U.S. Markets open in 5 hrs 37 mins

Venture Capital is Changing, But is it for the Better?

Rita McGrath

Venture capitalists are partying as if it’s 1999—and we know how that went. Entrepreneurship 101 says startups should conserve cash, keep costs flexible, and operate with parsimony. Way too many founders in the ’90s laughed at that—the same way they’re laughing today.

Investment in venture capital in 2018 surpassed $100 billion for the first time since 2000. With all that money sloshing around, the deals are getting bigger. In 2018, deals worth more than $25 million accounted for nearly 13 percent of all investment. And mega-rounds, defined as funding rounds worth more than $100 million, accounted for 47 percent.

Related Are Vegan ETFs the Future of Sustainable Investing?

In the midst of all this exercising of free-flowing pens, I have to wonder whether all those people putting all that money into so many me-too, growth-at-all-costs-we’ll-worry-about-profits-later ventures are a tad delusional. Some of the assumptions that would have to be true for so many businesses to become profitable, self-standing enterprises without continuous infusions of cash are truly heroic.

Consider the case of MoviePass, the long-struggling venture that hoped to “disrupt” (oh, that word) the conventional movie business by allowing customers to go to the movies in theaters for a fairly low subscription price.  Majority owner Helios & Matheson, who bought into the company in 2017, went for subscriber growth by offering virtually unlimited access to movies for a monthly subscription price of $9.99. Customers loved it—after all, that price was lower than it would cost to see just one movie in some theaters. And if subscriber growth was what the company wanted, this strategy succeeded wildly—going from 20,000 users to over 3 million at its peak. Helios and Matheson’s stock soared and for a few shining moments, on paper, everything looked great.

But the economics of this proposition simply didn’t work. The company paid full price for every customer ticket, so it lost money on every transaction.  It was never able to persuade theaters to share concession revenue and the hoped-for play of being able to sell consumer data gleaned from customers never worked out, either. From an entrepreneurship professor, people, it is really hard to build a platform on which you lose money on every transaction and hope to make it up somewhere else in your business model.

Related The Keys to Managing Business Inflection Points

inflection points

Meanwhile, as often is the case with failed ventures, MoviePass did teach cinemas that there is an interest on the part of consumers in a subscription business model for movies. AMC has launched its own, AMC Stubs A-List, which allows subscribers to see up to three movies a week for $19.95 a month. People have flocked to it, taking more than 175,000 initial subscriptions and surpassing the company’s expectations.

Which brings us to a second lesson (the first being don’t price below cost), which is that it is rare that being the first mover creates an indestructible position.  It can happen, but typically only when you have one of two things going for you. The first is network effects (the more users you have the more valuable the offering becomes to other users, so the first to get going are impossible to catch—think Facebook). The second is ecosystem effects (when you occupy a protected role in a business configuration—think Windows software and Intel chips). All too often, first movers just show sleepy incumbents what customers really want. When the Empire Strikes Back, the upstarts get squashed.

As Steve Blank points out, in VC 1.0 founders and employees had the same horizon for a liquidity event six to eight years from startup. Today, as companies can capture $50 million-plus funding rounds, they can put off going public for a decade or more. This fundamentally changes the entrepreneurship game. It puts early employees at a disadvantage. It encourages sloppiness. It leads to company valuations that have nothing to do with profitability and everything to do with hyper-growth. And it can’t last.

Well, it can as long as venture capitalists value growth and some mythical future exit event as highly as they do. The cynical among us observe that some of their behavior is something like a Ponzi scheme—if you are an early-stage investor and can persuade later-stage ones that this business is going to be the next Big Thing, you can get your money out even if the whole thing eventually implodes.  The problem with this is that it removes critical discipline from the investing process. Companies attract funding because of a charismatic CEO, the promise of being first in a hot new category or cool technology, and not necessarily because the fundamentals of the business make sense.

Related CEOs Who Take a Political Stand Are Seen as a Bonus By Job Applicants

We’re starting to see some rationality about this creeping in around the edges. Take Uber, whose theory of success (at least for now) is that it will dominate local markets for both drivers and riders eventually. If you believe that, then it’s worth subsidizing both sides with venture money. Uber may well be Exhibit A of the mythical first-mover advantage illusion. In just three months, Uber lost over $5 billion. The real problem here is one that we’ve seen before—to seed a market, a startup subsidizes early customers. The theory is that once you have them in the door, you can eventually create pricing power and raise prices. Eventually, unless you have some other revenue stream like darkly trading in people’s personal information, you have to charge enough to cover the cost of the service and make a profit. Once those $7 Uber rides start costing $30, riders will be back in their own cars or on the bus.

Another “what were they thinking?” example?  E-cigarette maker Juul. With investments from Big Tobacco and a ticked-off FDA disputing its claims that its products are healthier than regular cigarettes, its path to profitable growth doesn’t look like the smooth sailing someone must have thought it would have, since it has raised $14.4 billion over eight funding rounds. It’s also brazenly taken pages out of cigarette marketing of yore—trendy models, lax enforcement of age restrictions, seductive flavors, and a shimmering sense of being cool—many of which are today illegal. The backlash among regulators and policymakers is only just beginning.

So here’s an interesting irony. Despite the enormous sums in play, little goes to female and minority founders. In 2018, all female founders put together received $10 billion less in funding than Juul took in by itself.  The amount that went to female-founded companies was 2.2 percent of the total invested.

Related The Investment Gap

If you assume that entrepreneurial talent is evenly distributed across the population, this seems like a glaring blind spot. Women, after all, make an awful lot of spending decisions. In the United States, women owned 11.6 million businesses employing over 9 million people and generating $1.7 trillion in revenue. And a Harvard study found systemic differences in how venture capitalists talked to female vs. male founders. The men got asked mostly about their vision and the upside of their businesses. The women? Only the pitfalls and risks. And funding follows this defeatist impulse.

In a study by Morgan Stanley, they blame a lack of familiarity, as most investors have little to do with non-male, non-white founders. The cost? $4.4 trillion in missed opportunities.

It’s time for a rethink.

Rita McGrath is a Columbia Business School professor, and the author of Seeing Around Corners: How to Spot Inflection Points In Business Before They Happen.

This story was originally published on Techonomy.

The post Venture Capital is Changing, But is it for the Better? appeared first on Worth.