and have more protection. And so this is kind of a key theme that you're seeing. And part of it goes back to this point about there being fewer IPOs. So if you just see over time, there have been fewer and fewer IPOs, and last year there were only 23 IPOs. At the height of 2000, there were 350 IPOs, and it just has gone on from there, gone down from there. 23 IPOs last year. There's only been 1 technology IPO so far this year. This is a problem for a lot of companies and a lot of investors because it means that really the path to liquidity that's open to them is M&A as an exit. And one of the things that also has happened is the IPOs that have actually made it out have performed really poorly. So that one IPO, SecureWorks, that happened last week has 0% return on it. What this chart shows is, Last year, there were 23 IPOs, and from the moment they went public, which is the gray line, to the end of the year, the best performing IPO had a 26% return over its IPO price, and the worst had a loss of 12%. But this was like Fitbit, and Fitbit is now trading below its IPO price, so this was sort of a moment in time that didn't last. But you can see 2013 was probably the best year to go public, and it's just gotten worse and worse and worse. So again, it means that M&A is probably the most likely exit. OK, so private company valuations are going down, and I think you know that. I won't spend time on that side. But investors think it's actually gonna get a lot worse. So 91% of investors think this year the valuation environment will be either marginally down or significantly down. And this brings me to the fundamental problem. OK, so we had unicorns, and now we have unicorpses. And these are companies that have billion-dollar valuations. got sold and investors ended up pocketing all the money and employees got nothing. And so this is what you guys need to understand is the difference between common stock and preferred stock. Do any of you in this room understand that? No. A few of you, okay. So when you start a company, you will have what's called common stock. You will have equity in the company. that has no special rights or privileges, and that's what you will give to your employees. But when investors come in to invest, they get what's called preferred stock, which gives them the first money out. So when your company is sold, they get paid first. They also get special rights to dividends, and they get They get a whole series of special rights because they're giving you their money, and so they want to make sure that they're protected. Now, the reality is there's very little downside for most of these investors because almost every company that gets started, unless the team is not very good, they usually get sold for about what was put into them. And so the investors very typically will at least get their money back. So the risk is very low. But often the employees walk away with nothing. Or they just get, the new company that buys them gives them stock in that company, but they're starting from ground zero. So that's what happened with Gilt and Good last year. These are companies that raised, Gilt raised $270 million, they sold for $250. So the investors got 100% of the $250, and employees Got zero. Goode was a similar situation. There are actually a whole bunch of lawsuits around Goode because people claimed, employees claimed they didn't know that this was going to happen to them. It's one of the things you have to think about. I think a lot of founders are very naive about this point, and they freely take money and they focus on the valuation. Oh, I have a $100 million valuation. I have a $500 million valuation. Well, you don't. That's the valuation of the preferred stock that investors are putting in. But it's not really the valuation of what you have. And so it's just something you have to think about. And this is important when we get to the M&A context in a second. I'm gonna go through some data for you first. So if you, CB Insights did a good study of the companies that started in, 2009, there were 1,027 seed or VC-backed tech companies that started in 2009. Of those, 411 were able to raise a second round, 232 a third round, and so on, until you get 9 that were able to raise a sixth round, had a billion-dollar valuation, and that included Uber, Slack, and Instagram. It was a very special group of companies. of companies, but there were 1,000 companies that really didn't get to that level, and of those, 77% of the 1,000 are either dead or walking dead. It just goes to show you that it's not— this is really, really, really hard to do, and so you have to focus on the right things, and you have to focus on building a business and not building a feature. And you have to make sure that you're not raising too much money and wasting too much money, because that just kills you in the M&A scenario, because most companies are acquired, they don't go public. And so these are the sorts of things you have to think about. If you look at last year, there were only 5 private software companies that were sold for more than $500 million. And the $500 million number is important, because that means everyone made money. That means the employees were happy, the founders were happy. That's a really nice, meaty M&A return. Whereas you get into the Guilts of the world, and that was a $270 million exit. You see that there wasn't really enough to go beyond the investors, 'cause it doesn't take $500 million to build a great company. And that's why I use that as kind of the benchmark of where people should be happy and they made money. But there were only 5 of those exits last year, And then this year, there have been 3, but these are all public companies, actually. So Cvent, Texturn, Opower, which was announced today, these are all public companies that IPO'd. So just to give you a sense of just how few large deals there are. And I told you we bought 8 companies last year. This you can see what some of the other large acquirers in enterprise software are doing. There was a lot of M&A activity in 2012 and 2013. You can see what these companies were spending, billions of dollars on M&A. Then that continued into 2014. SAP buying Concur was the largest enterprise sale that we've seen. Then it really slowed down a lot in 2015. You can see the dollars spent. By these large acquirers just got smaller and smaller, and then in 2016, it's starting to pick up again, but again, it's not big, they're not big exits for any of these companies. So the other thing we've seen is that I talked about the disconnect in the public markets on valuations, so 2014, companies in our space, which is enterprise cloud, were trading at the height, and then it's gone down from there, and then there was a big correction that happened this year, and we're now trading near the historical mean of 4 times revenue. This is my last slide, and this is just explaining a little bit of what we see happening next. On the private side, companies really need to focus on on controlling their burn rate and sustaining themselves. There's going to be not necessarily a winner-take-all phenomenon, but it's not realistic for the same type of company to just get tons of funding that does the same thing as another. You'll see 1 or 2 winners in every space. There are gonna be a lot more flat rounds, down rounds, and lots of these structured deals to raise money. On the public side, we have to be very valuation sensitive when we're buying companies because we get valued by our investors based on our profitability. So we can't acquire a company with a large burn rate. And so you're gonna just continue to see burn rates challenging feasibility for M&A and a valuation crunch where oftentimes M&A is going to happen at a lower price than what the last round value was.
