No.8: 'Grow real, grow slow', Chamath Palihapitiya & The Pivot of Social Capital
Curated news, insights and stories about bootstrapped entrepreneurs building real businesses and the investors who want to finance them.
Good morning people,
Today we discuss why Chamath Palihapititya, one of the best venture investors on the globe, decided to quit the classic VC model and pivot to a technology holding company, and why entrepreneurs should “grow real, grow slow”.
Photo courtesy of Social Capital.
Who is Chamath Palihapitiya?
Originally from Sri Lanka, Chamath Palihapitiya (42) moved to Canada at age 6. He studied electrical engineering at the University of Waterloo before starting his career trading derivatives at an investment bank. He is best known for his work at Facebook, where he helped the back-then young startup grow its user base globally and efficiently. Chamath also made some successful angel investments in companies like Playdom (acq. by Disney), Yammer (aqc. by Microsoft), Box (public) and Palantir.
Social Capital version 1.0
Founded in 2011, Social Capital started as a classic venture capital firm: it raised close-end funds from institutional investors to made early-stage investments. In that regard, the firm has done a good job as it was an early investor in companies such as Carta and Slack, which is now valued at $7b and plans to list in June. As the firm was off to good start, it began expanding its investment activities into growth equity, public equity and even credit (though did not launch it). It also tested a new data-driven investment model called capital-as-a-service (more in another newsletter edition). Since its inception, the firm gathered $2b in asset under management and was seen as one of the most promising venture firm globally - so what triggered the change to a holding company?
We are no longer accepting new outside capital. By the end of 2018, we will have finalized a set of changes we began in 2017 and will become a technology holding company that will invest a multi-billion dollar balance sheet of internal capital only.
Growth at any cost
In his annual letter, Chamath explains that most of VC’s money today is going into financing increasingly expansive growth strategies:
The hardest thing for most startups today is the path to market: first finding product-market fit and a way to reach customers, and then building a ruthless machine to acquire, monetize, and retain them. Because of this, when the VC industry invests capital into fast-growing startups today, the plurality, if not the majority, of invested capital will go into user acquisition and ad spending, for better or worse (usually worse). […] Startups spend almost 40 cents of every VC dollar on Google, Facebook, and Amazon. […] Unfortunately, today’s massive venture-backed advertising, sales, and user acquisition playbook has morphed into one that champions growth at any cost. And it is creating a big bill that will soon come due...
Chamath Palihapitiya by Olivia Michael, CNBC
“Silicon Valley is a Ponzi scheme”
According to Chamath’s interview with Recode Kara Swisher, while Silicon Valley has created many breakthrough companies, the investment model behind it became similar to a Ponzi scheme - he calls it “The Shuffle Game” in Social Capital’s annual letter. The operator-turned-investor believes that the current venture industry is similar to a Ponzi scheme, where investors create the illusion of sustainable companies for their own benefits:
Marked up paper returns
Chamath’s argument is that venture capital firms are raising larger and larger funds based on paper returns - capital gains resulting from a new round of financing at a higher valuation than the previous one.
VCs habitually invest in one another’s companies during later rounds, bidding up rounds to valuations that allow for generous markups on their funds' performance. These markups, and the paper returns that they suggest, allow VCs to raise subsequent, larger funds, and to enjoy the management fees that those funds generate.
Driven by management fee, not performance fee
As funds get bigger, the management fees VCs are able to receive (regardless of fund performance) also increase to a point where VCs can get wealthy based on those fees alone.
Picture this scenario: if you’re a VC with a $200 million dollar fund, you’re able to draw $4 million each year in fees. (Typical venture funds pay out 2 percent per year in management fee plus 20 percent of earned profit in carried interest, commonly called “two and twenty”). Most funds, however, never return enough profit for their managers to see a dime of carried interest. Instead, the management fees are how they get paid. If you’re able to show marked up paper returns and then parlay those returns into a newer, larger fund - say, $500 million - you’ll now have a fresh $10 million a year to use as you see fit. So even if paying or marking up sky-high valuations will make it less likely that a fund manager will ever see their share of earned profit, it makes it more likely they’ll get to raise larger funds - and earn enormous management fees. There’s some deep misalignment here...
