Recent scandals among tech’s unicorns have turned investor attention to hypergiant funding and blitzscaling: Outcome Health faced an investor lawsuit regarding misleading claims; John Carreyou’s NYTimes bestseller “Bad Blood: Secrets and Lies in a Silicon Valley startup” centers around fraud charges faced by Theranos; and, most recently, WeWork has faced negative publicity for its IPO plans. But what is “hypergiant” funding and “blitzscaling,” and how can companies avoid becoming cautionary tales?
The dangers of conflating “hypergiant” funding with “blitzscaling”
Due to unprecedented amounts of global dry powder, “hypergiant” funding rounds have become more prevalent among venture capital (VC) and growth equity investors. Global funds held as dry powder, or kept in reserve, have increased from $400 million in 2003 to $2 trillion in 2018. Many top global VC funds, such as Sequoia Capital, Andreessen Horowitz, and NEA, have raised later-stage venture funds of $1 billion or more since 2018. As a result, “hypergiant” rounds of $250 million or more steadily increased from 38 over the course of 2014 to 35 per quarter in 2018.
Increases in hypergiant rounds have coincided with the rising popularity of a strategy known as “blitzscaling.” Reid Hoffman began teaching a class called “Technology-Enabled Blitzscaling” at Stanford University in 2015; according to Hoffman, the term can be described as “what you do when you need to grow really, really quickly.” He elaborated, “It’s the science of rapidly building out a company to serve a large and usually growing market, with the goal of becoming a first mover at scale… Google revolutionized how we find information – it has over 60,000 employees and has created many more jobs at its AdWords and AdSense partners.”
Learning from the mistakes of WeWorks and others
WeWork’s failed IPO demonstrates the dangers of conflating large funding with rapid scaling. Not all companies with large funding possess the same fundamentals to be successful at rapidly scaling.
The classic venture capital playbook is to jointly fund startups through a series of gate-staged rounds (i.e., Series A, Series B). Each round’s purpose and size are intended to reflect a startup’s needs at that specific stage. This strategy reduces risk for venture capital firms, as nearly 2/3 of startups stall and fail to exit or raise follow-on funding.
Masoyohi Son, CEO of Softbank and its Vision Fund, was said to have launched the Vision Fund to transform VC’s typical playbook of gate-staged investments. Softbank typically decides on its own if a venture is worthy of funding that is significantly greater than its ask. In 2018, while the median size of late-stage VC investments was $35 million, Softbank led or sourced 18 funding rounds of $350 million or more.
These days, if a startup needs to raise capital, it is easier than ever to tap into private markets. Therefore, it comes as no surprise that the median gestation period from seed to IPO has lengthened from 3.2 years in 2000 to almost a decade in 2019.
However, with WeWork’s recent failed IPO, it makes sense to examine sound hypergiant funding principles. Specifically, some entrepreneurs mistakenly believe that massive capital investments alone can be used to achieve a sustainable competitive advantage. While blitzscaling encourages rapid expansion in order to take advantage of network effects, it does not urge companies to ignore lean methodologies or standard investing concepts.
Valuable lessons from WeWork’s recent IPO failure
Hypergiant funding is not the inherent reason for WeWork’s failure, or Outcome Health’s recent lawsuits for that matter; rather, company executives ignored many basic principles. Notably, after WeWork’s failure, the NYSE tweeted the following:
“Before you take your company public ask yourself these four questions:
- Is there a compelling business case for going public?
- Is there a clear, strategic roadmap for the long term?
- Is your company’s financial house in order?
- Is the right executive team in place?”
While these questions may seem basic, they summarize many enduring considerations as companies scale and tap private or public markets for additional funding. Below are some guiding principles to keep in mind:
- A great vision and business plan are fundamental. As the proverb goes, “Vision without action is a daydream. Action without vision is a nightmare.” A company’s vision should be clear, concise, and inspiring. An example is Microsoft’s vision at its founding, “A computer on every desk and in every home.” In order to execute a vision, companies should have a comprehensive business plan that lays out objectives, actions to obtain them, and the timeframe to accomplish these actions.
