Every month, The Big Question video series brings together a panel of Chicago Booth faculty for an in-depth discussion. In this edited excerpt from November’s episode, Waverly Deutsch, clinical professor of entrepreneurship; Scott F. Meadow, clinical professor of entrepreneurship; and Ira S. Weiss, clinical professor of accounting and entrepreneurship, analyze the start-up bubble. The discussion was hosted by Hal Weitzman, Booth’s executive director for intellectual capital.
Tens of thousands of start-ups get funded in the United States at very early stages, but relatively few companies get funded at the Series A stage or beyond. What does that bottleneck mean for the industry?
Deutsch: In this country, over 500,000 people launch new companies every year. In 2011, 66,000 of those start-ups got angel funding, but only 2,000 got venture funding. So how are they going to grow their businesses? If there is this dependency on external funding, a lot of companies that think they’re now entitled to several million dollars of Series A venture funding aren’t going to get it.
Why is there such a big gap between angel and venture funding?
Weiss: Structural changes over the past seven years have affected start-ups and the funding side. First, it costs less than $100,000 to get a technology company off the ground. A lot of companies go from starting company to ‘proof of concept’ inexpensively. Secondly, the cost of getting your first customers has gone down drastically. Now you can market on Google or Facebook, so people get to that initial point much earlier. Thirdly, you now have crowd sources of funding. These mean that tens of thousands of early-stage companies have enough external validation that people are willing to write checks.
The venture-funding stage is more difficult. First, there was a very significant contraction in the venture-capital industry during the downturn: 30 percent of venture funds are gone. Secondly, that leaves larger funds, which have had a lot of success raising $500 million and up, but there are very few funds in the $100 million–$250 million range. Those are really the funds that have historically played more in the Series A and Series B. Thirdly, many more start-ups are addressing the same problems. The venture capitalists can sit back and say, ‘Who has the best team? Who has the best traction?’ So the next rounds become that much more competitive.
Meadow: Institutional investors tend to look at: Is it a start-up, is it a growth equity project, or is it near-term liquidity? They’re pretty strict with their definition of growth equity—you have a management team that can take it to the promised land. Because we’ve had a tremendous amount of success out in the public markets and in gaining liquidity, more and more naive funding is flowing in at the early stage. But when it comes to the post–proof-of-concept execution stage, you’ve got a much more sophisticated audience.
Some in Silicon Valley say we are in a funding bubble, that investors are taking on too much risk and it’s not sustainable. Are there parallels with the tech bubble of the late 1990s?
Meadow: There was certainly a reduced level of due diligence that went into any project. I’m seeing that now. There was also a problem that the firms with the most prestigious franchises were able to continue to sustain the funding because of their own franchise. Other companies that were just as worthy as the
ones that those firms supported couldn’t find that money. That goes back to this problem of a dearth of growth equity.
Deutsch: The question of if we’re in a bubble is all about risk reward. We’re investing about $25 billion of venture capital—the question is, where do those investors get their returns? A lot of investors, particularly in Silicon Valley, are funding a lot of business models without revenue models. So it may be worse this time around. In the internet bubble, they had revenue models based on e-commerce. Now, we have these things like WhatsApp, which is purely about distribution: get on every phone, get in front of every person, and you’ll get bought for billions of dollars. Where are the investors looking for their returns when we have companies that go public without self-sustaining revenue models, and the investors get to shift the burden from the funds and their limited partners to the mainstream investor and the stock-buyer? We’re getting more and more of those kinds of companies. Facebook and Twitter didn’t have self-sustaining revenue models when they went public, so that’s where the investment bubble on the venture-capital or private-equity side can impact the economy.
Weiss: There are some signs of a bubble at certain funding stages. A lot of start-ups are not just prerevenue but premetrics. Over the past 12–18 months, many more companies are getting funded prerevenue and prelaunch. That feels similar to the tech bubble. There are a lot of differences, though. Most of the money goes into companies with a verifiable revenue model. The WhatsApps of the world are the anomaly. Mostly you have a lot of really good business-to-business investments by tech venture funds that have external validated data, revenue models, and growing revenue, and a lot of the money goes in for marketing and growth.
Deutsch: I agree that WhatsApp is an anomaly, and it’s a disaster for young entrepreneurs. One in 2 million companies are going to do what WhatsApp did, but everybody thinks they can achieve it.
Meadow: What I see as a sign of a bubble is more and more naive investors coming in at earlier and earlier stages. There is no question in my mind that there’s going to be an explosion like before.
Deutsch: Naive capital is a really important thing to talk about. Venture capitalists have a lot of experience doing due diligence on their deals, and there are a lot of great angel investors, many of them former venture capitalists. But there are 300,000-plus people in the US who act as angel investors. In 2011, angels invested about $25 billion. Venture capitalists invested about $25 billion across all stages. So there is a lot more money coming from individuals who are not necessarily professionally trained, and who are investing their own money so have different fiduciary responsibilities and different goals, coming into the market at these early stages. It supports a lot of innovation, but it does create these unrealistic expectations.
Weiss: Think about the math: $25 billion from angels going into companies. That number’s been constant for the past decade. But the cost of creating companies has come down so much, so you have 10 times as many start-ups getting funded at the first stage. One sign of a bubble is that the big funds have raised so much money that they’re willing to pay valuations that are not based on external metrics. A lot of it’s driven by their need to put really big checks to work. That feels like a bubble. At the later stages, there are a lot of big funds that are pricing things in ways that are not based on economic fundamentals. However, it may unfold very differently than the last bubble. Then, you had a lot of companies going public with no revenue, and that public market fueled a lot of what happened in the private market. That is not something we have now. Now, to go public, the average revenue you have to have is about $55 million a year. So you could see a smaller correction, a 25 or 30 percent correction in the public markets. The public markets are open. If they shut a bit, the later-stage funding markets will shut a bit, and it will cascade like that. But I don’t see a big bursting like last time.
Deutsch: But even a correction has ripple effects that reach the average person. Lots of companies have parts of their pension funds or their investment portfolios in this tech game. So it won’t be the disastrous tech crash, but it will affect the broader market. In a very high stock market, if there were to be a correction, investor confidence could be hit, and you could see a ripple effect across the stock market, just like we did in 2007–08.
Meadow: Investor confidence plays out the way you would think: there’s a flight to quality. Franchise firms can fund as a result of that franchise. Not only do they have their own capital for their projects, but they are also able to bring in people from all over the country. The problem is, that shrinks the number of funds, which hurts entrepreneurship in general.