Raising Startup Money Has Become A Lot Easier Than Building a Profitable Business

There are 80 companies who have raised late stage venture capital at valuations greater than $1 billion.

Is this just a latter day best of all possible worlds where everyone is above average?

Or is there just too much dumb money chasing flashy promises? And dont get us wrong: the people who are so anxious to invest probably made much of their money the hard way - they earned it.

It's just that as you get closer to the top of a cycle, everyone thinks there's nothing but upside because if all those other knuckleheads did it, how hard could it be? But as the following article reminds us 'there is a fool in every market and if you don't know who it is, it's probably you.'

Bill Gurley comments in the Financial Times:

Perhaps part of the problem is that it has become relatively easier to raise money than it is to actually build a profitable business.
Eighteen months ago it was a company worth a billion dollars. Fab.com, an online store that sells quirky designs of everything from iPad covers to bonsai pots, had just been given another tranche of cash by a group of venture capital investors who seemed undisturbed by the company’s apparent indifference to making money. “I don’t [care] if we sell $200m this year or $300m this year,” chief executive Jason Goldberg wrote after the deal closed. “Wow first, money second.”

This was the fourth round of investment that the New York-based start-up had raised in a little under two years. Before this fundraising, Fab.com’s trajectory had been quite common for a high-profile winner. Technology companies usually start with a small injection of seed capital and continue with progressively larger infusions as they grow. The most successful eventually float on the stock exchange.

But when news came in June 2013 that Mr Goldberg had persuaded private investors to hand over another $150m in a transaction that valued his lossmaking retailer at more than $1bn, it was a sign of a far newer trend. In the past, any company would have struggled to raise anything like this much cash outside the public markets.

But times have changed. More than 80 closely held companies have won late-stage backing at valuations exceeding $1bn. These large private rounds, the distinguishing feature of the current technology cycle, are where the venture scene is most crowded and the deals most frothy.

Some say these companies would, in an earlier era, already have floated. The implication is that the late-stage rounds now in vogue are no riskier for investors than the internet IPOs of previous decades. This is a dangerous mistake. In last year’s record market for initial public offerings, the companies that were ready to go public did go public. Those that did not, stayed private for a reason.
One critical difference is that late-stage private companies have not endured the scrutiny of the IPO process. Auditors, bankers, three sets of lawyers (and let us not forget the Securities and Exchange Commission) spend months checking that every number is correct, important risks are identified, proper controls are in place. That is why board directors agonise over whether their company is “ready”. Private investment rounds involve no such pageantry.

Investors often assume they are being shown numbers that are comparable to what they would find in IPO filings, but the accounts they are looking at might not be audited until 12 months after the end of the financial year. The auditors, knowing there will be no excruciating SEC review of their work, might not feel the need to roll up their sleeves. And even if the accounts are accurate, distinctions can be missed. If a customer uses a $10 voucher in part-payment for a purchase, or receives a discount for the same amount, is that $10 included in the revenue figure? (US accounting rules require that it be recorded as “contra-revenue”, in other words, a deduction from the actual revenue.) A PowerPoint presentation might obscure the answer. The SEC would insist on making it clear.

Then there is the question of how one should consider valuations. Most public internet marketplace companies such as eBay and GrubHub conservatively publish net revenues — net, that is, of the 80 per cent or more share that is paid out straight to their partners. But private marketplace companies frequently point you to “gross” revenues, an inflated number that is five times higher than the one given by comparable public companies. A good banker in a normal IPO process would get this straightened out.

For all I know, Fab.com’s backers avoided all these pitfalls. It did not matter. Perversely, the act of dumping money into an immature private business can negatively impact its value. Barely four months after its tally of invested capital reached $330m, the self-styled “emotional commerce” company abandoned its plans for growth and fired hundreds of its staff. “We have spent $200m and we have not proven out our business model,” Mr Goldberg disclosed to employees, according to a report in Business Insider. What was once a billion-dollar company is now reckoned to be worth perhaps $15m.
It was a hard way to learn a simple truth: the only way to use up hundreds of millions in private investment is to take on massive operating losses. You can make your business bigger this way; customers love you if you give away tons of value. But you operate further and further from profitability. Worse, you leave everyone in the dark over whether the business model actually works.
Perhaps part of the problem is that it has become relatively easier to raise money than it is to actually build a profitable business. There is no need to buckle down, if the markets allow you to operate in a looser fashion.
And as I said, fundraising has become remarkably easy. I heard about a fund manager who was recently “invited” to invest in one of these many recent late stage private financings. An exclusive invitation has a solicitous feel, but it should arouse scepticism, especially if the party is crowded. As Warren Buffett said: “There is a fool in every market and if you don’t know who it is, it is probably you.”