By Philip Lay, Senior Advisor, The Chasm Group LLC
Ever since the advent of cheap and plentiful capital following the global financial crisis, a new business model has gradually muscled its way to the forefront, in many cases supplanting the conventional B2C — business to consumer — model and co-existing alongside the B2B — business to business — business model.
This is venture capital to consumer model which has become commonplace, particularly in consumer markets. Virtually every venture firm has one or more intentional or unintentionalVC2C’s in its portfolio.
The intentional cases are where investors have consciously invested in a business to get scale before monetization or before profitability. The unintentional ones are where the tech company in question has a business model that is resistant to profitability, possibly terminally so. Over the past two decades there have been plenty of cases, including household names like Youtube and Dropbox.
This model has a rather ignoble history. In recent times it was first attempted during the largely disastrous internet boom of 1995–2000. It went quiet during the nuclear winter of 2001–2007 and then reared its head again after the 2009 financial crisis when interest rates plunged to zero, startup activity in consumer internet 2.0 got going, and investors of all stripes were left with too much cash chasing too few deals.
A concomitant cause of this re-edition of the VC2C model is the continued resistance of public capital markets to permit a recurrence of the lightning-fast IPOs that blighted the first internet boom. This meant that privately funded tech companies have remained private for extended periods, from seven to ten years or more. So Dropbox, founded in 2007 only went public eleven years later in early 2018. Facebook, founded in 2004, went public in 2012 with investors skittish about whether they had yet found a profitable business model. Since then, they finally got their mobile act together, powering it with targeted ads and proceeded to build a massive advertising oligopoly along with Google.
In both cases, these companies were richly funded by VCs without having demonstrated that they had anything close to a profitable business model. Between 2007–2018 Dropbox raised a total of $1.7bn., virtually unthinkable for what is essentially a file-sharing utility albeit a well-designed, reliable and easy-to-use tool. Facebook raised a total of $2.3bn. in 14 rounds between 2004–2012.
By the end of these funding feasts, Dropbox had amassed 500 million users and Facebook had reached the 1bn. mark. In terms of valuation, Facebook was valued at $104 bn. as a result of its IPO, whereas Dropbox was valued at $9.2bn. Interestingly, this valuation was less than Dropbox’s earlier valuation of $10bn.+ three years before its IPO.
Since then we’ve seen two giants of the gig economy, Airbnb and Uber, achieve valuations of $38bn. and $100bn.+ as of the end of 2018. Whereas Airbnb now boasts a small profitability of around $100m. on $2.6bn in revenues and appears to have the beginnings of a solid business model, Uber still gorges on venture capital to the tune of losing around $900m. in Q2 2018 on $2.8bn. in revenues for that quarter. And neither one has yet gone public a decade after their founding, even though they have both announced their intention to do so in 2019, market conditions notwithstanding.
Uber is a case apart. It’s difficult not to empathize with taxi and limousine owners around the world who complain that Uber is basically subsidized by its investors. It’s fine if the funding serves to give flight to a business that at a certain point becomes (and remains profitable). But is it really okay for a business to rape and pillage the ride-hailing industry for easy pickings without showing any indication of becoming self-sustaining after a decade of critical financial support? Very few industries would tolerate this kind of investor largesse. I say these words despite being a frequent Uber customer. But my wish is that this subsidized model eventually gives way to one that actually stands on its own merits as a business.
What are the chances of this happening? From all appearances, its seems that Uber’s great hope is to do away with pesky drivers and make its money off of fully automated self-driving cars owned and operated by …. I wonder whom?
Consider that these poster-children for the vices and virtues of the past decade’s model of extended VC2C investing are among the winners. Snap was another richly funded high-flyer that has raised $4.9bn. in 12 rounds including post-IPO, without yet producing even a sniff of profits on its $1bn. or so of 2018 revenues. To be sure, Snap (formerly Snapchat) chose to go public before some of these other unicorns, and has been penalized by having a confused strategy and being somewhat marginalized by having Facebook targeting it competitively. As a cautionary tale in the consumer internet marketplace, Snap takes some beating: its market valuation is a fraction — 25% or so — of its IPO valuation just under two years ago.
Many more startups and scaleups have gone through repeated private funding rounds for a decade or more and show few signs of being in a position to go public or to generate profitable growth on a sustainable basis.
Which brings us to the VC2C problem that I believe is going to result in somewhat of a bubble burst this year, if not next. The era of cheap money is gradually ending, even though interest rates are still increasing quite slowly deterred by slowing growth around the world. There are far too many startups and young struggling scaleups chasing way too few acquirers (the other escape valve, IPOs, having become a perilous route to take for most under-monetized consumer internet businesses).
Yes, we have a few new mega-rich acquirers to supplant the IBM’s and Cisco’s of old, such as SAP and Oracle that kept their acquisitive urges mainly to their B2B world. And we have one oldie-but-goodie in Microsoft, recently revived under the leadership of Satya Nadella, to add to the hitherto highly acquisitive FAANGs. But a few of these internet giants, in particular Facebook and Google, are beginning to encounter problems of their own. Apart from increasing threats of regulation especially by the EU, their stock prices are under new pressure, and above all there’s a growing socio-political-regulatory “techlash” that I don’t see letting up anytime soon.
I’ve written before that the tech industry needs to stop indulging in its adolescent glee about disrupting the world, and start displaying a more grown-up approach to collaborating with users, customers, partners, and authorities, but it’s not clear to me that entrepreneurs and other techies have yet learned their lesson. It’s going to be vital that the tech industry keeps in good standing with all major stakeholders if it is to avoid a vicious backlash that could set the industry back years.
In this environment, with some of the large acquirers increasingly under fire, and the public capital markets entering what appears to be a less bullish, more volatile period due to increased macro-economic and political risks, many companies that are emblematic of the intentional and/or unintentional VC2C model will surely come under severe pressure as venture and private equity firms tighten up their investment criteria and show less appetite to keep funding their eternal, not-for-profit unicorns. This will surely make for a new form of interesting times for investors and boards!