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BubbleTime Stories #1: Insane Investing Behavior by Venture Capitalists
Every week I'm going to post about the absurd things that happened during the 2020-2022 bubble. First up, investors who stopped doing due diligence.
Starting in late 2020 and wrapping up in early 2022, Venture Capital was on fire. In 2021 specifically, VC total investment doubled to $361B in the US, according to KPMG.
The reasons for this funding surge will be discussed for years, but mainly it was triggered by massive government spending combined with zero interest rates in response to Covid.
This led to a dramatic increase in fund sizes, new funds, new investors, and new investing strategies. Money needed to be deployed, fast.
Unsurprisingly, this led to some pretty bad behavior.
Let’s start with the most obvious example - insane valuations.
Series A rounds were $15-30M on $100-300M valuations, with revenue under $5M. Also sometimes zero. Almost always overstated.
Late-stage rounds were even crazier, and companies were going public via SPAC at comically large valuations. Bird went public at a 2.3B valuation, today they are valued at $48M.
New Funds with Inexperienced VCs
A strategy for a new investor to win deals against traditional VCs was easy - Price. Offer more money, at a higher valuation, and the founder would take it. Not good enough? Offer a secondary, even at Series A.
This drove the traditional venture capitalists nuts because they had to move outside their comfort zone of investing. And they did.
Venture arms of large tech companies joined the party too but often did little to support their portfolio companies after the raise. It was dumb money.
No Due Diligence
With the speed at which money was flowing into startups, due diligence was all but abandoned. Term sheets at times were sent often within a week after the initial pitch.
Startups with broken financial processes, no product-market fit, alarming customer churn, and/or little to no revenue were receiving investment cheques in the millions.
Certain investors such as Tiger Global were notorious for this. They were attempting to build a private index fund and throwing cash at startups with no due diligence and no requirement for a board seat. One of their partners notoriously suggested they know if they are going to invest “based on a feeling in the first zoom call.”
Even traditional well-respected investors such as Sequoia made mistakes. Most famously, they (another other top tier investors) invested in FTX, the failed crypto exchange. Losses are expected, but the scale of the investment combined with the apparent lack of DD are surprising. (Note they have stated they followed their process, but they are being sued so they have to say that).
With round sizes and valuations skyrocketing, any investor pushing for proper due diligence simply lost out on the deal.
Many startups that raised Series A or even B had no functioning product, let alone product-market fit. Investors never called customers, played with the app directly (vs founder demo), properly vetted founder backgrounds, or looked at user engagement metrics under a microscope.
In real estate, you have bully offers. In venture capital, you have pre-emptive rounds. This is when investors approach the founder to close a new round before the startup is prepared to run a process.
Example: Startup XYZ just raised a $5M Seed on a $25M valuation 3 months ago. A group of investors like the company and the market thesis, so they decide to make an offer: $25M at $125M post-money valuation.
Startup XYZ certainly does not have the revenue or unit economics to raise at this type of valuation. The investor knows this, but they want in before anyone else can get involved.
Why would investors do this? Traditionally, it was because they had high conviction on the market and the founding team’s ability to execute at speed.
During 2020-2022 that changed. Existing investors pushed for pre-emptive rounds because they wanted to mark up their holdings so they could raise a new funding round.
Let’s say the seed investor of Startup XYZ invested the full $5M at Seed. This gives them 20% equity — or $6M post-money. After the pre-emptive Series A, now they (back of the napkin) own 16% equity — or $20M (a 230% increase).
Now the seed investor can go their LPs with a paper-money value increase and leverage this to raise a new, larger fund.
In most cases, the startup did not need the money. They certainly weren’t ready for it. Series A expectations are all about growth, while Seed expectations were about finding product-market fit.
The founders even knew they didn’t need the money, but guess why they took it? You guessed right - secondaries.
Fast-Talking Morally Gray Founders Were Rewarded
There are many very public cases of fast-talking founders who raised absurd amounts of money at insane valuations without having built anything much.
One of the more prolific cases is Domm Holland and Fast. This company raised $102M from Stripe, one of the most respected companies in the valley.
This story could easily be from 1999 and the first bubble.
The founder had a checkered past - including a legal battle where he threatened to sell personal data.
The company itself? Burning $10M (yes 10 MILLION) per month with $50k MRR. He literally lit $100M on fire in 10 months.
While Fast is a very public failure, there are hundreds, perhaps thousands of startups out there with equally morally gray founders. They knew the real path to making some money was to raise as large a round as possible, as competitively as possible. Why? Yup. Secondary.
Noticing a theme here? Large secondaries before Series A shouldn’t exist. But that’s another post.
Imagine you could walk into a bank, get $1M in almost free cash for some warrants, without any requirement for collateral or security?
That was Silicon Valley Bank. When a startup raised a round, often SVB would pop in to offer venture debt. They did look at financial data including invoicing, receivables, etc. The venture debt offered though was out of sync with the financials — for instance on $3M in sales with a $10M forecast, you could get $1-2M. With absolutely no collateral or security.
How much would you believe a startup’s sales forecast? Especially when their investors are telling them they must 4-5x this year?
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