This question is starting to be asked once again. In this recent NYT article, “A Hard Lesson in Silicon Valley: Profits Matter” they write,
“Start-up investors are warning of a reckoning after the stumbles of some high-profile “unicorns.” Now turning a profit is in.”
Apparently high profile VC Fred Wilson at Union Square Ventures has begun to sound the alarm in a recent blog post titled “The Great Public Market Reckoning”. In it he argues that “the narrative that had driven start-up hype and valuations for the last decade was now falling apart.” One in which he was of course a part of.
The article goes on to say,
“For the last decade, young tech companies were fuelled by a wave of venture capital-funded excess, which encouraged fast growth above all else. But now some investors and start-ups are beginning to rethink that mantra and instead invoke turning a profit and generating “positive unit economics” as their new priorities.”
But why do profits suddenly matter again? Well profits always matter when the enthusiasm and the thirst of investor greed suddenly begins to turn to caution. This change is once again being driven by the fact that the high-profile “unicorns” (the start-ups that were valued at $1 billion and above in the private markets) are not attracting the investor interest just as they reach the stock market.
The truth is, in the long run profits always matter. If you are an early stage investor, or even a later stage investor in a money losing startup, your principle concern is your exit. Sure, your investment on paper may have increased exponentially as the valuations of these startups have hit dizzying levels, but in order to get paid you need to either attract additional financing through the private market or unload all your shares to the public market in the form of an IPO.
At some point the valuations get to stupid levels, as we recently saw with WeWork. The investment community has begun to, once again, wake up to what is really valuable. A company with no profits, is not sustainable, and a company that is not sustainable eventually see their value drop to zero, as we are currently witnessing with WeWork.
WeWork had been hoping to raise as much as $4 billion from its stock market IPO. In addition to the roughly $13 billion it has already raised from private investors. Another $6 billion in loans from big banks such as JP Morgan was predicated on the completion of a successful float. In preparation for the IPO WeWork was being valued at a ridiculous sum of $47 billion. WeWork formally withdrew the prospectus for its initial public offering, capping a botched fundraising effort that cost the top executive his job.
As we previously stated that if you have no access to the public market then you need to attract new loans or investments from the private market. Getting new financing is now critical for WeWork. The company lost $690 million in the first six months. Even with $2.5 billion in cash as of June 30 at the current burn rate, the company could run out of money by mid-2020, according to analysts.
But haven’t we heard this all before? Yes, we have. We saw this clearly during the 1999 boom bust period of the internet. In fact, it is almost a carbon copy.
In a May 19, 1999, Wall Street Journal article entitled “Companies Chose to Rethink A Quaint Concept: Profits,” they asked the same question, “Profits matter. Or do they?” In it they write;
“James Borkowski always thought so, until he started listening to venture capitalists. "The attitude is almost antiprofit," marvels Mr. Borkowski, executive vice president of Industrial Microwave Systems Inc. He says that his two-year-old company originally planned to become profitable in the year 2000. "But our financial advisers told us not to be profitable too quickly," he says. So the company is projecting losses until 2001.”
"In this marketplace," Mr. Borkowski says, "the more money you lose, the more valuable you are.”
Sound familiar? During the dot com crash, many online shopping companies, such as Pets.com, Webvan, eToys and Boo.com, eventually failed and shut down.
Webvan went public in late 1999 on little more than hope. The stock doubled on its first day and the company quickly earned a $6 billion valuation, even though it had less than $5 million in revenue and cost over $27 to fulfill an order. The company flamed out quickly; going bankrupt in 2001. eToys and Pets.com likewise failed swiftly. Pets.com debuted on February 9 of 2000 and declared bankruptcy less than 300 days later. eToys took a bit longer to fail, going public in May of 1999 and declaring bankruptcy at the end of February in 2001.
Although the valuations are small in comparison to today, these were high profile examples of the time, of greed gone amok.
So why did the Venture Capital world and corporate bankers not learn an lessons from this era? Well, actually they have been well aware of the lessons. They just made a conscious decision to disregard them and ride the wave while greed was still vibrant.
Fred Wilson remembers the 1999 bust vividly. He knows first hand what it feels like when there is a fire and everybody is running for the exits at the same time. He apparently did learn some lessons as this time he prefers to be the one at the exit sounding the alarm.