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4040LocustStreet

PhiladelphiaPA19104
www.firstround.com
CONFIDENTIAL

February25,2016
DearFirstRoundLimitedPartner,
WerecentlyattendedaboardmeetingofaFirstRoundcompanythatisexperiencingstronggrowth(while
burningalotofcash).Duringthemeeting,therewasaconversationabouttherapidlychangingfunding
landscape.Andoneofthecompanys(bullish)laterstageinvestorswarnedthefounderthatthecompany
shouldnolongerrelyonraisingadditionalfollowonfinancing,sayingWeneedtoactlikewe'reMarkWatney
intheMartian.Wecan'tassumewewillgetashipmentofnewpotatoestosaveus.
TheWatneyRuleForStartups
Withahattipto
M
itchKapor
,itsclearthat
TheWatneyRule
forstartupsisrapidlybecominganewrealityin
theboardroom.Foundersarerealizingtheneedtorethinkpriorassumptionsaboutprioritizinggrowthaboveall
else,andareincreasinglyfocusingonburnrate,profitabilityandthepathtowardselfsufficiency.
Just
t
enmonthsago,inourquarterlyLPletter
wetalkedabouttheriskthatthe
industryasawholewillseea
3xdecreaseinreturnsand
commentedonsomeoftheirrationalbehaviorwewereseeinginthemarket,
sayingthatweworrythatmanyinvestors(bothVCsandLPs)arestillsittingdownatthemetaphorical
blackjacktableandtheyactuallyhaventfiguredout(orbeentold)thatthemathhaschanged.Andthatsa
recipeforabadnightatthecasino.Weeventooktheunprecedentedstepofpublishingthatlettertoshare
ourconcernswiththebroaderindustry.
Whilewearenotabouttojointheexpertswhohavebeen
tryingtocalltoponthemarketsince2004
,itisclear
thatmanyVCs(andLPs)havebeguntorethinktheirmathintheattempttoavoidthatbadnightatthecasino.
Therehasbeen
amarkedshiftinthecapitalmarketssurroundingtechnologystartups.
A
ccordingtotheWallStreet
Journal
,
InvestorsfundedfewerU.S.startupsinthefourthquarterthananyperiodinmorethanfouryears.Since
November,atleastadozentechcompanies,whichcombinedraisedwellover$2billioninventurefunding,have
announcedlayoffs,lettinggohundredsofpeoplethatinmostcasesrepresentedatleast15%oftheirstaffs.
Recodereported
onarecentreportfromCBinsights:
Inthethirdquarterof2015,therewere72$100millionequityfundingroundsforVCbacked
companies.InQ4,therewereonly39ofthosegiganticgrowthequityrounds.
Therewereonlyninenewunicornsbirthedinthefourthquarter,versus23inQ3.
Dealmakingactivityinge
neralfelltoitslowestlevelssincethefirstquarterof2013.

Wealsoseetheshiftreflectedinfoundersentimentabouttheavailabilityofcapital.Inourrecent
Stateof
Startups
survey,wefoundthat95%ofSeriesSeed,97%ofSeriesAand
awhopping99%oflaterstage
foundersfeelthatfundraisingwillgetharderin2016
.Andwhile63%offounderssurveyedfeltthat
entrepreneurshadpreviouslyheldthepowerindealnegotiations,only46%feltthatwouldstillbethecaseover
thenextfewyears.

The information contained in this letter is confidential and is intended solely for use by the limited partners of
First Round Capital, this report may not be redistributed or reproduced in whole or in part.


TheBetThatFoundersMade
Thedatashowsachangeinthemarketandcallsintoquestiontheimplicitbetthatmanyfoundershavemade
overthepastfewyears.Founders(andtheirinvestors)haveassumedthattheirabilitytoaccessfollowon
fundingwillremainfairlyconsistentandthatthesolemetricthatmattersisgrowth.

