The recent case of WeWork seems to have opened a pandora’s
box in the venture capital word about the importance of profit over growth when
investing in startup.
The U.S. office-sharing startup encountered the favour of many
investors for his bullish growth, doubling the revenue to 1.8B$ in 2018. Consensus
of investors means increased valuation, and, in the case of WeWork, reached the
record of 49B$ in January 2019.
Under these circumstances, the company started the plan for
what was expected to be the most successful IPO of the year. The optimism
lasted until the jaw-dropping 1.9 B$ losses in 2018 became known. Then it come
the tsunami with the Q1’19 losses and the serious governance issues which
emerged when analysts started to dig into these numbers.
The story is known, passing from the stepping down of the
CEO Adam Neumann, to the postponing of the IPO at, potentially, a third of the
originally expected price.
The consequences, instead, seem to be much wider leading to
a rethinking of startups and investors focus. The last decade mantra in Silicon
Valley of growth over all, encouraged any type of excess and the start-up
formula of spending lots of money to grow at the expense of profits, is losing
its dogmatic appeal passing through the scrutiny of a more rational approach.
The issue comes from the fact that the first question any
investor asks in assessing a startup is if it can scale, leading to an
astigmatic view focusing only on revenues while assuming profit will follow. Sometimes
it doesn’t. As highlighted by Fred Wilson,
the reality hits hard when companies which have secured billions from investors
– thanks to their astonishing top line growth – face the circumstances of the
public market where investors are basing their decisions on much more rational
basis than in the private market.
The most recent cases of mismatch between private and public
market are the ones of the fitness startup Peloton, and the online orthodontics
company SmileDirectClub, that had their shares immediately cratered after the
companies went public.
These and the WeWork cases offer few lessons learned for VC
and startup retail investors:
Domino Effect. WeWork turned into a WeWorry
for many other unicorns who were approaching IPO leading to the withdrawal of
some planned IPOs or
the deferral of others.
We see here how strong the interdependency amongst startups in different
industries and different geographies are.
Mind the valuation. Investment banks
cannot value loss-making technology startups for an IPO as the reaction of public
market can be very severe as proved by the cases of Uber, Lyft and Slack which dealt
with falling stock prices for months after listing this year.
Different KPIs for different industries. Focusing
on growth has been a successful strategy for software companies like Facebook or
Amazon where the costs hit at the increase of customer is very limited but is not
a paradigm which can be declined to any industry. It is a simple rule, if your
have an unfavourable gross margin due unit costs, the financial picture will look
just worse at the increase of customers.
Gross Margin matters. Both gross margins
and operating margins are now entering in the spotlight of VCs as a key profitability
indicator. As recognized by Nihal Mehta of Eniac Ventures, this was not
something the firm regularly looked at.