Top tech dealmaker Bill Gurley has a dire message for Silicon Valley: The unicorn fantasy is unraveling. Fast.
“There has been a fundamental sea-change in the investment community that has made the incremental Unicorn investment a substantially more dangerous and complicated practice,” Gurley writes in a 5,500-word essay. “All Unicorn participants—founders, company employees, venture investors and their limited partners (LPs)—are seeing their fortunes put at risk from the very nature of the Unicorn phenomenon itself.”
“Unicorn” is industry slang for a startup valued at $1 billion or more. From January through September of 2015, global funding to venture-backed companies soared, as did the rate at which VCs minted those unicorns. In early 2015, Fortune pegged the billion-dollar startup club at 80 members. Those ranks have since doubled, according to data tracked by venture-capital research firm CB Insights.
But late last year everything changed. Financing for startups fell 29% in the fourth quarter of 2015 from the third quarter, and it dropped another 8% for the first three months of this year. The birth rate for new unicorns also fell precipitously. Startups began scrambling to get their finances in order. Layoffs mounted, perks vanished. For consumers, prices started to rise.
Meanwhile, the number of tech companies exiting to the public markets dipped lower—until, in the first quarter of 2016, it hit zero.
Despite all of this, funds kept flowing to tech’s dealmakers. In the first quarter of 2016, US venture-capital firms raised money at the fastest rate since the first dot-com bubble, securing about $13 billion in financing.
At some point along this road, Gurley says the funding climate in Silicon Valley turned toxic.
“The pressures of lofty paper valuations, massive burn rates (and the subsequent need for more cash), and unprecedented low levels of IPOs and M&A, have created a complex and unique circumstance which many Unicorn CEOs and investors are ill-prepared to navigate,” he writes.
Here’s what Gurley thinks went wrong.
1. Emotional biases.
Gurley argues that the people involved in startup funding—particularly founders and investors—are motivated to pursue higher valuations at all costs. Founders “have a strong belief that any sign of weakness (such as a down round) will have a catastrophic impact on their culture, hiring process, and ability to retain employees,” he writes. Venture capitalists are sitting atop “amazing paper-based gains” that are inherently tied to the paper valuations of their portfolio companies. Falling startup valuations could call those gains into question, and could hurt VCs’ abilities to attract future investments to their funds.
2. “Dirty deals.”
As the fundraising environment has become more extreme, Gurley says “sophisticated and opportunistic investors” have taken advantage of founders. These “sharks” give founders the money they need to hit audacious valuation targets in exchange for “dirty terms” like guaranteed IPO returns and ratchets—basically, provisions that protect investors, often to the detriment of founders, employees, and earlier stakeholders. Food delivery startup DoorDash, for example, recently sold shares at a 16% discount and negotiated a deal in which investors could block a potential IPO, the Wall Street Journal reported in March.
Gurley says these “dirty term sheets” are a “massive problem” for two reasons. First, they make the math of a startup’s potential returns incredibly complicated. Second, they discourage VCs from investing in the future, which “severely heightens the risk of either running out of money or a complete recapitalization that wipes out previous shareholders.”
3. Inscrutable financials.
Private companies aren’t held to the same financial reporting standards as public ones. But Gurley worries that this has allowed founders to be ignorant and/or reckless in their accounting practices. “New potential investors might also be surprised how few Unicorn executives truly understand their core unit economics,” he writes. (“Unit economics” describe the costs and revenues of a business model on a per-unit basis—i.e., each ride Uber provides or burrito DoorDash delivers.)
The upshot of such behavior could be unwelcome regulation from the US Securities and Exchange Commission. “If those involved believe that ‘not being public’ also means ‘not being responsible’ … we will have deservedly invited more scrutiny,” Gurley states.
4. Too much money.
This is Gurley’s bottom line: For a long time, funding was easy to come by, and practically anyone could raise money. “Loose capital allows the less qualified to participate in each market,” he writes. “The reason we are all in this mess is because of the excessive amounts of capital that have poured into the VC-backed startup market.”
“More money will not solve any of these problems—it will only contribute to them.”