What is a Venture Orphan or Venture Capital Orphan?
Venture Orphans are companies that raised venture capital, but have failed to produce a venture-scale outcome. "Wounded Unicorns" is another term for them.
Venture capital is the perfect financial tool for a small subset of businesses. If the business has the potential to be worth a billion dollars plus in a relatively short time, then it is possibly a good fit to raise venture.
But VC is the wrong capital source for companies that aren’t on that path. The reality is that most VC-backed companies over the last few years aren’t likely to achieve the required escape velocity of doubling their revenue or more every year.
Many venture capital-backed businesses that growing at a healthy clip are still orphans. They aren’t growing fast enough to raise more money, but they have built a great product used by loyal customers.
Growth equity is a good fit for some of the larger ones, but many assets are too small for these players.
Without the ability to achieve venture scale and often with dwindling cash, these can be attractive acquisition targets if you can find a deal that works for all parties.
What are the different types of venture orphans?
With all the money sloshing around before 2021, many companies were funded that will end up as venture orphans.
Never found product-market fit (bottom quartile) - Startups are an exercise in trying to find product-market fit. These experiments didn’t work out and aren’t worth saving. Some of them may even have real revenue, but if you talk with customers, it becomes clear that the software isn’t providing enough value to them.
Raised too much money - These are often good businesses with bad balance sheets.
I’ve heard that 40% of venture-backed companies are now worth less than the value of the preferred shares. This likely underestimates the true extent of the situation.
The "All-In' podcast guys said they think most unicorns (billion dollar plus) companies from the last cycle are worth less than their preference stack. This means that if the companies sold today, the VCs wouldn’t even get all their money back, and the founders would get nothing.
Healthy, profitable, and growing - The weird thing about the venture capital model is that venture orphans are not necessary in any financial distress. They can be healthy, profitable, and growing and still be a venture orphan because they just aren’t growing fast enough.
Some even were prudent and didn’t over-raise when money was easy. They can choose their destiny. Often that means running the business indefinitely for cash flow or a life-changing financial exit when the time is right. These look more like healthy bootstrapped businesses that used cash to get off the ground.
Top quartile - Not venture orphans. They are growing quickly and can stay on the venture path.
Why is now the right time to buy venture orphans?
Before the end of 2021, the startup and venture capital market enjoyed years of “irrational exuberance” in the zero-interest rate environment. We saw record levels of fund-formation, sky-high valuations, and capital deployed. Much of this by new and inexperienced investors.
Then an abrupt reversal at the beginning of 2022 with soaring interest rates cut off the money faucet. Now in late 2023, over a year later we starting to see the impact in the startup ecosystem.
It’s very difficult to raise capital now even for great startups. We are seeing many startups shut down that weren’t able or willing to cut expenses to get to default alive.
Are venture capital orphans good businesses?
Most businesses exist to make money, so if a business is consistently losing a bunch of money every month, it is fair to ask whether it is even worth saving.
The truth is many of these venture capital orphan businesses never found product-market fit and the answer is likely no. There is nothing to salvage.
The high-margin asset-light businesses often hide good businesses underneath the excessive spending though. Software and marketplaces can be great businesses with new cost structures and/or new management in place.
The top quartile of VC-backed companies are likely growing quickly and are in a position to continue to raise more money and stay on the VC path. The bottom quartile of companies probably just shut down. That leaves the middle second and third quartiles as interesting businesses.
Figure Out True Profitability
We go on a case-by-case and basically rebuild the P&L and look at what the company could look like under a different model. Elon just did this with Twitter. A $40 billion huge social media platform with decades of tech debt is playing on the hardest mode possible. The average $3 million ARR SaaS company has a much more predictable team and cost needs.
Many e-commerce and other real-world product or service businesses are often not very good businesses. They were propped up with spending and can have upside-down economics that may be impossible to fix.
Why is it hard to buy venture capital orphans?
The incentives are all messed up.
