Letters

Large Fundraising is not Value Creation

August 2021

Large Fundraising is not Value Creation

In your daily reading you may have noticed an increase in the number and amount of venture fundraising for startups and early-stage companies. Not long ago, a venture capital fund with more than 1 billion USD was a rarity. No more. There are now quite a few with more than 10 billion USD and even one raised at 100 billion USD, a number that to my knowledge also tops the largest Private Equity Fund.

This capital is being put to work at a frenetic pace. The competition for funding the hottest startups is high and entrepreneurs oblige by raising more capital than needed in a funding arms race. The industry statistics bear this out. In the last half-year, the venture funding activity was 3x larger than the average of prior years (see figure 1):

Figure 1
Source: CB Insights; Somar Analysis

We understand this excitement. It is a great time to be alive and to launch an innovative and disruptive business. There has never been as much depth and speed of innovation as there is now. The pace of consumer adoption is also the fastest ever. In addition, most of the innovative companies have very efficient business models, requiring little capital to scale, unlike more than 100 years ago when the growth businesses of the time required extremely high capital investment in assets such as refineries, oil fields, steel mills, railroads infrastructure and even bank capital.

However, as investors we are concerned. Strong incentives often lead to perverse consequences in human affairs. Overcapitalized startups tend to develop habits of unfocused management with a lot of unprofitable side projects and grow “fat” in expense early on, creating poor practices that impair their long-term profitability prospects.

Founders and start-up managers face a common human conundrum: short-term pleasure with long-term costs or short-term pain for long-term gain? Specifically, do you take as little capital as possible and run a lean and focused shop to create a high-performance organization and minimize dilution? Or do you take as much capital as available to shut out your competitors, build an empire through acquisitions and grab significant media attention now while relying on a shallow moat and impairing your long-term profitability prospects?

If the answer was easy, this would not be a conundrum. Human nature makes this decision hard. Especially, when venture capital investors threaten to shower your competitors with capital that will be used to compete against you.

At Somar we pay extremely close attention to this issue. We strongly admire entrepreneurs that take the hard road of minimizing capital raised. It demonstrates focus, conviction of their own strategy, and a moat that is not easily breached with capital alone.

In the table below we present two groups of companies that chose two opposite approaches to the conundrum described above:

Table 1
Source: Crunchbase; Bloomberg; WeWork; Somar Analysis

It is interesting to note that while the group of companies that raised significant amounts of capital is no longer led by their founders, the group that minimized fundraising still has their founders as active CEOs.

While still early days to make a conclusion on these, the leaner fundraisers have created significant more shareholder value than its comparison group. This difference is easier to grasp in the chart below:

Figure 2
Source: Crunchbase; Bloomberg; WeWork; Somar Analysis

One might counterargue that the case studies are “cherry-picked”. However, both Uber and WeWork have been the two largest fundraisers of venture money in the past 5 years with no other company having raised more than $10 Bn except for Didi, which also has a poor track record for value creation1 and would support our conclusions if added to the group.

Entrepreneurs like the founders of Zoom, Figs, Duolingo and Upstart are our heroes. It is a pleasure to partner and support them as they continue to build amazing companies that create significant value for its customers, employees, communities, and its shareholders.

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It is always a pleasure to hear what is in your mind and to update you on our thoughts and progress. I look forward to hearing from you at either pedro.ramosatsomarcap.com or +1.646.581.6842.

All the best,
Pedro Ramos

[1] One can link Didi’s low valuation to its ongoing regulatory problems in China. But even considering its IPO price, its multiple of value creation would not change the conclusions presented in Figure 2.

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Disclaimer: This website is for general information purposes only and is not intended to be, nor should it be construed as investment advice, nor a solicitation or offer to buy or sell any securities, related financial instruments, or  interests in the Somar Master Fund, LP (the “Fund”) or its feeder funds. The information contained herein is not complete, and does not contain certain material information such as disclosures and risk factors about the Fund or its feeder funds. Opinions expressed are current opinions as of the date of this material only and are subject to change without notice.Hedge funds: (1) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; (2) can be highly illiquid; (3) are not required to provide periodic pricing or valuation information to investors; (4) may involve complex tax structures and delays in distributing important tax information; (5) are not subject to the same regulatory requirements as mutual funds; and (6) often charge high fees. 

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