One of the top dealmakers in the world of tech investing has a dire warning for startups: beware of "dirty term sheets."
On Thursday, BenchMark VC Bill Gurley wrote a 5,700-word blog post detailing how the world of investing in startups has changed. This shift, he explains, will influence everyone from founders and employees to VCs and LPs. The industry, as a whole, is evolving because of the "unicorn" class of startups, Gurley, an early investor in Uber, writes. He goes on to define these unicorns as startups in pursuit of massive valuations though their hard business figures largely do not justify it.
"The pressures of lofty paper valuations, massive burn rates (and the subsequent need for more cash), and unprecedented low levels of IPOs and M&A, have created a complex and unique circumstance which many Unicorn CEOs and investors are ill-prepared to navigate," Gurley's essay reads.
Interestingly, the already supremely popular blog post dives back-and-forth between outward criticism and helpful advice, but overall the tone appears to be reflective. It is penned for just about anyone involved in the tech space.
At the center of his warning is an argument that props up this notion that a bursting startup funding bubble is likely. Belief in a bubble leads back to the fact that too many of these private companies have raised too much, beyond their valuations, and aren't producing, according to Gurley.
"Loose capital allows the less qualified to participate in each market. This less qualified player brings more reckless execution which drags even the best entrepreneur onto an especially sloppy playing field. This threatens returns for all involved."
The fact of the matter is that Gurley has been warning about this same dilemma for years. And each time it generate serious press attention.
This case is no different except that timing is truly on Gurley's side. Far and wide, down rounds—financing events for companies where they raise less money, usually at a lower valuation, in a follow up raise—are becoming more common. Additionally, we have the recent high-profile collapses of blood testing startup Theranos and human resources tech firm Zenefits, among others, to champion the cause.
Importantly, Gurley explains that the way investors are interpreting valuations is different, today, than in recent years. And that skepticism has a real impact on companies that have become dependent on private investment to keep the lights on.
Ultimately, these conditions set up an environment for predatory investing, according to Gurley, where terms can be set in funding agreements which disproportionally push the risk onto entrepreneurs. Dirty term sheets, authored by "shark" investors, can include nasty provisions like “ratchets” and “superior preferences”; things that essentially guarantee/force payouts or allow for the possibility of agreement restructurings.
The "sharks" promise these 2014/2015-style valuations, and at times cash, but at worse terms. To remedy the situation, Gurley says it's better for a startup to take a hit to their pride, accept a down round and valuation, rather than pursuing the largest number available.
Another interesting counterpoint in this discussion is that while the data shows that some startups might be having a hard time raising money it also seems VC's are establishing massive funds. If the targets for investment are getting weaker than why the need to amass increased resources? Gurley's answer is that most VC's are frantically raising cash before the value of their current investments plummet. It's as simple as that.
