Equity = Expectations (Part 1)
So from my seat as the head of innovation and technology at Lincoln Property Company, I tend to be the beachhead for a lot of technology (and non-technology) companies building businesses that want to change the real estate market and sell me on that vision. Ever since we started making venture investments in early stage businesses through LPC Ventures, we have received tremendous inbound of companies that are looking to raise money in an attempt to grow quickly. Some of these companies are pure software businesses that solve real estate managerial problems or transactional problems, some are real estate service companies parading as technology companies, and some are flat out hard asset real estate companies dressed up with a beautiful deck. They all seem to want to fit into the same capitalization box. That’s the problem.
To expound on this, we’re living in a world with the following conditions:
Never been easier to start a business
Real estate is an asset class that has seen tremendous appreciation over the last decade
Real estate is something everyone has an experience or an opinion on considering where we live, work or hang out all includes a real estate component
Technology has exponentially increased process efficiency
Technology is more accessible than ever before
Successful entrepreneurs are glorified and everyone wants to build a unicorn
Capital is plentiful and needs to find a place to be parked
Yield is hard to come by and so you have to go further out on the risk curve to achieve the same returns you might have just five years ago.
We’re in an A players market for talent, top talent can command whatever they want for compensation
We’re in an attention economy where you have to pay more for the same set of eyeballs as you did five years ago
We’re in a global economy and that means access to global capital and global opportunities
So with some of these baselines covered, let’s get back to my initial point. Everyone wants to be a technology company and wants to be viewed or better yet valued like a technology company. The problem with that though is that every business that uses technology to achieve their business outcomes, now thinks it should be a technology company. How does that manifest itself and how did we get to this point? When we continue to lump businesses like insurance (insurtech) or medical care (healthtech) into the bucket of technology, we misrepresent what it is. If you sell software to insurance companies to help them process claims more efficiently, you are in fact a technology company. If you are a new age insurance company that’s using technology to acquire customers and interact with customers, then you are in the insurance business, not the technology business. An urgent care that uses technology to book appointments and uses electronic health records for its patient documentation is a health care company, not a technology company. Software may be eating the world but it shouldn’t reclassify industries. These “new-age” challengers in traditional industries might grow faster than their incumbent competitors but their customers are the same and they’ll usually require large pools of capital to compete and unhinge their competitors market share, often spending huge amounts of capital in rather inefficient upfront ways. That’s where venture capital tends to step in. But should it?
Venture capital was originally designed to fund technology risk. In a true software company where you have tremendous upfront R&D costs, huge technology or execution risk, venture capital is an ideal suitor for the equity stack. It’s binary. It understands high risks of failure but it knows the value of its dollar. It has inherent leverage in its use of proceeds. It usually knows that if it can place itself in funding the development of technology that can scale, then once it’s built, it can sell it a million times over and scale with high margin efficiency. When you are faced with tremendous amounts of risk at the front end of a business plan, then equity is the only viable option and unless you want to lose your friends and families’ money, venture capital is often your best option. Venture capital likes this profile of risk because it understands the growth trajectory if you achieve breakout success. After all, venture investing is a discipline of investing in high growth and high risk and wasn’t built for the middle, slow and steady outcome.
Back to the idea of industry classifications…
When you change the appearance of these businesses, you change their expectations. When an entrepreneur shows up at a venture capital firm with a pitch deck showing a huge total addressable market (TAM) and a vision for an edge data center company, the company needs to understand what treadmill they’re asking to jump on and at what speed. The data center company is in the real estate business, not the technology business…despite technology being a core component of a data center. When you take on venture capital, the expectation is to grow extremely fast. If you’re in the business of building data centers, and you need equity capital to build physical space, then you can then only move as fast as building a data center takes in time. If you raise venture capital on a lofty goal and a high valuation and your use of proceeds is not going toward a high leverage use, then you might be jeopardizing your business given the higher valuations expectations. Might it be better to raise less, think about growing slower, but organically, and funding with less dilutive options over time due to your ability to sustain your own growth?
I had a great conversation with the CEO of a large tech-enabled property manager the other day who has taken on a LOT of venture capital and we were talking about the merits of taking on VC money. He said to me something that resonated, “I primed my investors to know that this was going to take decades, not years, to build a large business. This is not a technology business that scales through traditional software channels, this is a real estate management company, it’s a service business.” I thought that honesty and awareness of what he was building was a beautiful thing. While he might have set out to grow extremely quickly and reinvent an industry using technology, he very much understood that he was competing across the entire value chain of real estate management, not just building a slick app that you can sell like hot cakes. When you compete on that level, across an entire value chain, you’re playing a very long game and it takes a long time to untangle well established industry knots. The fruits of that labor though can be extraordinary and can make lasting, meaningful change. The equity in his company needed to understand that and adjust its expectations of a fast exit once the business realized what it was when it grew up, a property manager. This CEO is a brilliant leader and had the self-awareness to know what he was building and didn’t fall into the same trap many other leaders do in trying to persuade the market that they were a “tech company” when in reality they were a real estate company. If this CEO decides to raise more equity, it might come with a new set of expectations. He might also recognize the predictability of his business and fund the business with a much lower cost option that can continue to help them grow without diluting the business. Whatever he decides, I’m impressed by his ability to leverage venture capital at the onset and knowing when to pivot to tell the true story vs. the one that wall street needs to hear to maintain lofty (and sometimes unrealistic expectations).
So where is the GAP:
You’re a real estate operating startup, you know that technology is central to building your business, you know real estate deals of any kind take time and you want to build a brand. You have cap ex needs, working & operating capital needs to attract talent to build your platform and you need some GP capital to invest in your real estate projects. You don’t have decades of experience but you’re hungry and committed to knocking off the incumbents in the space. Who do you turn to to get off the ground?
Venture dollars don’t usually make sense here. Friends and family money is awkward. Debt isn’t feasible. The answer today is “someone or some firm in your network that believes in you.” What I believe is the right answer is some combination of private equity, HNW and other real estate platforms that are willing to expand into other product types and like your vision. That category of startup capital is undefined right now. That’s what I believe could be defined and well represented as a business unto itself. The challenge is that the return profiles are odd, unpredictable and extremely varying depending on product type. I’ve seen a few GP funds but they typically like to fund real estate deals on a project by project basis. What I’d love to see is a pool of capital that’s branded for startups who want to shake shit up, compete on either a real estate service line or a product type and make it the funding in a box needed to get off the ground. So the next time I see a rent to own strategy for single family, a flex-office for ecommerce, a third-party logistics startup for fresh produce, a cabin-in-the-woods business model, I’ll remind them that venture equity comes with expectations, so make sure you choose your equity wisely. Perhaps one day there will be a special bucket for this type of startup equity.