As of the past two years, tech startups became increasingly more attractive in the eyes of some very wealth suitors—hedge funds.
A recent example of this attraction is Snapchat, the popular photo-messaging startup. After refusing a $3 billion dollar buyout offer from Facebook, Snapchat received $50 million in Series C funding from Coatue Management, a hedge fund.
Coatue Management is just one of many hedge funds who have begun investing in startups. Another hedge fund, Maverick Capital, even became a seed investor in Zenefits, an online HR management startup.
Why Hedge Funds Are Interested In Startups
Traditionally, as noted by the Wall Street Journal (WSJ), venture capitalist (VC) firms invest in young startups and foster them until they are ready for exit, usually in the form of a sale to another company or an initial pubic offering (IPO). By contrast, hedge funds typically stay out of the private market—except for the occasional investment in a late stage startup—and hold publicly traded stocks and securities. Hedge funds typically invest this way because they prefer the liquidity provided by the public markets.
However, over the past two years, more hedge funds have gained interest in investing in startups. TechCrunch attributes this recent affection to tech startups waiting longer before going public. The previous benchmark to go public was $100 million in revenue. Once a startup reached this revenue benchmark, their strategy was to go public and use the raised capital to expand into international markets. Once the startup went public, hedge funds would purchase its stock and capture the growth of this international expansion.
Now, however, startups are taking a different “going public” approach. Under this new approach, startups—with Twitter and Facebook being recent examples—hit the traditional revenue benchmark of $100 million, but instead of going public, decide to continue expansion into international markets as privately held companies. Thus by the time the startup goes public, there is less immediate upside for investors since much of their growth into international markets took place while the startup was still private. As a result, in order for hedge funds to capture returns from international expansion, they must invest earlier in the startup’s fundraising process—before the startup goes public.
A change in the startup ecosystem is also credited for drawing hedge fund investors. Forbes notes three changes that have eased the transition of hedge funds typically operating in the public market to entering the private market. First, Forbes recognizes that there is more transparency and information that can easily be accessed through websites such as AngelList and OurCrowd. Second, investors no longer have to invest in an idea where they are uncertain if there will be a market for the product. With websites such as Kickstarter, investors are able to gauge interest levels by monitoring crowd funding campaigns. These campaigns signal to investors which ideas are likely to be welcomed by the market, thereby mitigating one type of risk commonly associated with investing in startups. Finally, the 2012 JOBS Act has opened private investing to more investors by relaxing securities regulations and has removed the ban on general solicitation, making it easier for hedge funds to solicit capital.
How This Will Affect Startups
For early-stage startups, more available capital is generally a good thing especially for those seeking growth funding and early series financing. Now that hedge funds are more willing to invest in startups at an early stage, startups will have access to greater amounts of money. And hedge funds can afford to be flexible on pricing and often give higher valuations. Hedge funds have this greater flexibility because they work under a different model than VCs—10% or 20% of returns for a hedge fund would be considered a success. [The average returned rate for hedge funds was reported to be 7.4% by Bloomberg.] VCs work under a model that requires a higher percentage return, and they price startups in such a way to optimize their return and the startup’s value.
Some entrepreneurs welcome the entrance of hedge funds into the early stages of startups because they bring both an expertise in public markets and a bigger checkbook than VCs. However, others entrepreneurs have reservations about their potential contributions. Hedge fund managers tend to have a more passive role in the investment than VCs. VCs typically provide more than just capital—they are involved in the operations of the startups, including board-level decisions. As a new startup, this kind of guidance can be crucial to the startup’s success. The concern of not receiving proper guidance is essential for the success of early-stage startups. However, this concern would not be as great in a more mature startup that has already undergone several rounds of financing, and thus has already benefited from early guidance and their own learning experience.
TechCrunch also notes that with hedge funds driving up the valuation, there may be a perception of a tech bubble. Because hedge funds are valuing startups at a higher price, the valuations may be artificially inflated, making the company harder to sell. The WSJ illustrates this concern with a quote from Bill Ready, the CEO of Braintree, a digital-payment startup.
“ ‘We never seriously entertained the hedge-fund guys,’ Mr. Ready said, adding that he worried those investors might set a valuation so high—higher than that set by venture capitalists–that it would pressure Braintree to sell or go public at potentially unsustainable prices.”
Thus, a word of caution: Although early-stage startups are in need of capital, they should be aware of how much they are taking and what they are being valued at.
Coupled with the fear of artificially high valuations, startups should be cautioned that because there is a lack of accountability between the startup and the hedge fund, some funds have tried to unload the private stock when the startup encounters difficulties. VCs are investing more than just capital—they invest time in helping the startup develop. This makes VCs less likely to try to unload their investment when the going gets tough.