Cash rich Israeli startups risk the 'foie gras' effect

Dollars Photo: Shutterstock

Research by CB Insights found that fattening up startups with too much cash before an IPO can harm them in the long run.

In March, many Israeli startups completed financing rounds of $100 million or more including public transport planning and operating platform Optibus, which raised $107 million, cybersecurity company Orca Security, which raised $210 million, and cybersecurity company Snyk, which raised $300 million and has raised $525 million in the past 15 months.

Optibus, Orca and Snyk exemplify the huge amounts of money flowing into promising tech companies worldwide, and in Israel in particular, over the past year. This flood stems from the zero percent interest rates, which encourage investors to seek new investment options like startups and IPOs on Wall Street, which have recently been demonstrating the huge potential returns from investing in tech companies.

This massive influx of capital apparently contains many major advantages for Israeli startups. With this generous financing, the startups can hire more developers and engineers, develop their technology platforms, and add features that they have always dreamt about. They can hire more sales teams worldwide and swiftly expand exposure of their products, systems, services and solutions.

Many of these large financing rounds include a secondary element in which the entrepreneurs and employees themselves sell their shares and options for millions of dollars. Yet alongside these advantages, history and experience shows us that large financing rounds can be a double-edged sword for some of these companies.

Several years ago, CB Insights conducted research which led them to introduce the term 'foie gras effect' to describe the damage that excessive financing can cause, comparing it to geese that are forcible fattened with food, sometimes until they die. The foie gras effect suggests that too much funding for a startup can damage its development in the long run. The long term foie gras effect was demonstrated in CB Insights research published in 2019. The research studied the returns recorded by the shares of tech companies since their Wall Street IPO. The researchers unexpectedly found that tech companies, which had raised more than $100 million before their IPO recorded significantly lower returns than companies which had raised less than $100 million before their IPO. While the companies that had raised higher amounts had external growth of 64%, the companies that had raised smaller amounts had external growth of 263%.

The first group of companies that had raised higher amounts included Groupon, which had raised more than $1 billion from investors since its well- publicized IPO in 2011. Groupon has since fallen hard and is traded at a fraction of the amount at its IPO. In contrast, the second group included Palo Alto Networks, which was founded by the Israeli Nir Zuk. Palo Alto Networks raised only $65 million prior to its IPO in 2011. Since then its revenue has risen 12-fold.

"We know that in life only paranoid people survive and succeed," says Glilot Capital founding partner Arik Kleinstein. It could that startups that raise too much money begin to suddenly feel that they are very successful and they become less paranoid. Just raising money is never a measure of success on its own. Success is when you have loyal and satisfied customers who won';t move to your rivals."

Blitzscaling

In 2015, LinkedIn cofounder Reid Hoffman, today a respected investor, began pushing the term blitzscaling. According to Hoffman, the main emphasis of any startup should be to grow as quickly as possible in order to become a market leader, while considerations of efficiency and profitability should be secondary. After the startup has captured the market leadership position, it will be able to earn excessive profits for decades to come, as Google, Amazon and Facebook have done. This approach is what causes many venture capital funds to bombard their startups with cash so that they can grow on steroids.

"Companies are today required to present hyper-growth and grow their revenue fast from $1 million to $10 million and $50 million, in order to capture the market leadership position," explains D10 venture capital fund partner Rotem Eldar. "Buy hyper growth like this also has its risks. When companies grow they need to double their workforce quickly and this of course can lead to mistakes in hiring. When companies grow very fast, it can also make it difficult for them to keep their DNA and unique organizational culture, especially when all this happens during coronavirus and employees are working from home and never meeting up."

In order to make the path to the overall aim of market leadership even shorter, companies seek non-organization growth by acquiring rivals. Once Israeli startups were acquisition targets for international tech giants but with the help of the large funds they are raising, Israeli companies are themselves seeking acquisitions. A recent example was Next Insurance, which last month acquired Us digital insurance company AP Intego in a huge deal worth hundreds of millions of dollars. But such mergers also entail risks.

Kleinstein says, "Statistics show that half of mergers fail. That's the case when huge, experienced companies are the buyers and it's even far truer when young startups are the buyers. In the merger process, there are a lot of mines such as a clash between organizational cultures and the departure of key people when the company is bought. The risk for startups is that they are bitten twice, when they lose money and when they invest a lot of focus on managing the merger, which ultimately fails."

And perhaps the biggest danger of growth on steroids is that the music of cash will stop one bright day. US entrepreneur Justin Kan, one of the founders of live-streaming company Twitch, which was acquired by Amazon, once said, "It doesn't matter how much money a company raises, in the end it all gets wasted within 12-24 months."

The meaning of this is that companies get used to the rate of burning cash according to how much they raise. It then become difficult to go back once the supply of cash stops.

Eldar says, "To lower the rate of burning cash is very difficult to do because usually with a startup most money goes on salaries, and reducing the cash burn rate requires laying off employees, something that nobody wants to do and it hurts the company."

Published by Globes, Israel business news - en.globes.co.il - on April 1, 2021

© Copyright of Globes Publisher Itonut (1983) Ltd. 2021

Dollars Photo: Shutterstock
Dollars Photo: Shutterstock
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