Fundamentally,theventuremodelissimple.Astartupraisesventurecapitaltoaccelerategrowthwiththeir
VC'sinvestmentsubsidizingshorttermlossessothatthecompanycanfocusonvaluecreationforthelong
term.Implicitinthismodelare
twocoreassumptions
:

1.
Thatfutureinvestorscarefarmoreaboutgrowththanprofits/burn
2.
Thatiftheygrowfast,thecompanycanrelyonraisingadditionalfundingroundsatalow
costofcapital.

Forthelastseveralyears,theseassumptionshavebeenafairlysafebet.Manyfoundershavebeenableto
raiseventurecapital,increasetheirburnratestofuelgrowth,andthenraisefuturefinancingsatahigher
valuationasaresultofthatgrowth.Overthecourseofthefourthquarter,wehaveseensignsthatthecore
assumptionsdrivingthelatesta
gefundingmarketarestartingtoshift.We'reseeinglaterstageinvestorsplacefar
morefocusonburnrateandprofitability(oratleastdecreasinglossratesandaclearpathtoprofitability)and,asa
result,itsgettingmeaningfullyharder(andmoreexpensive)formanycompaniesthathavehighgrowthplansthat
entailbiglossestoaccesslaterstagecapital.We'veseenseveralcompaniesachieveambitiousgrowthplans,yetstill
finditchallengingtoraisefollowoncapitalduetoconcernsabouthighburnandthefundamentaluniteconomicsof
thebusiness.

Obviously,therearemanyexceptionshere.Somecompanieshavegrownsolarge,sofast(likeAirbnbandUber)
thattheirabilitytoraiseadditionalcapitalhasnotbeenimpactedtodate.Enterpriseandconsumercompanieshave
differentcharacteristicswhenitcomestocashprofilesandfundingneeds...Butingeneral,we'reencouragingour
laterstagecompaniestoreviewtheirassumptionsaroundtheirburnratesandtheirabilitytoaccessadditionalcapital
inthenearterm.Manyprivatecompaniesarepursuingoperatingplansthatarepredicatedonoldassumptionsand
weveencouragedthemtoreviewtheirplansundernewmarketassumptions,andmakechangeswhereappropriate.

Somemightbelievethesechangesrepresentatemporaryblipinthecapitalmarketsandthatvaluationsand
fundingwillquicklybounceback.Wedonot.

ThePublic/PrivateMarketDislocation
Forthelastseveralyears,therehasbeenamassivedislocationbetweenvaluationsofpubliccompaniesand
valuationsofprivatecompanies.WhenFacebookwentpublicanditsstockdroppedby50%,Twittersvalueactually
increasedintheprivatemarkets.Whenthepublicstockpriceofmarketplacelenders(likeLendingClubandOnDeck
Capital)dropped,itsomehow(magically)hadlittleeffectonthevaluationsofprivatemarketplacelenders.Thiswasa
newandscaryphenomenon.Itwasasifpromisingbaseballplayersintheminorleaguesweresuddenlyableto
earnahighersalarythanveteranallstarplayersinthemajorleagues.Perhapsthiswaspartiallydrivenbythelimited
supplyofpromisinghighgrowthcompanieswhichcreatedanauctiontypedynamicinwhich
GreaterFoolTheory
droveprices.Orperhapsitwasduetothefactthatpubliccompaniestradeeveryday(ongoodnewsandbadnews),
whereasprivatecompaniescontrolwhentheytrade(sotheywereabletohavefarmorecontroloftheirvaluationby
onlytradingongoodnews).

Thistemporarydislocationisrapidlybeingcorrected.AccordingtotheWSJ,
ofthe48venturefundedU.S.tech
companiesthatwentpublicsince2014,35nowtradebelowtheirinitialpublicofferingprices.
Andaspublictech

The information contained in this letter is confidential and is intended solely for use by the limited partners of
First Round Capital, this report may not be redistributed or reproduced in whole or in part.

