For a 22 year old technology entrepreneur with a PowerPoint “pitch deck” and dreams of making billions, there’s only one place to go. 3000 Sand Hill Road, Menlo Park, California. That’s where the money’s at.
Sand Hill Road is home to the world’s best venture capital (VC) firms. VCs are the technology industry’s money men. They back talented entrepreneurs with millions of dollars in exchange for a stake in the future of their companies.
(Think Dragon’s Den, except with Mark Zuckerberg pitching Facebook instead of a guy pitching edible birthday cards for dogs.)
There’s an outrageous boom on Sand Hill Road at the moment. Today I want to tell you what’s happening over there – and why it’s making some investors nervous.
How billionaires are made
Here’s how venture capital works: the entrepreneur pitches his startup idea to a VC to get “seed capital”. This is the first round of funding, and it usually comes before the company has made a penny.
When his product gets some traction (and he needs more money) he goes back to the VC for more funding. This is the “A round”. All going well, he’ll come back later for a “B round”. And so on. Each time, the entrepreneur gives up a slice of his company for cash.
It’s a great deal for the entrepreneurs. As well as a tonne of cash they get support, advice and introductions (which is important when you’re a 22 year old software genius who’s barely seen the outside of his dorm room).
As for the VCs… that’s not so clear. Because the big VC firms are all private, it’s hard to know how much money they’re making. But we do know a few things: they get their money from private investors such as pension funds or university endowments. They normally charge fees of “two and twenty” (that’s two percent of all the assets they manage, plus twenty per cent of profits).
And finally, we know that they make all of their money on a small number of massively successful investments. Those successes, they call unicorns.
Mystical forest creatures
A unicorn is a startup whose value has risen to $1bn dollars, based on fundraising (as opposed to the stock market). They’re the ultimate VC success stories. The venture capital industry exists to find the next unicorn.
(At a $41bn valuation, the taxi app Uber is the ultimate unicorn. One investment in Uber will pay for a hundred failed investments.)
There was a time when they were incredibly rare – hence the name. Not any more though. Remember the “outrageous boom on Sand Hill Road” I mentioned earlier? The source of – or maybe the result of – that boom is a massive increase in the value of startup technology companies. So now there are way, way more unicorns.
How many more? Well, in 2013, 15 companies reached the magic $1bn mark. In 2014, 38 companies did. Today, there’re 98 of them in total.
So one of three things has happened. Either:
– lots of money has piled into startups and driven valuations to unrealistic levels (bad),
– or startups are tapping into deeper pools of private money, which allow them to be more fairly valued before they’re floated on the stock market (okay),
– or technology startups are doing amazing things and making tonnes of money, which warrants a big valuation (good).
You don’t need to have been around too long to remember the 1990s dotcom bubble, in which investors lost their shirts on pie-in-the-sky internet companies. Is this unicorn/venture capital boom another bubble?
Maybe. But maybe not! There are some big differences between 1999 and today. Startups now wait longer and raise more money from VCs before they float on the stock market, which pushes up their valuations. And startup companies, especially those applying for late-stage funding, make more money than they used to.
Whether or not there’s a venture capital bubble, something important is happening over there. I’ll be coming back to it in future issues. But one thing is for sure – in the words of Matt Levine,
“I don’t know if we’re in a tech bubble, but I have to say that if we are and it pops, we’re all going to be pretty embarrassed that we were walking around talking about “unicorns.”
Until next time,