Seed -> Early -> Late -> ?
But to raise at an up valuation, a company must grow as fast as possible. How do you do it? Well… you spend most of your current funding on paid user acquisition to generate “growth” in order for the next investor in line to lead the new round at a marked-up valuation. From seed, to early, to late-stage investors:
VCs bid up and mark up each other’s portfolio company valuations today, justifying high prices by pointing to today’s user growth and tomorrow's network effects. Those companies then go spend that money on even more user growth, often in zero-sum competition with one another.
LPs and startup employees will pay the bill in the end
Ultimately, the bill gets handed to current and future LPs (many years down the road), and startup employees (who lack the means to do anything about the problem other than leave for a new company).
LPs (Limited Partners, the investors in a VC’s funds) are offered to invest in a VC’s fund every 2 or 3 years. However, it takes longer to build a company and see a realised outcome:
Their [LPs] money, after all, is what pays the VC’s newly trumped up management fee: marking up Fund IV in order to raise money for more management fees out of Fund V, and so on, is so effective because fundraising can happen much faster than the long and difficult job of actually building a business and creating real enterprise value.
Finally, startup employees are stuck with stock options not worth what they expect:
In a world where startup valuations are massively inflated, employees are granted stock options at similarly inflated strike prices.
What should investors and entrepreneurs do?
The solution to this change in the venture world is that venture investors should go back to basics:
We need to return to the roots of venture investing. The real expense in a startup shouldn’t be their bill from Big Tech but, rather, the cost of real innovation and R&D.
In his talk at “This Week in Startups”, Chamath also suggests a counter-intuitive solution for entrepreneurs to protect themselves (watch at 34min46sec):
Grow slow. Grow real, grow slow.
In other news
GetYourGuide gets $484m from Sotfbank
Go BIG or go REALLY REALLY BIG.
“The market leader in attractions sales remains TripAdvisor via its TripAdvisor Experiences and Viator brands. In 2014, TripAdvisor paid about $200 million to acquire Viator. GetYourGuide’s and Klook’s presumptive valuations are now about ten times as much as that. The Berlin-based-GetYourGuide alone has raised $659.5 million since its founding in 2009. Given their price tags, GetYourGuide and Klook may have little choice but to go public, merge, or both. “The valuation doesn’t leave many strategic buyers with sufficiently deep pockets to take them out via an acquisition,” said O’Sullivan.
Revenue-based financing is the alternative to VC
Revenue-based financing is rising and Techcrunch dug into Lighter Capital’s alternative financing options ebook.
What’s the appeal? As I said, RBFs are essentially dressed up debt rounds. Founders who opt for RBFs as opposed to venture capital deals hold on to all their equity and they don’t get stuck on the VC hamster wheel, the process in which you are forced to continually accept VC while losing more and more equity as a means of pleasing your investors.
How To Lose It All: 8 Startups That Went From Investor Darling To Cautionary Tale
If your company went bust because of lack of funding, just check this list and you might feel better.
Despite their efforts, 70% of upstart tech companies fail — usually around 20 months after first raising financing. And its not just the companies with relatively few resources that bite the dust. Every year, all types of firms go out of business — even after raising hundreds of millions in funding and achieving billion-dollar valuations.
Uber investor gets a $600m payday
I guess it was worth replacing the founding CEO.
When Uber Technologies Inc. went public on Thursday, investor Bill Gurley received one of the biggest personal payouts in venture capital history: an amount estimated to be more than $600 million, according to data compiled by Bloomberg. But the path to that payday was neither obvious nor easy, and included the purge of the company’s fiery founder and chief executive officer, Travis Kalanick.
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Michel
About Mereo
Mereo is a newsletter-driven publication about entrepreneurs building real businesses and the investors who want to finance them. Mereo is written by Michel Geolier, a venture investor based in Munich, Germany.
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