Pando

Sorcery! Bloomberg apparently just learned how venture capital works

By Michael Carney , written on March 17, 2015

From The News Desk

Apparently someone at BloombergBusiness -- the magazine formerly known as BusinessWeek --  just graduated from their VC as a Second Language course.

What other reason could there be for publishing this embarrassingly dumbed down and altogether alarmist guide to the lingo and deal terms that are widely known to anyone who has spent any time in and around the startup industry?

In addition to revelations like -- gasp! -- private market valuations don’t map precisely to a company’s real-time value and many startups generate little to no revenue, the report offers shockers like... deal terms often provide venture investors downside protection. Serious question: Is it really possible that a financial publication has never heard of a liquidation preference? (Newsflash: Lenders get paid out before shareholders too, in a bankruptcy or sale.)

On behalf of everyone who pays attention to the venture market outside of the one to two years per decade when it’s the cool thing to do, may I say: Duh. For decades, VCs have joked to hopeful entrepreneurs that they’ll gladly grant them any valuation they want as long as the investor can set the rest of the terms. That a near-century-old publication like NotBusinessWeekAnyMore had to conduct a special investigation to discover the concept is just plain sad.

BloombergBusiness’ authors write:

“Snapchat, the photo-messaging app raising cash at a $15 billion valuation, probably isn't actually worth more than Clorox or Campbell Soup. So where did investors come up with that enormous headline number?”
Do tell. Was it sorcery? Or maybe it involved a dart board. After all, the authors do describe the method behind these deals as “secret.”

Judging by the tone of the piece, these deals are not just complete lunacy, but somehow shady and scandalous too, conducted in “backrooms” even. I think the word they may be looking for is “conference rooms.” Are we supposed to be suspicious that negotiations for privately held companies are held in private? Isn’t that precisely the value of being privately held? Where exactly would the authors like Uber and AirBnB to secure their next round of financing, the neighborhood Starbucks? Or maybe the proceedings should be live-streamed for public consumption on CNBC (or Meerkat).

And heaven forbid that investors who are betting often tens of millions or even billions of dollars of institutional money – remember, this is money that regularly comes from public pensions and endowments – on the riskiest asset class around, ask for downside protection in exchange for granting valuations based as much on potential as on performance. Or maybe that’s the issue, that companies that are inventing the future in real-time don’t know exactly where their businesses will be in 12 to 24 months, as if this is either novel or newsworthy.

BloombergBusiness continues:

“The practice obfuscates the meaning of a valuation, which can become dangerous down the road because private investors aren't taking the same risks a public-market shareholder would.”
Really? It’s public market investors, with the benefit of Sarbanes Oxely, audited financials, and second-by-second liquidity, who are taking the bigger risk?

Since BloombergBusiness seems intent on speaking in cliches how about this one: “no risk, no reward.” It’s not as if public market investors regularly generate 1,000-times or better returns the way many of early startup investors can. Then again, it's rare that a stock will go to zero overnight either.

At the same time these private market investors are agreeing to have their money locked up for, in most cases, multiple years. In exchange for the inability to sell at will if things go south, these still-nascent companies routinely grant their investors some form of downside protection. Do public market investors not hedge their bets in much the same way through the purchase of options and derivatives?

Honestly, did the publication even do a Google search? Or, ahem, watch a PandoMonthly interview? Entrepreneurs like Stewart Butterfield have been open about pretty much every single “revelation” the magazine has unearthed.

“Unicorn,” the BloombergBusiness authors would have their readers know, is not just a playful way of describing companies valued at more than $1 billion. Rather, it’s a “made-up word based on a creature that doesn't exist.” The horror! Because remember, “wolves” truly do work on Wall Street and “corporate raiders” like Michael Milken really did charge into high rise offices and steal employees’ wives and livestock. Spare me.

If this were all that was wrong with the article, it could be dismissed as a clumsy Venture Capital 101 primer for industry outsiders. But when the arguments aren’t obvious, they are patently wrong or disingenuous. For example, the publication trots out fears of dilution by founders as if it’s something entirely unique to the private markets. Of course, that’s not remotely true. When public market companies raise new rounds of capital, or issue equity-based compensation to attract and retain employees, existing shareholders get diluted in much the same way.

In fact the biggest single factor driving valuations up are Wall Street investment firms that are entering the private markets paying nearly any price to get into a company before it goes public – a fact that this financial publication conveniently glosses over.

Ironically, the article trots out Snapchat as its first example of a company that relies on “fuzzy, insane math” and value “obfuscating” deal terms. Snapchat’s valuation is no doubt well ahead of its business. But that shouldn’t be news, and its value to an acquirer like Facebook or Alibaba is based on far more then existing revenue. (Remember WhatsApp? Does Bloomberg think that $19 billion was based on its business? What about Oculus Rift -- a company Facebook paid $2 billion for that hadn’t shipped a product. And recall, Microsoft valued Facebook $15 billion long before its advertising business merited such a price. Now the company’s market cap hovers around $220 billion.)

It’s not just ironic because it’s so clueless, it’s laughably so to choose Snapchat as your example because as Pando reported last week, the ephemeral messaging company is actually taking the rare and controversial step of trying to avoid all this structure in its latest round of fundraising by asking investors to purchase plain vanilla, common shares. And according to several sources close to Uber’s late stage fundraising efforts, the company has progressively renegotiated away many of the more favorable terms granted to early investors.

As Snapchat, Uber, and other recent deal examples demonstrate, we are in an era of industry exuberance and capital abundance that means many of the very deal terms that BloombergBusiness miraculously uncovered this week are actually less common than they were in decades gone by. Sure some struggling late-stage companies (see: Box) and less experienced early-stage founders must accept less than favorable terms. But by and large, the deals being struck across Silicon Valley over the last year have been some of the most founder-friendly in the industry’s history. Just ask any investor who has backed a hot company following a Y Combinator demo day.

Most embarrassing of all, BloombergBusiness trots out a valuation equation – the illustration for which it must be said looks like it was pulled from a middle school math textbook – that includes “founder’s hopes and dreams” and “investor FOMO.” The publication explains, to its obviously naive readers:

“A severe case of FOMO can cause some to do crazy things to get into the hottest deals. But they don't just want the promise of an IPO or an acquisition someday; they want it to happen soon.”
Of course on Wall Street, investors never jump onto hot stocks and ride bull markets based on a fear that everyone but them will get rich, and public companies never sell the market on their overly-optimistic vision of the future. Isn’t this just the old saw of “greed and fear” with different labels? The two ends of the capital markets may occupy different positions on the delusion versus reality spectrum, but it’s not like they’re trading in different emotional currencies.

The venture capital and startup industries are comprised of adults, all of which know and willingly accept the rules by which the game is played. The only group that appears to be just waking up to these realities is BloombergBusiness, and judging by the stance the stuffy old publication has taken, their readers.

I would say I’m surprised by this latest journalistic atrocity, but that would require me to ignore the numerous examples of mass media parachuting in to “cover Silicon Valley” in recent years only to badly botch the job. There's a meme that legacy business media likes to trot out at times like when Zuckerberg wears a hoodie to his IPO roadshow or software companies go public while still choosing exponential growth over profitability, that Silicon Valley doesn’t get Wall Street. Tone deaf and painfully obvious pieces like the one published by BloombergBusiness today prove that, at the very least, this is a two-way street.

[Disclosure: Michael Carney has accepted a position as an associate at Upfront Ventures that begins in April. To the best of Pando’s knowledge, the companies in this post and their competitors have no affiliation with Upfront. This post went through Pando’s usual editorial process.]