(*FOMO = Fear Of Missing Out)
As a consumer, you may love Uber. Lots do. But Uber is a vivid reminder of the potential perils of FOMO-driven late stage venture investments. While most early stage venture investments may not evoke your friends’ envy, and each one faces considerable risk of even surviving to maturity. Nevertheless, early stage venture investments offer the best shot at the rich returns that venture capital investors historically have enjoyed.
Uber is an instructive case study in the perils of late stage investing, especially in well-known “unicorns” – still private ventures valued at $1 billion+. Yes, Uber has achieved remarkable market penetration and become a household word. So it’s not surprising that as Uber sought later stage rounds of private venture funding, many investors felt that FOMO urge and the company’s valuation moved ever higher. Its latest fundraising round valued the company at $68 billion.
But for late stage investors, here’s the million (or is that billion?) dollar question. Will this business ever, under the scrutiny of public markets, justify that valuation? I wouldn’t bet on it. Despite its tremendous consumer market advances, Uber still hasn’t turned a profit. The Wall Street Journal recently reported that Uber suffered a $3 billion loss in 2016 and that losses continued at $708 million in the 1st Quarter of 2017.
In fairness to Uber, some factors contributing to those losses have been fixed. Uber has closed down its money-losing business in China in exchange for a 17.5% stake in China-based ride hailing leader Didi Chuxing as well as a $1 billion investment in Uber from that Chinese leader. More recently, Uber combined its money-losing Russian business with Russia-based Yandex NV’s Yandex Taxi. It’s also now winding down its subprime auto leasing program, which, in supplying more drivers with the essential tool of the trade – a car – discovered losses approaching $9,000 per leased vehicle. They had been projecting only about $500 per car. Oops! Finally, Uber has replaced founder Travis Kalanick as CEO with Expedia’s proven, highly regarded CEO, Dara Khosrowshahi.
So things should get better. The question though is whether things can improve enough to justify a $68 billion valuation. Several mutual fund leaders holding shares don’t think so. The Wall Street Journal reported in late August that Vanguard, Principal Financial Services, and Hartford Funds recently marked down their investments in Uber by 15%. T. Rowe Price reduced the value on its books by 12%.
The Wall Street Journal has also reported that Khosrowshahi’s deal could make him billions. Companies don’t offer packages with that kind of potential unless the problems are REALLY big. I learned that from personal experience when, many years ago, I was hired as CEO of a dramatically over-leveraged LBO. If I could make the company “work,” I’d earn a 4% ownership stake. Even Jeff Bezos or Mark Zuckerberg couldn’t have made that company “work.” Sometimes you have to learn the hard way.
We fear that lots of late stage ventures, especially unicorns, will never enjoy exits justifying their late round valuations. According to CB Insights, as of last October there were 176 unicorns globally, valued collectively at $628 billion. As of late August, 2017, there were more than 200, valued collectively at over $700 billion. The number has continued to grow because excessive valuations may be impeding many from going public. Private owners have little interest in IPOs below latest private round valuations. Potential corporate suitors aren’t biting either for the same reason. The pipeline is clogged with too many over-valued unicorns.
Even when IPOs do happen, recent results haven’t always been positive. Snap and Blue Apron are two good examples.
Snap’s valuation in late 2016, shortly before its IPO, was $18 billion. Its $17/share IPO represented a valuation about 10% higher, but it is unlikely that many late stage investors were able to sell out right away. The market has been rocky since, and Snap’s current stock price of $14.46 represents a valuation of $16.8 billion, roughly 7% below its pre-IPO level.
Blue Apron has had an even tougher time. According to Reuters, its $10/share IPO translated to a valuation 14% below its last private fundraising round two years earlier. Since then, the stock has retreated from $10/share to $5.34 as of September 6, reducing its valuation more than 50% below its pre-IPO level.
That brings us back to our major point. Avoid FOMO-driven late stage investments. We believe the way to win in venture capital is by concentrating on early stage investment. Of course, that’s not to say that winning is easy. Historically only 15-20% of ventures generate a positive return. Most lose their entire investments. Ten years out, most those ventures won’t even remain in existence.
But if you work with a savvy venture capital firm that practices rigorous venture screening and due diligence, and if you diversify enough within the asset class, your odds of success can improve. By diversifying, we don’t mean a mutual fund-type approach. That doesn’t suggest the degree of screening and due diligence rigor that is possible. We mean investing in perhaps five to ten high quality deals, where each one has strong potential. Such selection rigor should result in beating the historical average 15-20% deal success rate, and history suggests that some of those successes should be big winners.
Consider these illustrative scenarios. We believe they are realistic for the kind of high quality venture capital firm we just described.
- Assume you make five investments of equal dollars, four fail entirely, and one returns a multiple of 10x after five years. That would double your total investment in five years, representing an average annual return of 15%. If that one winner returned a multiple of 20x, your total investment would have been quadrupled, for an average annual return of 32%.
- Let’s say the firm makes ten equal size investments, eight fail, one delivers a return multiple after seven years of 10X and one delivers a return multiple after seven years of 20x. That would be a tripling of your total investment in seven years, representing an average annual return of 17%.
These kinds of returns are realistic for the savvy professional venture capital firm that screens its options rigorously and invests only in ventures it really likes a lot. VCapital’s leader Len Batterson’s team record over 30+ years, focused almost exclusively on early stage deals, is a deal success rate of 37% and average annual gross return of 28%. That’s what high quality venture capital investment is about.
And please, whatever you do, avoid FOMO. The odds in these late stage deals don’t look good.