- Business models are paramount. Capital-intensive, low-margin businesses cannot sustain a competitive advantage with new technology and massive funding alone. Total addressable market (TAM), barriers to entry, customer satisfaction, and sustainable free cash flow (or a feasible, well-conceived path towards one) are enduring investment concepts. Alibaba raised only $50 million venture capital before becoming cash-flow positive in its third year of operation, and Facebook was generating over $1.5 billion in operating cash flow prior to going public.
- The core business is foundational. Investors often heavily discount new, additional products and growth avenues. Yet, some companies begin rapid expansion into new areas without fixing the fundamental issues in their core business first. An example is WeWork’s launch of its elementary school product area known as WeGrow.
- Scale at the right time, rather than as a result of access to capital. It makes more sense to scale when there is data available on the competitive landscape and the degree to which a product satisfies a strong market demand, such as a sizeable serviceable addressable market (SAM), strong user growth, and/or requisite proof-of-concept data (i.e., clinical studies). Scale too quickly and the company might stall; mistakes can become compounded. On the other hand, scaling too slowly might not be aggressive enough.
- Internal controls should not be sacrificed for profit. WeWork was forced to react to investor concerns regarding related-party transactions, such as Mr. Neimann’s personal ownership positions in buildings leased by WeWork and We Co’s $6 million purchase of the trademark of the word “We” from a company controlled by Mr. Neimann. Internal controls such as audits and expenditure review triggers for items over $1,000 can pay dividends later on.
- Accounting principles exist for a reason. Overly complex spreadsheets can generate accounting mistakes if they become too cumbersome to operate and update. A lack of financial standardization can result in inappropriate revenue recognition and theft. Finally, separation of bookkeeping and auditing becomes crucial as companies scale. Investors value independent audits, and strategic investors are known to request Quality of Earnings (QoE) reports for larger scale acquisitions.
- Governance matters. Companies should implement written codes of conduct and implement structures that avoid bias and conflicts in decision making. Elizabeth Holmes of Theranos prevented subsequent board efforts to replace her by multiplying the voting rights of her shares to give her 99% of total voting rights. At WeWork, Neumann’s voting shares and the stipulation that significant power passes to his wife, the company’s Chief Brand and Impact Officer, in the event of his death raised significant concerns. A newer investment strategy – Environmental Social & Governance (ESG) – has emerged in recent years, and it emphasizes some of these concepts. ESG and sustainable investing focus on relations with employees, customers, and stakeholders, as well as proper corporate governance – leadership, pay, voting rights, and history with the SEC and regulatory bodies.
- Accountability fosters growth. As companies scale, specialization becomes more important. Key performance indicators (KPIs) and accompanying analytics are critical to the deployment of a significant amount of capital. Additionally, intermediate milestones allow companies to course-correct early in the journey at significantly less expense.
- Cultures that cultivate fear can be dangerous. At Theranos, for example, would-be whistleblowers were threatened with lawsuits, and some employees were fired and marginalized over criticism of company practices. As a company quickly grows, executives should manage and measure their cultures to ensure they are addressing employee concerns and encouraging trust.
- Reliability prevails in relationships with customers and investors. There are serious repercussions for presenting false information to healthcare providers, patients, and investors. Following Wall Street Journal allegations that Outcome Health misled advertisers by overcharging clients and manipulating campaign results, key investors decided to sue Outcome Health for committing fraud, and the company is being forced to reinvest $159 million in the company while the co-founders step aside from daily management. In the case of Theranos, the SEC charged CEO Elizabeth Holmes with “massive fraud.” As part of the settlement, Holmes must return millions of shares to the privately held company, pay a $500,000 fine, and she cannot serve as an officer or director of a public company for 10 years.
Conclusion
Modern scandals among notable unicorns in healthcare and technology have caused entrepreneurs and investors to reflect on recent events. While global dry powder remains high and the number of unicorns has multiplied, hype does prevail over math in a world that relies on ratios such as Return on Invested Capital (ROIC). Sooner or later, sophisticated investors penalize dysfunctional business models. That said, with the appropriate framework and culture, companies can easily avoid becoming yet another cautionary tale.
To learn more about Gilmartin and how we strategically partner with our clients, contact our team today.
Caroline Paul, Principal
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