The Curse of the Megaround

With what everyone seems reluctant to call a bubble in late-stage, private financing in full swing, I thought I’d do a quick post to drill into a concept I presented in my 2015 predictions post, something I call the curse of the megaround.

We will do that by examining the forces, and the winners and losers, surrounding a megaround.  Let’s start with a hypothetical example. Company X raises $200M at $1B pre-money, giving them a $1.2B post-money valuation.

Champagne is popped, the financing is celebrated, the tech press bows, and the company is added to many unicorn trackers.

Now what happens?

• The CEO is under immediate pressure to invest the additional capital.  If you take the rule of thumb that most venture rounds are designed to last 18-24 months, then a $200M raise implies a cash burn rate of $8 to $10M/month or $25 to $30M/quarter.  That is an enormous burn rate and in many cases it is difficult or impossible to spend that much money wisely.

• The CEO is under heavy pressure to triple the value of the company in 2-3 years.  The investors who do these rounds are typically looking for a 3x return in 2-3 years.  So the CEO is under huge pressure to make the company worth $3.6B in 2-3 years.

• This, in turn, means the CEO will start investing the money not only in promising growth initiatives, but also dubious ones.   Product lines are over-extended.  Geographic over-expansion occurs.  Hiring quality drops — in an attempt to not fall behind the hiring plan and lose all hope of achieving the numbers.

• In cases, money is waste en masse in the form of dubious acquisitions, in the hope of accelerating product, employee, and customer growth.  However, the worst time to take on tricky acquisitions is when a company is already falling behind its own hypergrowth plans.

• All of this actions were done in the name of “well, we had no hope of making the plan if we didn’t open in 12 countries, hire 200 people, add 3 product lines, and buy those 2 companies.”  So we may as well have tried as we would have been fired anyway.  At least we gave it our best shot, right?

• This often comes to a head in a Lone Ranger moment when the board turns on the CEO.  “Didn’t we agree to that hiring plan?  Didn’t we agree to those product line extensions?  Didn’t we agree to that acquisition?” the CEO thinks.  But the board thinks differently.  “Yes, we agreed to them, but you were accountable for their success.”

Yes, being CEO can be a lonely job.  This is why I call it the curse of the megaround — because it’s certainly a curse for the CEO.  But the situation isn’t necessarily a curse for everyone.  Let’s examine the winners and losers in these situations.

Winners

• The founders.  They get the benefit of a large investment in their company at low dilution without the downside of increased expectations and the accountability for delivering against them.

• The private equity fund managers.  Provided the turmoil itself doesn’t kill the company and new, more realistic plans are achieved, the PE fund managers still get their 2+20 type fee structure, earning 2% a year baseline and 20% of the eventual upside as carry.  In a “more normal” world where companies went public at $300M in market cap, there would be no way to earn such heavy fees in these investments.

Losers

• The CEO who is typically taken out back and shot along with any of the operating managers also blamed for the situation.

• The company’s customers who are typically ignored and under-served during the years of turmoil where the company’s focus is on chasing an unreachable growth plan and not on customer service.

• In the event the company is sold at a flat or down valuation, the common stock holders (including founders and employees) who can see their effective ownership either slashed or wiped-out by the multiple liquidation preferences often attached to the megaround.  (People love to talk about the megaround valuation, but they never seem to talk about the terms that go with it!)

• The private equity limited partners whose returns are diminished by the very turmoil their investment created and who are stuck paying a high 2+20 fee structure with decade-ly liquidity as opposed to the 1% fee structure and daily liquidity they’d have with mutual funds if the companies were all public (as they would have been pre-Sarbox.)

• The private equity limited partners who ultimately might well end up with a down-round as IPO.

In some situations — e.g., huge greenfield markets which can adopt a new solution quickly and easily — a megaround may well be the right answer.  But for most companies these days, I believe they are more curse than blessing.