This might be as good as it gets for the venture darlings.
After years of building their business profiles with round after round of funding, the day of reckoning for the late-stage private companies is drawing near.
Moda Operandi, Poshmark, Rent the Runway, The RealReal, Warby Parker and the rest all face their own individual circumstances and investor bases. They will rise and fall on their own merits. But eventually, their investor base is going to look for their payday — the all-important exit.
An initial public offering is often seen as the brass ring, giving investors a chance to unload some of their stock directly to the Wall Street rank and file or to wait to see how the market reacts and then sell accordingly. Online styling service Stitch Fix Inc. went public late last year and after a somewhat rocky ride, is now valued at $2.3 billion. Luxury platform Farfetch made its move last month and has a market capitalization of nearly $6 billion.
Absent an IPO, companies needing a new investor base can find a strategic or private equity buyer. Or if prospects dim, they can take the dreaded down round, which brings in more funds, but at a lower valuation for everyone involved.
This is all part of the natural give and take in the investment world. Each investor — from seed backer to venture capitalist to institutional power player — has their own place in the ecosystem, their own rhythm.
The good news is that many experts see a market filled with much healthier companies than in years past. Spending more time closely held has helped many of the industry’s top names develop and mature. Strong companies with a solid proposition for shoppers will win out regardless of what happens in the stock market.
The bad news is that while there are 100s of founders and companies working to build their dreams, not every company is in tip-top shape and even good businesses can find themselves struggling to satisfy investors that made bets early, paid for all the growth and now have a contractual right to sell.
“We are getting pretty late in this venture cycle,” said Ryan Cotton, managing director at Bain Capital. “It feels a lot like 2000 did with tech companies — that moment where, of course, there has to be some sort of winnowing out. It is getting really late in this game and when you’re at round F and round G…some of these companies are just running out of runway.”
Cotton, who led Bain’s successful investment in Canada Goose, sorted the marketplace into three types of companies:
* Good businesses like Amazon and Facebook that genuinely require time to mature — “amazing companies that eat money for a very long time until they got to a place where they could print money for a very long time.” Ryan put the recently public Farfetch into this group as well.
* Good businesses that are a victim of bad capital structures, where founders have seen their stakes heavily diluted by venture capital firms that are now looking for a payoff. These companies are candidates for private equity investments that could consolidate the investor base and offer a longer runway.
* Bad ideas that Cotton said “just found dumb money.” These players will ultimately get dissolved, absorbed into other players looking to pick up some new capabilities or otherwise fade.
Companies in all three groups face a suddenly stickier market. Public stocks have traded off sharply in recent weeks over luxury worries in China, higher interest rates and general questions about how long the economic run can last.
Cotton said that’s created a disconnect in valuations between the public and the private markets. The disconnect has, in turn, heightened attention on Revolve, which publicly revealed its IPO late last month, when the market prospects were better.
“I think the market’s looking at that one,” Cotton said of Revolve.
In effect, Revolve has become something of an unwitting test subject. If it goes public and gets a strong valuation, others will line up behind it and rush for the exits while the market is still relatively near its highs.
In the go-go days of the late Nineties dot-com bubble, it was much easier to go public without real prospects. Many early investors were rewarded with blockbuster IPOs from companies that had little more to offer than some marketing splash, a starry-eyed dream and the promise of more buzz to feed into the Wall Street machine.
That all worked — until it didn’t, and then it all came crashing down.
The dynamic is somewhat different now.
“The whole market has gotten smarter,” said consultant Cort Jacoby, partner in A.T. Kearney’s consumer products and retail practice. “The investor base is looking not only for companies that have traction in the market or have generated sales volume or have generated growth in sales, but that they’ve been able to demonstrate that it’s an ongoing enterprise.”
Even solid companies with real businesses have had to skip the public markets this time around.
Walmart Inc. scooped up Bonobos for $310 million last year — the valuation was less than it had been in the past, but the deal left the brand with what founder Andy Dunn has described as “a safe and permanent home.” It also gave Dunn a bigger e-commerce role in the digital native universe as senior vice president of digital consumer brands at Walmart U.S. e-commerce.
If it were easier to tap into the public market, the Bonobos story might have ended differently.
Jacoby said: “In the past, that might have been a company that would have gone public and, quite frankly, it would have struggled. The fact that the market required a longer period of time, that provided a fork in the road for them.”