SaaScompaniesexperiencemultiple
compression,wearefinallybeginningtoseeimpactvaluationexpectations

forprivatecompanies.AsRedpointsTomaszTunguz
p
utit
,
Fundraisingisatrainandthepublicmarketsare
thelocomotive.Itcantakeawhileforthepublicmarketsimpacttobefeltintheprivatemarkets,buttheresno
denyingthelocomotivehashalveditsspeedbymorein24months.
Whilewehaven'tseenameaningfuldrop
inthenumberofseedstagecompaniesraisingcapital(ourQ4wasbusierthanourQ3,forexample),we(
and
others
)haveseenameaningfuldropinfoundersvaluationexpectationsbothattheseedstageandatthe
laterstage.

Webelievethatstartingin2016,privateandpubliccompanieswill(onceagain)begintobevaluedinan
increasinglyconsistentfashion.Thischangecan(andwill)bepainfulformanyprivatecompanies.Companies
thatneedtoraiseadditionalcapitalwillhavetopricetestinthecapitalmarketsandmanywillraiseatlower
pricesthantheypreviouslydid.Andweworrythatmanyprivatecompaniesmayunfortunatelyfindthatthereis
no
marketclearingpriceatwhichtheycanobtainadditionalinvestment.

Whilesomefoundersarerespondingaggressivelytothemarketchanges,manyarenot.Entrepreneurs,by
nature,areoptimistsitswhytheyaresuccessful.ButuncheckedoptimismcanbeafoundersAchillesheel.
Thereisanentiregenerationoffounders(andfunders)whohaveonlyexperiencedonekindofmarketthe
boomtimemarketofthelasteightyears.Theyhaveneverexperiencedadownturn,andmanybelievethatthis
isjustatemporaryblip.Someevenbelievethattheventurecapitalistswhoarebloggingandtweetingaboutthe
marketdownturnaredoingsoinadeliberateattempttodrivevaluationsdown(disregarding,ofcourse,the
impactthatlowerpriceswillhaveonthatVCsexistingportfolio).Wehavebeenworkingaggressivelytohelp
coachourfoundersontherealities(andconsequences)ofmarketcycles.Indeed,atourCEOSummitlast
Octoberwefeaturedatalkonthelessonslearnedbyafounderwhosecompanyhitthewallinthe2000dot
comcrash.

Akeydifferencebetweentodayandpriortechmarketcorrectionsisthefactthattodaysvaluationadjustments
oftenhappeninpublicwhereasbefore2010,mostprivatecompaniesvaluationswerekeptprivate.Indeed,
beforeFacebook,itwas
e
xtremelyrareforaprivatecompanytopublishtheirvaluation
.Inthepastfewyears,
however,weveseenmanyprivatecompaniesannouncetheirvaluationasabadgeofdistinctiontohelpattract
customers,pressandemployees.Thefactthattheseprivatecompanyvaluationsarenowsharedwiththe
publiccombinedwithmutualfundinvestorslikeFidelityandTRowepublishingmonthlyvaluationsonthese
companiesmeansthatanyvaluationcorrectionwillhappenintheglaringspotlightoftheentireindustry,
exacerbatingthenegativeimpact.

AReturntotheOldNormal
WeclearlydontbelievethatweatFirstRoundaretheonlypeoplewhohavenoticedthesechanges.There
hasbeenamarkedincreaseinthenumberofventurecapitalistswritinginsightfulblogpoststalkingaboutthe
changesinthemarketandwarningofanewnormal.Yet,whileweagreewiththeirobservationsonthe
marketchangeswedontbelievethisisthenewnormal.Rather,wethink(andhopethat)thisisareturnto
the
oldnormal
.Arecognitionthatthe>3xincreaseinvaluations(andthemetricstheywerebasedon)over
thelastfewyearshadgottenaheadofreality.

