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7 Unraveling Rings To Flush $60 Billion In Venture Investment

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The current technology bubble peaked in 2014 and it will take a decade before another one begins.

That's because seven concentric rings of capital have built up around startups in search of high returns from super-charged growth.

But as money-losing technology companies watch their post-IPO prices plunge, those rings are disintegrating.

That should come as depressing news to any startups that are burning through their cash. That's because venture investors are telling their portfolio companies to cut staff before they have any hope of getting more money to keep them afloat.

Of course, after those cuts many of the startups will discover that the signal they're sending to customers by firing staff is that they are imperiled.

And that signal will send customers fleeing to companies with more financial staying power.

So the venture firms will lose their investments -- unless a big company buys up their struggling portfolio company at a discount.

On March 4, I met with the CEO of a data storage software company who told me that venture capital firms are telling their portfolio companies to get profitable fast. That means portfolio companies are going to be firing staff and finding other ways to cut costs.

If you look at the data storage industry, you can see how much the financing environment has changed recently.

In 2015, Cisco Systems  tried to acquire Nutanix for $4 billion CRN reported. (Nutanix supplies so-called hyper-converged technology that combines into one appliance the functions of up to 12 devices via cheap hardware and sophisticated software).

Nutanix -- which filed for an IPO in December 2015 -- held out for between $6 billion and $7 billion, according to CRN.

By February 26, Nutanix -- which according to its prospectus lost $126.1 million in its fiscal 2015 and had $54.9 million worth of cash last October -- had put its IPO on hold. CRN reports that the IPO delay may extend until the third quarter of 2016, depending on market conditions.

The data storage CEO told me that he has heard that Nutanix recently went back to Cisco to explore an acquisition. But Cisco -- which CRN reports recently launched its own hyper-converged product with help from a startup, Springpath -- is not interested.

Nutanix did not respond to a request for comment.

Nutanix's investors include venture capitalists like Lightspeed Ventures and Khosla Ventures which own 23% and 10.9% of its stock, respectively, according to its prospectus.

Fidelity holds 6.1% of Nutanix's stock. And in January, Fidelity wrote down the value of that stake by 17% according to Bloomberg.

Before getting into the reasons why it could be another decade before animal spirits light up the technology scene, let's peer inside the anatomy of technology bubbles.

To really understand what is going on, it helps to think of startup funding as seven concentric rings of capital.

1. Sweat Equity

The innermost ring should be founder's capital -- that is, founders who put their own money into the company in many forms from cash to borrowing on their credit cards to working for free.

2. Customers and suppliers

In theory, founders should use that money to build their product and then finance subsequent growth from profits the company earns from selling the product to customers (and suppliers who are willing to extend more generous payment terms).

But often, startups do not generate profits from selling their products because they want to grow very fast so they can get big enough to go public or be an attractive acquisition target.

This adds new rings of capital to the company's financial structure -- each of which has a different appetite for risk and willingness to be made a fool by the founder's dream-weaving skills.

3. Friends and family

These investors are emotionally connected to the founder, greedy enough to be willing to buy a lottery ticket, and likely to cut her slack if the company fails.

4. Angels

These wealthy individuals are generally attracted to a startup operating in the industry where they made their pile. They like to think that they can share their experience and contacts to help make another killing while riding a younger horse.

5. Venture capital firms

VCs add much more structure to the relationship between the founder and the capital provider. VCs must know whether the startup is setting and achieving growth goals and have the power to replace the CEO if they think it's needed to save the company.

Venture funding tends to peak after a great year for IPOs.

2000 was a record year for both venture investment and IPOs. That year -- when the NASDAQ began its plunge -- featured 406 IPOs and more than $105 billion in venture capital investment, according to Wired.

15 years later, venture capital peaked again -- though not as high as the 2000 level.

In 2015, venture capital investment rose 23% from the year before -- reaching $58.8 billion, according to the NVCA.

2014 featured 273 IPOs, the largest number since 2000, according to Renaissance Capital.

But last year IPOs fell dramatically -- when 38% fewer companies (170) priced IPOs according Renaissance Capital.

But those numbers -- which include IPOs of private-equity backed companies and others -- mask an even less appealing outcome for venture-backed technology companies.

The Wall Street Journal reports that the number of venture-backed technology companies going public has fallen steadily -- from 30 in 2014 to 16 last year.

With shares of those newly minted IPOs down more than 30% on average as of mid-February 2016, it should come as no surprise that 2016 has not produced a single venture-backed technology IPO.

6. Mutual funds

In 2015, mutual funds participated in about 45% of the funding rounds of startups valued at over $1 billion, according to securities filings and data from Dow Jones VentureSource.

Mutual funds justify investing in startups if they see evidence of a vibrant IPO market that will turn their shares of a company poised to go public into market-beating returns.

Mutual funds were drawn into the current bubble by the absence of alternative ways to earn high returns. But this time, the mutual funds are introducing a new feature to the market -- by holding investment committee meetings that re-price the startups every quarter.

These publicly-reported prices are sending powerful signals -- mostly negative -- to investors about how well these private companies are doing.

As the Journal reported, BlackRock , Fidelity Investments , T. Rowe Price Group and Wellington Management -- their mutual funds own 40 startups worth over $1 billion -- cut by an average of 28% below their original purchase price the valuation of 13 of those startups.

7. Public

The general public buys shares of a company whose product they use without recognizing that the IPO is often engineered to pop on the first day in order to reward the underwriter's institutional clients who get a chance to buy in to the IPO a few days before the offering.

In theory, the public gets the best information about how a company is doing because of our financial reporting requirements.

But in practice, analysts at large financial institutions get better information because of what they glean from conversations with top executives during conference calls and at investor conferences.

The companies that did go public in 2015 earned the lowest average return since 2011 -- trading about 2% below their IPO price, according to Renaissance Capital, "the weakest level since 2011’s negative 10% return."

Put Your Checkbook Away Until 2023

Bubbles form when those at the inside of the ring induce Fear of Missing Out (FOMO) in the hearts of those at the next ring out. That's what makes angel investors, venture capitalists, and ultimately mutual funds invest in private companies.

And bubbles collapse when venture capitalists and mutual funds realize that public investors are losing their appetite for IPOs. That fairly rapid switch from FOMO to Fear of Losing Everything (FOLE) leads to a predictable behavior pattern.

It is clear now that the IPO market for the current crop of venture-backed technology companies peaked in 2014.

Seized by FOLE, venture capitalists and mutual fund portfolio managers are terrified of the conversations they'll have with their investors about how they managed to lose their money.

That fear takes the form of stern conversations with executives at portfolio companies -- many of which are run by CEOs who are good at pushing rapid sales growth, rather than managing a more slowly-growing company that breaks even.

Unless the startup's board replaces the CEO with someone who can turnaround a money-losing company, that startup is likely to run out of money.

As VCs stop investing, so will angels. And with the technology IPOs losing altitude, public investors will shun IPOs.

As startups burn through their cash, most of them will perish -- flushing billions in venture capital.

It could take a decade to revive FOMO and accrete those concentric rings of capital around the core of an entrepreneur whose technology excites customers to buy.