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When Unicorns Take Flight

July 15, 2015

This column first appeared in Venture Capital Journal.

At the start of this year, I was quite optimistic about the M&A environment, and I’m sure I wasn’t alone in the venture community.

My enthusiasm seemed well grounded. The economy overall and tech spending were growing, the cost of capital remained at historic lows, public companies were flush with cash, the currency of their stock was strong, and there was strategic and competitive consolidation happening in several tech sectors.

Now halfway through 2015, the economic environment remains strong, but we’ve seen only two $1 billion-plus tech transactions versus six last year, and even sub-billion-dollar activity has lagged compared to the last several years. So, what gives?

First, high-quality companies are staying private and independent much longer. And why shouldn’t they? Capital is available with little dilution, and there is usually partial liquidity for founders and early investors in secondary transactions. So a young company can grow and incur losses without feeling the pressure to have an exit. Obviously, we’re hoping all our unicorns can be the next Uber or Airbnb, and if they are, then we are doing the right thing for our LPs by letting them accrue value before they go public.

The problem is that they aren’t all going to go public. Two-thirds of successful venture liquidity traditionally comes from M&A. Each sector can have a leader, and maybe a fast follower or two that are independent companies. The rest will need to find a home eventually, but how many public companies will have the desire or even ability to acquire them?

All of these signs show that we are seeing the repercussions of an overheated private equity market. Many have been talking about a “bubble” in private valuations and I believe it is true. It’s very tough for a public company to pay a vastly different revenue or earnings multiple for an acquisition than what it gets for its existing business, especially when the numbers are large. There are exceptions—an acquisition that is uniquely strategic or where there is an absolutely critical competitive need—but these really are exceptions.

As a venture capitalist, I wonder if we should be putting more pressure on companies to get liquid. We have been content to mark up our investments and raise money in late-stage rounds rather than push to an exit for private shareholders. It’s hard to advise an entrepreneur otherwise when money is so cheap, but it’s a double-edged sword.

I hope to see a modest cooling off in late-stage rounds because it would make M&A much easier and might save us from a more protracted and severe downturn later, but experience suggests this will not happen.

This frothy environment is also affecting entrepreneurs and making many become enamored with high private valuations. My advice to all entrepreneurs is to keep your burn rate reasonable and have a plan to get to cash flow breakeven. It’s a lot easier to decide to invest and grow faster than it is to cut back. I like for every portfolio investment to plan for being a public standalone company, but more often than not, there is a right time to be acquired. Savvy entrepreneurs think early about likely merger partners and optimal timing of M&A in case they need to go down that path. But the path has to be cleared!