Asaresult,investorswillchangetheirlensfromfocusingsolelyonrevenuesandgrowthtoalsolookatunit
economicsandburnrate.Founderswillbegintomakechangesincoreoperatingprinciplesandresource
allocationthatmightimpactthelivesofhundredsoreventhousandsofdedicatedemployees,vendorsand
customers.Andultimately,strongercompanieswillresult.Don'tgetmewrong,evolvingfromaunicornintoa
cockroach
willbeextremelypainfulbutjustlikeMarkWatneyonMars,thesooneryourealizethesituation
onthegroundhaschanged,themoretimeyouhavetosciencetheshitoutoftheproblemandsucceed.

The information contained in this letter is confidential and is intended solely for use by the limited partners of
First Round Capital, this report may not be redistributed or reproduced in whole or in part.

Ineachofourquarterlylettersforthepastseveralyears,wehaveincludedawarningthatweareseeing
companiesraisefollowonfinancingroundsatmuchhigherpricesthanwehaveseenbeforeandweexpect
thatseveralofourcompanieswillendupbeingmarkeddownovertime(withmanypotentiallybeingwrittenoff
entirely).Wevemodifiedthiswarning(somewhat)inthisletter,asmarketvolatilityanduncertaintycausesthe
industrytoquestionlaterstagevaluations.Marketpriceshaveatendencytoswingtoofarateitherendofa
cycle.Wecontinuetotryourbesttoconservativelyvalueourcompaniesatapricethat,webelieve,represents
theircurrentfairmarketvaluebutrecognizethatthisisdifficulttodoinarapidlychangingmarket.

OurApproach
Whilemanyinthemarketmightbewakinguptothenewmathofventureinvesting,wehavebeenfocusedon
thisforquitesometime.Sowedontexpecttoseeanymassivechangetoourinvestingstrategyorpaceinthe
comingquarters.Wedontanticipatesittingoutthemarket.AswesaidinourQ12015letter,Webelievethat
greatcompaniesemergeduringbothboomtimesandbusttimesandthatstickingtoourinvestmentmodel
(andstrategy)isespeciallyimportantduringbothendsofthecycle...Greatcompaniescanbestartedinany
market,andwehavetriedtoremaindisciplined(inanundisciplinedmarket)andfocusedonthetwonumbers
thatmatter:entrypriceandexitprice.

Wecontinuetodeploycapitalinnewinvestments,especiallyasmarketvaluationsbegintoapproach
oldnormalprices.Givenourexpectationthatfollowonfinancingwillbehardertoraise,wearepayingclose
attentiontotherunwayandmilestonesofournewinvestmentsalongwiththequalityofcoinvestorsinour
syndicatestoensureadequatecapitalization.Forfollowoninvestments,wearetacticallyshiftingtoamore
defensiveposturebeingalittlemorecautiousinseekingoutopportunitiestobuyupincompaniessowecan
ensureadequatereservestoprotectourcorepositionsshouldthemarketcontinuetodeteriorate.

FundPerformance

AttachedyouwillfindourfundScorecardscontainingGrossandNetfundperformance,aswellasasummary
ofthepubliclyreportedquarterlyactivityineachfund.Whilewearehappywith(mostof)ourfunds
performances,wewanttostressthatmostofthevaluationincreasesareunrealized,anduntilthese
companiesendupintherealizedcolumn(throughIPO,M&Aorsecondarysales)thevaluationsarejust
paperincreases.Ourvaluationpolicyrequiresustovalueourportfoliocompaniesbasedonmarketprices
andintodaysmarketweareseeing
increasedmarketvolatility,resultinginincreaseduncertaintyabout
appropriatevaluationsforlaterstagecompanies
.Pastexperiencehasshownthatvaluationscanchange
significantlyovertimeanddespiteourbestefforts,
weexpectthatseveralofourportfoliocompanieswill
continuetobemarkeddownovertime
(withmanypotentiallybeingwrittenoffentirely).

Asalways,ifyouhaveanyquestionsorrequireanyadditionalinformation,pleasedonthesitatetocontactany
ofusorourCFO,JeffDonnon.

WarmRegards,

TheFirstRoundPartners

The information contained in this letter is confidential and is intended solely for use by the limited partners of
First Round Capital, this report may not be redistributed or reproduced in whole or in part.