Photo: iStock
Photo: iStock

Opinion | Venture capital firms now want to get ‘boring’

Venture capitalists are urging startups to be guided by more traditional metrics

We favour the sensational and extremely visible. This affects the way we judge heroes. There is little room in our consciousness for heroes who do not deliver visible results or those heroes who focus on process rather than results, writes Nassim Nicholas Taleb in his book—The Black Swan: The Impact of the Highly Improbable.

Such human behaviour bias to favour and celebrate “visible results" over everything can perhaps best explain the last decade of the startup landscape—where young tech companies were fuelled by a wave of venture capital-funded excess, which encouraged fast growth above all else. The “sensational" bit explains why we are overawed with the likes of Elon Musk and theatrics involving fast fingers on Twitter, or a 25-year-old founder’s overcommitment to his loss-making startup by over-leveraging himself, or a larger-than-life vision of seeing flying cars.

But some of the recent disasters of the startups especially at the public markets are having VCs to question such biases or upend their playbook—to go for “boring" instead of “sensational" and increasingly focus more on the “process" than “extremely visible" results.

Successful venture capitalists, such as Fred Wilson and Brad Feld, globally known for their industry wisdom, are now urging startups to be guided by more traditional metrics, such as ‘unit economics’ and ‘guidance to profit’ and calling out the ‘cult of personality’ culture which often masquerades as thought leadership.

There are concerns being raised largely on three factors:

1. Making a strong case for gross margins: Public market investors value visible margins. A look at the numbers and picture will be clearer. Consider three tech unicorns with widely varying gross margins: Zoom, Uber and WeWork. Zoom, which can boast of exciting gross margin of 81%, is trading at over 15% premium. Uber, in comparison, with suboptimal gross margin of 46%, is trading at a 27.52% discount and WeWork with an abysmal 20% gross margin was expected to get listed at 68% to 78.7% discount, before its initial public offering (IPO) plan was shelved. These statistics are not aberrations but represent a close correlation between margins and valuations.

Companies such as Cloudflare (77%) and Datadog (75%) that have reasonable gross margins have been received quite well in the public markets, compared to those, such as Lyft (39%) and Pelotan (42%), with suboptimal gross margins that are trading at considerable discounts to their issue price.

Price discovery in public markets is a lot more rational, and even though there could be temporary speculations, in the long run valuations in public markets boils down to time tested metrics of ‘margins,’ than an obsessive focus on ‘growth’. This essentially goes back to boring entrepreneurship 101 which says that without some consistent growth and improvement, your business will probably die and decline. And without profits, you have more of a lottery ticket than a true business.

2. Software is eating the world: There are a number of sectors in which Software has already gobbled up the traditional - telephone directories, communication, music, and now distribution has largely gone online. And yet, public market results show us that “business model" matters. It is not possible to masquerade a traditional business model under the guise of “tech" and demand valuations akin to “tech". It wouldn’t work.

3. Cult of personality culture: VCs are faced with a dilemma—rein in the charismatic founder to avoid any mistakes or allow him full rope to innovate, experiment, fail and succeed. In the past, VCs have tilted towards the latter, because charismatic unbound founders, such as Elon Musk, Mark Zuckerberg and Steve Jobs, have delivered results.

Venture capital had become ‘sensational’ - attracting more and more capital and talent, and backing trendsetting companies with larger than life mission, such as ‘...elevate the world's consciousness’ or ‘…powering global commerce all around the world,’ in the hopes of finding and funding the next Alibaba or Facebook.

Feld tries to differentiate between personality cult and thought leadership. Quite often former may masquerade as the latter, making it difficult for outsiders to differentiate. While, thought leadership is about experimentation, feedback, curiosity and analysis contributing to perfection in leadership, cult personality is about reinforcing one’s ego by proving his vision and ideas are always correct, and it contributes to god complex.

At times it is hard to differentiate between the two, but the high profile exits of Adam Neumann and Travis Kalanick tells us that it is a skill that one has to nurture.

As huge criticism is being drawn towards startups, it is now also time for VCs to take some responsibility. As someone who has tracked the private markets for more than a decade now, it appears that investors seem to be changing their goalposts a little too often. In the past, especially during the periods of excesses, they have given signals that frugality is not necessarily a virtue appreciated by them anymore. They have, in as many words, said that often winner is decided by the quantum of capital raised. Opacity has to give way to a tighter corporate governance especially when the startup is prepping to go public. In fact, this is at the heart of the problem—preparing startups for a public outing. All is great when you and your partners are the sole owners along with venture capitalists who understand uneven results, but when you are listed, there is an analyst who “judges" your results and reads too much into them. He likes routine rewards—the key which startups will have to learn. VCs who often refer to their investments as a “baby", will have to handhold them for adulthood where “process" takes precedence to deliver “routine" results, where the “less visible" is appreciated or as Taleb puts it when “relevant becomes the sensational".

Shrija Agrawal is Mint’s associate editor. Due Diligence will cover issues in India’s venture capital, private equity, deals and startups space.

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