When venture capitalists invest, they are ruled by emotions. When they have fear of missing out (FOMO) on the next big thing, they compete with one another for the biggest bite of the next big thing. And when that next big thing turns into a gigantic disaster, the fight-or-flight response abruptly turns FOMO into fear of losing everything (FOLE).

These emotional swings have a direct effect on company founders. As VC FOMO swells, founders whose companies are at least doubling every year should raise as much money as they can. This may prepare you for when FOLE predominates -- at which point VCs will let you twist in the wind until your company is cash-flow positive.

This comes to mind in considering the fate of SoftBank, the publicly traded company that controls over $100 billion in venture capital. SoftBank invested billions in WeWork, which signed long-term leases for office space, added beer and fruit-infused water, and subleased desks short-term. 

After WeWork's valuation dropped 83 percent from $47 billion in January to $7.8 billion last month, SoftBank announced November 5 that it had taken a $4.7 billion charge to write-down the value of that investment (and another charge for the loss in Uber's value), according to The Wall Street Journal. SoftBank CEO Masayoshi Son publicly apologized, saying, "My own investment judgment was really bad. I regret it in many ways," noted the Journal.

Indeed, it is very difficult to defend Son's investment judgment in pouring $10 billion into WeWork. After all, despite doubling its revenue, WeWork burned through $1.4 billion in cash in the first half of 2019 on $1.5 billion in revenue.

Rescuing WeWork -- which is stuck with nearly $18 billion in long-term leases -- will be very costly. It will be difficult to find its few profitable leases and costly to get out of the money-losing ones. SoftBank might need to put in even more than the $18.5 billion in equity and debt that it has already committed to WeWork since pulling its IPO.

My interpretation is that SoftBank thought that either WeWork could eventually get big enough to become profitable or, if not, it could persuade IPO investors that the company was worth much more than the $47 billion at which it made its most recent pre-IPO investment. Both of these thoughts strike me as a good outcome for SoftBank and not good for potential IPO investors.

How Do Venture Capitalists Make Money?

To understand how SoftBank's losses are likely to effect how it invests, it helps to know how VCs' business model is supposed to work.

VCs take money from pension funds, endowments, and others that is locked in for a decade. VCs charge a 2 percent management fee and take 20 percent of profits they generate.

Unfortunately for their investors, the typical VC fund has not generated very high returns -- especially given how much riskier venture capital is than a stock index fund. According to Cambridge Associates, the average VC fund earned a 9 percent internal rate of return in the decade ending in 2017 -- the same as the far less risky S&P 500 index.

To succeed, for every 10 companies in their portfolio, VCs typically have one big success -- generating 10 or more times the value of the investment through an IPO -- two that break even after being acquired, and seven that fail. 

A frothy IPO market is good for VCs who are ready to take a portfolio company public. To do that, companies typically have $100 million in revenue, are growing faster than 30 percent annually and likely to keep growing that fast; and are burning through cash at a modest rate -- or in some cases profitable.

Will SoftBank's Woes Affect How VCs Invest?

With WeWork, SoftBank was testing the limits of how much deviation from that profile the IPO market would tolerate.

IPO investors balked at owning shares in WeWork, which had no realistic prospects of getting profitable, an ephemeral mission -- "elevating the world's consciousness" -- and a management team fond of intoxicants with absolute voting control. 

Since WeWork pulled its IPO, money-losing recently public companies like Uber and Peloton have cost their IPO investors bundles. As of November 7, Uber and Peloton shares were down 36 percent and 12 percent, respectively, from their IPO prices.

These outcomes are not good for venture capitalists seeking to take companies public, because they suggest that IPO investors will keep balking at their pricing their companies above the value at which they most recently raised private capital.

Still, I don't expect venture capital firms to change the way they invest in startups. They will probably try to keep their most promising companies afloat until the current FOLE abruptly returns to FOMO.

After all, the best time to sell is when everyone else is fighting to buy. 

Published on: Nov 11, 2019
The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.