Wastefulness haunts Israeli startups as crisis looms

Lavish parties: Credit Shutterstock Tomas Simkus
Lavish parties: Credit Shutterstock Tomas Simkus

Lavish parties were thrown, expensive offices leased and superfluous employees hired as US funds poured cheap money into startups, without due diligence. Now the party is over.

Many in Israel's tech sector believe that the shutting down of grocery delivery startup Avo's Israel operations and the complete closure of AI solutions company BeyondMinds, with over 60 layoffs, is the start of a worrying trend. After years of success and prosperity, more and more companies are expected to fail in the coming months.

Over the past two years, unprecedented amounts of investment have flowed into Israeli startups and now the music seems to be stopping. Influenced by higher interest rates, rising inflation and the collapse of tech shares on Wall Street, there has been a significant slowdown in startup funding that has not yet been fully expressed in the figures, which are reported with a lag. However, investors speak about an almost complete paralysis in startup investments in the advanced growth stages. Everyone is trying to understand where we go from here.

Now that the frenzy is fading, it is easier to view the problematic perspective that developed in the startup market, during the days of cheap and available money over the past two years: from the death of proper due diligence as part of the investment process, through excessive waste that startups adopted, even those still in their relatively early stages. These practices, or 'sins', during times of abundance are likely to haunt the industry as the current crisis worsens.

1. Not checking and investing blind

"When we raised money last year, our entire due diligence process comprised just two meetings until we received a term sheet. Once such a due diligence process took 6-8 weeks and last year that shrank to five days," said the CEO of a startup that raised tens of millions of dollars. "Our investors looked at the presentation - which had data about revenue, growth and a list of customers - and everything was concluded with that. Nobody asked to see an excel sheet with other figures, nobody interviewed our management and nobody tried to talk with the customers."

The responsibility for shrinking the traditional due diligence process by investors is mainly attributed to huge foreign funds, who influenced by zero interest rates and the injection of money by the US Federal Reserve into the American economy, received billions of dollars under management. The funds charge management fees as a percentage of the amounts they manage and so they have a clear interest to take on the management of more money, even if they cannot do so in a sufficiently proper way.

Some of these funds like Tiger Global, and Coatue were originally hedge funds, specializing in publicly traded shares on the stock exchanges, but who expanded to invest in privately-held startups in order to capture success at an earlier stage.

Other players who led the trend were more traditional venture capital funds like Insight Partners, who simply rapidly expanded the amount of money under their management. Relinquishing due diligence also swept along Israeli firms who realized that they had just one day to make a decision on whether to participate in an investment, in order to not completely miss out.

The numbers describe the story best: in 2020 Tiger Global's fund managed $3.75 billion for startup investments. In 2022, the fund had more than tripled to $12.7 billion In order to hand out enough checks, use up the fund within a year and raise more instead, Tiger Global made 335 investments last year, an almost inconceivable average of 1.3 deals per working day.

Dr. Anat Alon-Beck of the Department of Law at Case Western Reserve University has researched the new players who have entered the investment arena including the hedge funds. "They are less sophisticated that the traditional venture capital funds. Hedge funds already tried in the past, without success, to enter startup investment during the dot.com bubble and now they have returned for another round."

She added, "These funds don't look deeply at the numbers and without due diligence miss substantial things. They do not ask for a place on the board of directors and offer a friendly approach to entrepreneurs, which means allowing entrepreneurs to operate without any oversight at all. The big problem is that this conduct has completely changed the dynamics in the market and other players had no choice but to adopt a similar approach."

The damage that this approach has done is not clear because such a short due diligence is not sufficient to take intelligent decisions and a lot of money has gone to companies whose technology is not good enough, or who have substantial problems that have not been uncovered. Instead of bad companies closing after raising small amounts of money, they continue running and burning tens of millions of dollars.

Bessemer Venture Partners partner Amit Karp points to other problems resulting from short due diligence, problems that might now actually be discovered now that the industry is going into crisis. "Part of the function of due diligence is to create an acquaintanceship between the company's team and the investors and see how they get along," Karp explained. "But when the process takes only two days, it's like getting married without having gone out on any dates. Now that the crisis has arrived and everybody has to join together to get through it, the entrepreneurs suddenly discover that they don't know their investors at all, and don't know how to work with them."

2. Who even needs a business model

When Gil Dibner, the founder of the Israeli-European fund Angular Ventures attempts to define recent years in the startup investment market, he uses the term 'collective delusion,' used by the business guru Prof. Scott Galloway. "In recent years everybody has thrown big money at problems and opportunities, even when it was clear that throwing the money would not succeed in solving these problems," he says.

"Now suddenly everybody is waking up to this collective delusion and understanding that beyond the opportunity, it is important that the company also has revenue, and unit economics (profitability for the sale of each product unit) and that it can justify the valuation that it was given."

Take for example the grocery delivery startup Avo. Talking with investors in the company we now hear that Avo's business model was simply not logistically efficient and that it was losing more than it was earning on every new customer.

