VCs Want to Give You Wads of Cash. Why You Shouldn't Take It
Apple hoards billions of dollars of its own cash. So perhaps it shouldn't come as a surprise that small companies are following suit, socking money away for a rainy day--and they are doing it with money from investors.
Data analysis and management company Cloudera announced a monster $900 million round from computer chip maker Intel in late March. Airbnb is reportedly in talks with T. Rowe Price, private equity firm TPG, and Dragoneer Investment Group for a $500 million round. And car-share startup Lyft raised $250 million from Alibaba and numerous other investors in April.
An inflated stock market, a strong merger and acquisition scene, and flush private equity firms on the prowl for higher returns are spurring more late-stage investments in promising companies, which might previously have gone public before. Now these companies are playing a waiting game, and taking money for which they may not even have an immediate need.
"Private market valuations are outpacing public market valuations by a healthy margin," says David Zilberman, a partner at Comcast Ventures, in San Francisco. "Many companies are indeed bankrolling money for a rainy day, or for if and when the market corrects." Comcast has more than a dozen companies in its portfolio for which it has provided late-stage venture capital, Zilberman says. Among those are social media company Flipboard, smart medical device Jawbone, and most recently ClearSlide, a collaborative sales software company.
While saving up for an uncertain future may seem like a smart idea, it comes at a cost: These startups run the risk of diluting ownership and possibly misspending their wads of cash, experts say.
How We Got Here
So why is the money flowing more freely now? In short, there's a lot of pent-up demand. Private equity and venture capital funds sat on the sidelines throughout much of the recession waiting for the economic situation to level out before they committed valuable cash. There's more than a $1 trillion of unspent cash in the private equity world, a record level, according to Bain & Co.'s global private equity report for 2014.
In 2013 about $9 billion flowed into later-stage investments, compared to about $10 billion for earlier-stage companies, the National Venture Capital Association reports.
"Companies are not 'opting out' of going public, but being smart by hedging against an IPO market that may be unreceptive and taking advantage of the easy cash," says Kathleen Smith, principal at Renaissance Capital, an IPO advisory and research firm.
And as private equity and venture capital funds go shopping, they're joined by other investors not typically seen on the hunt.
"Huge pools of capital from the largest asset groups in the world are hunting for returns from high-growth companies," Ross Fubini, a partner at venture firm Canaan Partners says. That includes traditionally private market investment groups such as Tiger Global and T-Rowe Price, "which have gotten comfortable with the risk in investing in pre-public companies," Fubini says.
Also on the scene are corporate capital groups such as Google and Intel, investing in companies that might complement their core businesses, or where they see an investment upside, Fubini says.
Late-stage investments are also a counterbalance to riskier early-stage rounds, but returns can still be pretty sweet, Zilberman says.
The Million-Dollar Question
Of course, the question the remains: Just because the money is available, should you take it? Some Silicon Valley founders think it's a no-brainer. Nextdoor CEO Nirav Tolia told the New York Times recently, "There's a Silicon Valley expression: Eat when the food is passed." Nextdoor accepted $60 million in funding last year even though it had no immediate need for the cash.
But there are serious downsides to stashing extra money from investors. For one thing, you may shrink your ownership of the company, but there's also a very real risk of blowing the money unwisely.
"Injections of cash at outrageous valuations do not create value in the majority of circumstances," says Bryan O'Rourke, Chief Executive of Integerus, an investment advisory firm in New Orleans specializing in wellness technology. "In fact this often undermines value because management does not know how to apply the capital in a business not mature enough to understand its model."
Private equity or other investors, for their part, are generally looking to earn two to three times the dollars invested, depending on the deal, compared to 10 times the amount invested for earlier deals.
Meanwhile, high-growth firms are still in the driver's seat, with median valuations for all private companies up 20 percent compared to 2010, the trough of the recession, according to one estimate. That helps explain why many of the companies are willing to take the extra cash, despite the dilution risk.
"When valuations are as high as they are, company owners are willing to take in more capital even if they are getting diluted," says Jeff Kadlic, managing partner of private equity firm Evolution Capital, in Cleveland.