SHOCKER! Facebook Confirms Investors Focus on Reality, Not Hype

Is it possible that for what will go down as a fleeting moment, investors got loaded on Kool-Aid and went too far funding startups missing the only important ingredient in business: making money?? One of the most respected voices in Silicon Valley thinks so.

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Y-Combinator’s Paul Graham sent a letter to his portfolio companies in an attempt to manage expectations and sober up the frat parties. I’d classify the message as wise and pithy as a Warren Buffett shareholder letter. In it, Graham explains the Facebook (NASDAQ:FB) IPO has the potential to stick a pin the the startup investing cycle:

What does this mean for you? If it means new startups raise their first money on worse terms than they would have a few months ago, that’s not the end of the world, because by historical standards valuations had been high. Airbnb and Dropbox prove you can raise money at a fraction of recent valuations and do just fine. What I do worry about is A) it may be harder to raise money at all, regardless of price and B) that companies that previously raised money at high valuations will now face “down rounds,” which can be damaging.

The only “down rounds” entrepreneurs have been discussing is how many rounds of drinks they can down at lavish parties following a capital raise. How quickly everyone forgot 1999.

Believe it or not, new entrepreneurs must meditate on a crucial fact: Boomers and their retirement funds are at the core of institutional money in public markets. These same Boomers not only got hosed by the recent Great Crash of 2008, they got annihilated when the dotcom bubble bust. How badly? The Nasdaq (NASDAQ:NDAQ) is a daily reminder we’re a LONG way from the peak of Nasdaq 5,048.62 (on a closing basis).

So what’s the point? Investors have been hoodwinked a lot lately. So much so they are finally interested in businesses which make money. You can’t really blame us. We are buying future revenues … and if you don’t have any you’re worth a pro rata share of a dime a dozen.

So, what did Graham advise his little seedlings?

If you haven’t raised money yet, lower your expectations for fundraising. How much should you lower them? We don’t know yet how hard it will be to raise money or what will happen to valuations for those who do. Which means it’s more important than ever to be flexible about the valuation you expect and the amount you want to raise (which, odd as it may seem, are connected). First talk to investors about whether they want to invest at all, then negotiate price.

If you raised money on a convertible note with a high cap, you may be about to get an illustration of the difference between a valuation cap on a note and an actual valuation. I.e. when you do raise an equity round, the valuation may be below the cap. I don’t think this is a problem, except for the possibility that your previous high cap will cause the round to seem to potential investors like a down one. If that’s a problem, the solution is not to emphasize that number in conversations with potential investors in an equity round.

If you raised money in an equity round at a high valuation, you may find that if you need money you can only get it at a lower one. Which is bad, because “down rounds” not only dilute you horribly, but make you seem and perhaps even feel like damaged goods.

Sounds like 2000. Man, did that suck. Personally, I just got done raising a round about 6 months before the dotcom bubble burst. The growth assumptions in our model essentially became worthless overnight. However, there was a silver lining to our story: we actually MADE MONEY. So, while 99% of the entrepreneurs and investors I knew were waking up to a new job search, our company steadily grew to this day without any more investment capital. My experience echoes Graham’s best advise:

The best solution is not to need money. The less you need investor money, A) the more investors like you, in all markets, and B) the less you’re harmed by bad markets.

I often tell startups after raising money that they should act as if it’s the last they’re ever going to get. In the past that has been a useful heuristic, because doing that is the best way to ensure it’s easy to raise more. But if the funding market tanks, it’s going to be more than a heuristic.

That experience of startup austerity was sad at the time, but the best business education I ever received. I’ve started two more ventures since then and the core framework was starting with a profitable model. In my third and current venture, Wall St. Cheat Sheet, the focus on revenues and margins has created a completely bootstrapped business which prides itself on spending every dollar in the context of how hard it is to make every dollar. As Graham also wisely warns:

The startups that really get hosed are going to be the ones that have easy money built into the structure of their company: the ones that raise a lot on easy terms, and are then led thereby to spend a lot, and to pay little attention to profitability. That kind of startup gets destroyed when markets tighten up. So don’t be that startup. If you’ve raised a lot, don’t spend it; not merely for the obvious reason that you’ll run out faster, but because it will turn you into the wrong sort of company to thrive in bad times.

That’s the Darwinistic nature of capitalism. And, sorry to say, it’s better these free-wheeling spenders go out of business as early as possible because they are horrible investments when they finally go public. Look no further than Groupon (NASDAQ:GRPN) for current proof. These companies are simply undisciplined and unsustainable parties for the founders and employees lucky enough to suck capital out of the business before the music stops.

I’ll leave you with a highly relevant story. A few days after the Facebook IPO I was at an investor meeting for a group of very prominent local business people. 80% of the attendees were over 50. Before we got started, the group had a series of deep chuckles at the expense of new Facebook shareholders. Why? They saw it coming. They’d heard the stories of “future” potential and monetization. They’d been there and done that. They saw the Groupon and Zynga (NASDAQ:ZNGA) IPOs get flushed down the toilet. They didn’t like the wild ride LinkedIn (NYSE:LNKD) investors took post IPO. They were tired of being pitched the next great app at a pre-money valuation of $2-3 million. These guys have a much smaller investing time horizon than a decade ago. They want businesses that make money now and are priced according to sane valuations giving them a realistic probability of making enough reward for their risk. And now Mark Zuckerberg has proven these types of investors are back in vogue.

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