Cockroaches Rise, Unicorns Fall as Venture Capital Plays Moneyball
Startups finding solutions to expensive problems that need solving are better suited for a new phase of tech sector funding.

Two straight quarters of declines in VC funding globally show how tech sector money has pulled away from growth-at-all-costs unicorns in favor of the slow-and-steady “cockroaches.”

Now that sobriety has set in, the tech world sees in hindsight how a nearly indestructible creature, able to live on dust, would be more attractive to investors than something that doesn’t exist – like profits among some of the most well-known tech plays of the past few years. Think Pinterest, Yelp, etc.

“We like businesses that are able to fuel their own growth,” said David Crow, a tech industry consultant and former OMERS Ventures Director. “The ones that are able to show strong unit economics, strong margins and strong customer growth.”

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Leading the devaluation charge, Fidelity Investments wrote down unicorns including Dropbox and Cloudera, companies that had gorged on VC money for putting growth ahead of profitability.

To qualify as a unicorn, a private startup must have achieved $1 billion in pre-IPO funding. A cockroach, by contrast, is a business that builds slowly, focusing on the fundamentals, keeping a close eye on revenues and profits, and limiting spending on fixed assets so that it can withstand economic and competitive headwinds. Shopify, which took 11 years to get to unicorn status, is a classic example.

The pivot away from unicorns has been quick. According to KPMG, only 5 new VC-backed companies entered the unicorn club in the first quarter of this year – less than half that of any of the first three quarters in 2015. And not one VC-backed tech IPO made it to market. Aggregate VC activity fell to 1,829 deals, the lowest since Q2 2013. Total VC funding globally dropped 33 percent from a quarterly high of $39 billion in Q3 2015 to $25.5 billion in Q1 2016.

Sex in the Stairwells

Zenefits is emblematic of the trend. One of the fastest growing startups ever, the online insurance broker went from launch in 2013 to $583 million in funding and 500 employees by the beginning of 2015. By September that year head count had exploded to 1,600.  The story of its decline – the parties, the power struggles, the flawed products and processes, the lack of legal compliance, the lies told to clients, the sex in the stairwells – is just waiting to be turned into a Netflix series.

By February 2016, Fidelity had marked down Zenefits by nearly two-thirds below what it paid for its stake in the company less than a year earlier.

VCs are looking at startups with more  attention to business fundamentals than they did in the heady days of mid-2015. The difference between then and now is like the difference between New York Yankees owner George Steinbrenner and Oakland A’s manager Billy Beane.

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In the late ‘90s, Steinbrenner had the financial clout to swing for the upper decks in pursuit of baseball’s biggest hitters. But the financially strapped Beane (whose story was the basis of the film Moneyball) focused on signing lesser players with one thing in common: a high on-base percentage. The crew he assembled went on to win 20 straight games in their first season together. In the 2016 game of startup investing,  investors are looking for Billy Beanes.

In the words of KPMG/CB Insights’ Venture Plus Q1 2016, it’s the startups with positive margins, controlled expenses and a clear path to profitability that will get the funding. In other words, well-grounded, like cockroaches.

Andrew Light, Managing Partner for the Americas at Melbourne-based VC firm EatonSquare, echoes the sentiment. “For us it always comes down to people on the management team. Have they done this before? Did they have success? Is the business solid enough to inspire the confidence of investors? For a lot of venture capitalists, taking on early-stage stuff is too risky because if it doesn’t turn out it damages their reputation and makes it harder to sell the next bet.”

Cybersecurity

So where does one find these low-lying, long-lasting diamonds in the rough? One place where cockroaches seem to congregate is the cybersecurity space. Network and enterprise security provider Paloalto Networks took 7 years to get to IPO, while threat forensics and malware protection firm FireEye took 10 years.

Managed security services provider Trustwave, which was just acquired by Singtel, was founded in 1995. Trustwave launched its first managed security product in 2002 and spent the next 13 years slowly building out a global infrastructure of operations centers while growing its customer base.

Up and comers to watch in this space include smartphone security firm Lookout and cloud-based network security service firm Cloudflare.

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It’s no surprise that many cockroaches are innovating in the cyber security space as opposed to social sharing or other areas that aren’t obvious bets when it comes to monetization. Global spending on information security is expected to more than double to $170 billion by 2020 from $75 billion in 2015, according to estimates compiled by Forbes.

Companies innovating successfully on expensive problems that require solutions as a legal imperative will have more luck getting funded than those coming up with gimmicks.

As Flickr founder Caterina Fake warns in her widely shared article The Age of the Cockroach: Companies that want to outlast the coming funding crisis will need to “plan for a future without much money in it.”

 

 

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