So why did investors agree to invest over $100 million in the company? Because Avo wanted to cope with a relevant problem and was working on a buzz market with large potential that was growing very rapidly in terms of revenue. Some of the preparedness to invest in companies without a clear business model derived from slovenly conducted due diligence but not only. Vertex Ventures partner Tami Bronner explains, "Even when investors knew well that the company had no unit economics and understood that even the entrepreneurs themselves did not know how to explain how they would become efficient, there were still many times that they chose to put money in. The outlook was that the most important thing was who was growing fastest, who was reaching the right customers and who was developing functions before their rivals. The issue of efficiency was perceived as something that would sort itself out in the future, or something that the next investor who bought shares in the company at a higher valuation in the following round would need to cope with."

3. To fully take advantage of the market

The valuation of the company in the past was meant to express some sort of connection to its business results, profit or at least its revenue. All this was completely erased last year, with even companies that had minimal revenue of several million dollars becoming a unicorn worth over $1 billion. Instead of representing the current situation of a company, the valuation became a declaration of intent that the company was stronger than its rivals and was aiming high. The valuation given in the most recent financing round became a starting point for talks over the next round or an IPO.

"The company will grow into this valuation," investors would sometimes say when they tried to explain to themselves why they had invested so much for such a small share in a company. There are two sides to this story. On the one hand, were the huge funds jammed with money that became almost indifferent to the price they were paying and shoved more and more money towards the entrepreneurs. On the other hand, the entrepreneurs themselves knew how to take advantage of cheap money and present dynamic growth forecasts, which they themselves didn't completely believe in order to boost the valuation.

Karp says, "Competition was created on who would become a unicorn first and entrepreneurs raised more money than they needed according to valuations that were too high. It was very difficult for entrepreneurs to say no to the money that was being given to them. The result is that now nobody believes in the valuations that were given in the past few years."

Bronner adds that you need to be very strong to resist the temptation and not fall in line with the market. "The entrepreneurs were worried that they would raise too small an amount or at too low a valuation and it would not look good to their employees and customers. Now that the crisis has arrived, it is easier for entrepreneurs to agree to a lower valuation because they know that it won't reflect badly on them."

The current situation is that many startups are 'stuck' with an irrational valuation that makes it hard to raise additional funds or sell the company in the future accord to its real price, which is much lower. Employees have also been hit because they will struggle to exercise their options that were distributed according to the valuation during the bubble and now they are seriously out of money.

4. Money thrown away on celebrations and parties

The grandiose parties, luxury vacations in exotic countries and expensive advertisement campaigns to hire new employees all expressed the wasteful attitude adopted by startups in recent years. When cheap money flowed easily into the company's coffers, they had no difficulties in spending it quickly.

While super-rich tech giants like Facebook and Google tend to offer perks like babysitting and laundry services to employees, this is intended to improve their productivity. Some Israeli startups focused on perks that had no relation to productivity like performances by expensive artists. Extreme examples were fintech company Rapyd, which brought to Israel teams of DJs from abroad to their parties, while cybersecurity company Wiz hired the most expensive Israeli performers to sing Disney movie songs to their employees.

The startups always had convincing explanations on how all these expenses were designed for essential aims - to attract quality employees. As these practices became more lavish so did the expectations of employees and companies were required to invest in even bigger gimmicks to attract attention. But now that the market's direction has changed, the aim is to save and to streamline, while at least some companies regret the millions that they casually wasted.

"When the cost of money is zero, you can justify everything, and everybody celebrated, and if you didn't behave the same way, it probably looked strange," says Dibner.

He continues, "When an entrepreneur who has no revenue still receives $100 million and they tell him he is worth $1 billion, he feels like somebody who has already succeeded. In this situation, when the money comes easily, the entrepreneurs think that they can hire 100 people, pay a developer NIS 80,000 for four days work and take vacations in the Caribbean. It is very difficult to explain to an entrepreneur that he should take less money and that sometimes a team of ten people with motivation can be more effective than a team of 100 people."

Karp thinks that money was wasted on more things than big parties. "The wastefulness is a side-effect of the large amount of money in the market. The parties themselves weren't the big expenditure. The wastefulness was expressed in leasing the most expensive offices with more space than needed and unsupervised spending of marketing like buying advertisements for the Super Bowl without checking if it was beneficial and by how much. It is now clear that it will be necessary to tighten the belt."

In many cases, the board of directors and investors were those that pushed the entrepreneurs into burning more cash in order to prove growth and provide an excuse for going out to raise more money, which would be at a higher valuation.

One startup CEO says, "You have to be a manager with a strong backbone in order to go against the flow and explain that there is no point in adding more sales people now because the market is not yet ready for this and there is no point in developing more functions for a product before there are sales."

Published by Globes, Israel business news - en.globes.co.il - on May 26, 2022.

© Copyright of Globes Publisher Itonut (1983) Ltd., 2022.

Lavish parties: Credit Shutterstock Tomas Simkus
Lavish parties: Credit Shutterstock Tomas Simkus
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