If founders raised a bunch of money and didn’t see explosive revenue growth then their equity is worthless if they sold today because it is buried under a large preference stack (VCs get paid first). They’ve dedicated years of their life to the company and often have their identity closely tied to it. Founders by nature, are infinitely optimistic and are rarely willing to sell and move on.
They could exit and take their skills to the next opportunity. But if they sold now, they would get no money and lose their salary and benefits. It is easiest for a founder to continue running the company and take a salary if the company has runway. I’ve seen some where they are nominally running the company, but they are really just taking a salary and doing other work on the side.
Founders are the ones that often kill the deal if they are on the board. An acquihire to a big company is a better outcome for them even if their shareholders get nothing. They are effectively trading an asset that they don’t really own anymore for cushy jobs with bonus incentives.
Generally, VCs have mentally written these companies off due to power law returns. They see this isn’t the next Uber. The best VCs know the game is basically home runs that return the fund and zeros. They should be spending time on the winner’s of their portfolio.
But not all VCs are in the top-tier. Many don’t have any fund returners in their fund. These not-as-top VCs are clawing for every dollar to try to return their fund and won’t be as open to making a deal. If these investments are mark-ups on paper then it is better to leave them that way and not jeopardize the next fund than rush to take markdowns.
VCs generally would love to get off the board but don’t want to hurt their reputation by suggesting anything that isn’t viewed as founder-friendly. They’d love to get their time back and focus on the next potential homerun, but it is tough for them to remove themselves without looking like they are giving up on the founder.
This all becomes easier later in a fund’s life when VCs want to close out their fund and are more likely to be open to a deal.
Otherwise, most VCs are fine with letting the company die or pivot for the 10th time on the 0.1% chance they pivot to a unicorn.
The employees also see it isn’t the rocketship everyone was hoping for. The constant pressure of venture growth without success doesn’t make for a fun place to work. Many would be happier in a calm steady company or will hop to the next chaotic startup.
What are venture orphans’ exit options?
Strategic acquirers - The best for everyone is to sell to a larger strategic company for a great multiple. This is where you hear of 40x ARR sales. Everyone gets cushy jobs and earnouts. This isn’t very common.
Growth equity - Larger companies (Series B+) are often big enough to raise additional growth equity. The terms may not be super friendly, but they can continue on the path.
Financial buyers - Most financial buyers don’t want to or are unable to deal with the operational difficulties of turning a venture-backed growth business into a calm, cash-flowing one. Search funds, most private equity firms, etc., generally buy stable cash-flowing businesses.
Acquihire - The founders and some or all of the team join a larger company. Sometimes, this is for a nominal amount of money or zero for the shareholders. The company may continue on or just be shut down. This is where many end up.
Recapitalization - This is a restructuring of the company’s debt and equity. The goal is to reset the company’s capital structure to put it on a path toward success in the future. These are creative and often complicated deals that we specialize in at Verne. We work to broker misaligned incentives between VCs and founders in non-venture growth outcomes.
We are founders and builders and are comfortable jumping in and building alongside the founders. We like to let them focus on what they are best at, and we will supplement with ourselves and others in our network. We are happy to craft a deal that works for everyone.
How do you craft a deal to win everyone over?
Founder - It depends on what they want. Most are cash-poor and have been under-compensated for an extended period of time. We can often bribe them with cash payouts and some equity. If they want to stick around, we can also just recap the company (cram down existing investors and re-up the founders) if they want to continue with building.
VCs - VCs generally want out. They can get some money back, off the board which frees up their time, maybe some equity in the future company, ability to close out old funds, and a PR win by talking about the sale.
Sample Deal Structure:
VCs - Cram existing down to 10-20% of the equity. Or zero if they want out.
Founders - Give founders 10-30% of the equity if they can make it profitable, also bribe them with cash bonuses for a successful transition.
Buy the majority of the equity for a fraction of the last round plus some growth capital for the turnaround phase. This is often well below the liquidation preference.