Financed to Endure

Where is liquidity??

This is one of the most important questions facing the venture capital industry today.?

Without liquidity from existing investments, limited partners can be forced to cut back new investments in the asset class, which in turn can make it difficult for firms to raise new funds of desired size. As we see it, this is ultimately bad for the innovation economy at large.?

There are many reasons why we believe this is happening.?

The “Magnificent Seven”--the seven top tech stocks (Alphabet, Microsoft, NVIDIA, Meta, Apple, Amazon, and Tesla)--accounted for over 30% of the entire S&P 500, and an obviously much greater concentration of the overall technology market cap. It’s not sustainable, from a regulatory nor financial perspective, to believe the path for venture capital leads to acquisitions by only these companies. And arguably it’s not healthy for the innovation economy either to put such power in a small cadre of companies.?

In our view, the US IPO market recently has also been muted at best, and questionable if the value outweighs the transaction costs and regulatory and financial burdens that being public requires for some companies. We’ve seen poor incentives built in certain public companies managing for quarterly earnings, not building enduring businesses. And from a valuation standpoint, we think the rise of systematic ETFs versus active management have overweighted towards stocks based on market cap causing high concentration in the public markets–not an alluring reality for smaller, emerging public companies. Long term this may or may not hold, but we need to build our companies for scenarios where this is not an option, while being ready to move if it becomes one.??

Therefore, we need a path for these “good” venture-backed businesses to endure on their own even though they might not be good candidates for M&A or IPO.?

There is a category of businesses like Stripe and SpaceX that are charting their own course to compound in the private markets for at least the short term, and we believe they can endure as winners in their own categories. These companies appear to have tremendous access to capital, both primary and secondary, given the compounding nature of their businesses and we think could be very well positioned to endure privately. In our view, they are also able to leverage their own balance sheets and cash flows to drive liquidity for investors that need it as well.?

We need a long term solution for companies that may not be in that category today, but have founders that have the will to be one of them over the longer term, and are just stuck with minimal to no options today. I am talking about the hundreds and thousands of technology companies that are growing but don’t fit the Stripe/SpaceX category today. They are run by great founders who want to make it their life’s work, if there was a pathway to endure in the private markets.?

At GC, one of our core mantras is to innovate to meet the needs of founders. Our Customer Value strategy is our attempt to solve this financing gap.

Liquidity tied up in CAC

My partner Pranav’s recent piece, CAC is the new CapEx, shows how our industry has been thinking about growth for technology companies all wrong. As he mentions in the piece, technology companies are asset-light but expense-heavy. In traditional industries, to grow you often have to spend on Capital Expenditures (CapEx) (e.g., machines, buildings). But for tech companies, we don’t have CapEx, we have Customer Acquisition Cost (CAC). And today, CAC is often financed entirely by the company’s own balance sheet (likely comprised predominantly of equity), tying up a large part of their cash.

In the traditional world, CapEx is financed using an entirely different source of capital, typically asset financing. The tech world needs an equivalent for CAC. When you have a source of capital that is fully aligned with the use of capital, we believe it allows the business to scale without encumbering the rest of the business with risk. We think this alignment is critical and why traditional corporate debt has not been the right solution for growth, with the consequence being increasing reliance on equity financing.?

But in our view, CAC is often the single largest reason tech companies don’t generate excess cash. In fact, CAC is a discretionary use of free cash flow (for future growth) versus other Opex line items which is often how it is thought of right now. If you extend that thinking, then removing discretionary CAC, these businesses are often inherently cash flow positive– one proxy to measure this is EBITCAC.?

Once you treat CAC as an asset that can be financed by an entirely separate pool of capital, you now have the ability to re-allocate the excess cash generated to other uses. For many companies, that may be product, engineering, or even more growth investments to get to scale. But for many scaled businesses, many that find themselves in the liquidity dilemma, this excess cash is a pathway to liquidity for employees and shareholders. IPOs and M&A can be rife with exogenous risks and factors: market troubles, regulators, perceptions and human emotions. What is more controllable is the amount of liquidity our businesses generate.? As Pranav noted in the piece, by our conservative estimates, the Cloud 100 companies on average spend over $10M per month each on CAC, amounting to over $12B per year that is tied up in CAC that could be unlocked by just 100 companies.

Imagine all of the money that is tied up in CAC, which we believe is a pretty poor use of equity capital, was instead moving back into the hands of the endowments, the pension plans, the new entrepreneurs, and the founders and employees that took risks. VC isn’t dead, but we think it’s in need of an accelerant.?

This capital allocation mindset and discipline is critical for our companies. It gives founders and senior leaders agency over their financial futures. Instead of waiting (or maybe, praying) for far-fetched M&A or IPO opportunities, we can build the pathways to returns ourselves. Equity was typically meant to be a company’s cash flows discounted to today’s value–it is time we get equity to be what it was always meant to be.

We believe solutions like our Customer Value strategy are a huge step forward in that journey. This shift in thinking is critical to continue to scale our ecosystem, provide liquidity to our limited partners, and keep the innovation flywheel accelerating.??

You can hear more about our Customer Value strategy in action on the StrictlyVC Download podcast, hosted by Connie Loizos and Alex Gove.

This piece was simultaneously published on LinkedIn and at https://www.generalcatalyst.com/perspectives/financed-to-endure.