The fork has also led others, including Bare Necessities and Eloquii, into the arms of Walmart, which is arming for its continuing battle with Amazon.
Companies that do manage to take the IPO route might well find the public markets an unforgiving place to be.
“If I look at a company like Warby Parker,” Jacoby said. “You know what’s going to happen once it goes public. The quarterly financials are going to outweigh everything else. Until you’re really ready, it’s going to be really difficult. If you’re not ready, the market kills you when you miss your numbers.”
Choosing a way forward is not just tough for the company’s sake — early investors often have competing agendas, timetables and a contractual voice in the process.
“Patience is not necessarily the number-one attribute of a number of these investors,” Jacoby said. “There’s going to be certain early investors saying, ‘Whoa, I’ve made 1,000 times my money; let’s take it and go.’”
Early-stage investors tend to place lots of bets, expecting the big wins to outweigh the many losses. But even with funding, it’s hard to build successful brands that can become consumer powerhouses.
“What we’ve seen in any of these high-growth, e-commerce companies is it’s actually hard to break out,” said Michael Kumin, managing partner at Great Hill Partners, which has stakes in a range of growth companies, including Bombas and The RealReal.
“There are lots of companies that can get to $25 million to $50 million in revenue, but to get to hundreds of millions in revenues with either profitability or a good path to profitability — those are tough to do,” he said.
In part, that’s because newer companies can focus on a single channel or a single product with a pretty lean staff. Bigger businesses, however, are more complex, requiring a larger workforce and more spending.
Some companies in the early stages will simply take in too much money, as they or the market or both misjudge their true potential.
“There’s always a risk if you overcapitalize your business against the market opportunity and the execution,” Kumin said. “I don’t think that many of these companies are playing in very big, addressable markets and that they’ve built a good brand and have significant momentum.”
Still, Kumin said the opportunity in consumer is still too great to ignore.
“A bunch of huge new companies are going to be created over the next few years,” Kumin said. “Investors are going to want to be a part of that.”
That sentiment — that the market is in the midst of a massive revolution and that good things are coming to the consumer space one way or another — has helped keep companies in the private sphere longer.
“Companies are staying private longer because there’s so much private capital available,” said Brian Hughes, co-leader of the venture capital practice for KPMG U.S. “They’re taking advantage of a really active and available private company market.”
He pointed to Warby Parker, which has raised close to $300 million, including $75 million in March, at a valuation close to $1.7 billion, and Rent the Runway, which has raised over $210 million, including $20 million in March at a valuation of $750 million.
Both of those companies are nine years old and have seen their business models change and mature under private ownership.
“They’ve built out some physical stores,” Hughes noted. “That may not have happened if they had gone public because they would have had to have shown earlier profitability. This allowed them to think about what their business model is.”
The buzzy start-up phenomenon is an issue that’s important not just for the Silicon Valley crowd or the investors who feed them, but for the fashion industry at large as well.
For one, the ideas that get fed now influence what gets funded in the future.
And while the retail sector has been maniacally focused on Amazon and its outsize growth, the start-up crowd has had a perhaps overlooked impact on the broader scene.
Instinet analyst Simeon Siegel argued recently that it is the “ceaseless launch of start-ups” that’s truly wreaked havoc at the mall.
“As VC capital flowed, anyone with a web site and sewing machine could create a sweater company and with barriers to entry torn down, barriers to succeed grew sky high,” Siegel said.
The analyst pointed to research showing that venture capital interest in the space has waned. After making over 450 investments annually in U.S. retailers and e-commerce companies in 2014 and 2015, the count fell to about 300 last year.
“The number of retail start-ups funded by VC ballooned over the past decades, and we believe this growth of competition may have contributed meaningfully to a drop in pricing power,” Siegel said.
VC-backed companies spent heavily to cut price and acquire shoppers, hurting companies that operate closer to reality.
But the tide could be turning.
“Fallen unicorns [that were once valued at $1 billion] offer a reminder — and warning — that profits matter, offering hope for a more rational start-up environment,” Siegel said. “The past several years saw a clear start-up shift from growing sales at all costs to the need to chart a path to profitability. And this is probably best seen, and perhaps triggered, by some of the start-up stars which saw their lights fade in recent years, with high-profile examples including Nasty Gal and JackThreads. And more recently, Birchbox has been vocal about its shift to focusing on profits.”
When it’s all said and done, it’s the companies that make money, not buzz, that win the day.