By: Mark at www.CapitalistExploits.at [15]
Many are arguing that startups, and more specifically hi-tech startups are in a bubble. I've argued it myself herein [16] and with colleagues over the past several months. Accelerators and Angel groups are popping up everywhere, from Akron to Auckland and everywhere in between. Money is flowing like champagne on an oligarchs yacht!
To the casual observer, and even to some of the VC world's most prominent insiders the exuberance is creating some concern. On September 25th Marc Andreessen tweeted this (amongst 17 additional posts on the same subject):
When market turns, M&A mostly stops. Nobody will want to buy your cash-incinerating startup. There will be no Plan B. VAPORIZE.
Andreessen is of course referring to the majority of early-stage tech companies that raise a bucket of money, burn it up quickly while developing their product, hiring and ramping up, desperately trying to time that burn with the inevitable need for additional funding. All the while hoping to add enough value so as to be able to raise the next round higher than the last... get the (market) timing or the execution wrong and:
Raising new money becomes harder & harder. You have bigger bulldog to feed, need more and more $ at higher and higher valuations.
Therefore you take on escalating risk of a catastrophic down round. High-cash-burn startups almost never survive down rounds. VAPORIZE.
Even if you CAN raise an up round, you are increasingly likely to incur terrible structural terms like ratchets to chin the bar.
That nice hedge fund investor willing to hit your valuation bar? Imagine him owning 80% of co after down round. How nice will he be then?
You can read the full Twitter rant and more here [17].
We had this happen to us recently with a hi-tech company we invested into a couple of years ago. Management went after a specific market that didn't pan out. They had to pivot, re-shuffle management and address another market. The unexpected additional burn ate up the cash, and when it came time to raise more money the company had to try a down round. Unfortunately even that was unsuccessful… VAPORIZED!
The chart below represents the amount of money raised by startups per TechCrunch headlines. In the spring of 2014, investment into startups totalled more than $5 billion over a 3 month period. By the fall of 2014, new investment has declined approximately 40%, to just over $3 billion.
Could we be seeing the early stages of a bubble bursting?
Maybe the top is clearly being signaled by the likes of Google, Facebook and Apple using their high-flying stock (Apple’s market cap topped $700 billion today!) as currency to pay what seems like ridiculous amounts for tech businesses run by groups of twenty-somethings. A billion is the new million. It's not "real" money anyway, right?
It's cheaper for these behemoths to use paper to potentially grab the next "big" thing and keep the competition at bay, or give them the slight edge that will keep those massive market caps growing.
Nowadays I regularly find myself in debates with kids who barely remember the dot bomb days. The topic is always why it's different this time. Yes, I know it's different now than it was then, it always (sarcasm) is.
But… here comes the punchline… As much as I don't want to admit it, there may actually be some truth in that last statement. Andreessen also recently said that, "Software is eating the world." There is a massive, paradigm shift occurring in the way business is done and wealth is created.
Instead of toiling in the fields and the factories, technology IS making things cheaper, faster and better in almost every industry that currently exists, and the new ones being created by this shift.
Nathan Heller wrote an excellent article for The New Yorker: Bay Watched: How San Francisco’s new entrepreneurial culture is changing the country [18]. In the article Heller quotes Naval Ravikant, the founder of Angel List:
Once, an entrepreneur would go to a venture capitalist for an initial five-million-dollar funding round—money that was necessary for hardware costs, software costs, marketing, distribution, customer service, sales, and so on. Now there are online alternatives. 'In 2005, the whole thing exploded,' Ravikant told me. 'Hardware? No, now you just put it on Amazon or Rackspace. Software? It's all open-source. Distribution? It's the App Store, it's Facebook. Customer service? It's Twitter—just respond to your best customers on Twitter and Get Satisfaction. Sales and marketing? It's Google AdWords, AdSense. So the cost to build and launch a product went from five million…. and it's now to fifty thousand.' As a result, the number of companies skyrocketed, and so did the number of angels: suddenly, you didn't need to be a venture-capital firm to afford early equity.
The cost to start a company, try an idea and secure a market is getting close to zero. With Kickstarter you can literally slap together a video, show some 3D drawings of your product "idea", and raise money from people willing to purchase it before it's even created! This is unprecedented.
This paradigm shift led The Economist to publish an extended article on startups titled A Cambrian Moment [19].
What's a Cambrian moment? 540 million years ago there was an explosion of life forms on the planet. Prior to the "explosion" the planet was populated by simple organisms. No one is sure what triggered it, maybe it was an alien picnic basket left behind, a rise in global temperatures, a freak event, or… The end result was that within a few million years the plant and animal kingdoms became much more varied.
Over what amounted to millions and millions of years nature has purged most of the life forms that resulted from the Cambrian Moment. That left us with what we have today, which is also constantly evolving. Remember, something like 98% of all the life forms that ever lived are now extinct!
The Cambrian moment occurring in technology today is being created by new materials, more efficient manufacturing, inexpensive and powerful devices and platforms… the Internet! Like the original "Moment", most of what is created now will evolve or become extinct at some point. Before that happens we'll see thousands, perhaps millions of startups come and go.
Going back to the comment that it's "different this time," Joe Horowitz, a 30-year veteran of the VC world wrote a short but concise piece that Alex Konrad featured on Forbes recently [20]:
During times of recession the economy is stimulated with low interest rates and once they get low enough, the yield on bonds and other fixed investments becomes so unattractive that money starts to flow into equities. Stocks begin to be described as bargains as CEOs of public companies scramble to trim costs and improve profitability.
Once the momentum of this flow of money gets into full speed, public fund managers search for ways to produce returns that are better than their peers, so the window begins to open for IPOs. The quality of these offerings are often very high because there is a pent-up inventory of successful venture backed companies ready for these moments. This leads to some great IPOs (i.e. ServiceNow, Workday, Palo Alto Networks, Twitter, FireEye, etc.) and the light of Silicon Valley begins to shine more brightly. But as these stories become more pervasive venture capital attracts more capital. Limited partners invariably over invest in the asset-class; public market investors chase high priced private deals and newly hatched seed funds sprout up from every espresso bar in San Francisco. Everyone is now a venture capitalist. All you need is access to capital and to be buzz-word compliant.
So are we entering the bubble part of this cycle? The answer is pretty clear from all the signs we are seeing; signs we have seen before. To [Benchmark partner] Bill Gurley's credit he was the first to sound the alarm. There is little doubt that his recent comments about the pending risk of a bubble resonate with most experienced venture investors. The vast number of start-ups receiving capital today from inexperienced investors combined with excessive levels of funding at over-optimized valuations sets the stage for significant investor disappointment which puts us all at risk.
I’m not going to argue with economic cycles, or with Joe Horowitz. This has all happened before and it will happen again. I too think that the market is frothy. Valuations are high, but guess what, deals ARE getting funded and they are getting follow-ons and getting bought! Until they aren't.
Right now this is the reality. Don’t fight the tape as they say on the floor. There will be winners and there will be losers.
My advice to investors is diversification, not just amongst their startup portfolio (obvious), but also in asset classes. Maybe it's time to pare down what's expensive and start buying what's cheap..?
My advice to company founders is to take the money while it's there. We could be one Black Swan event away from another 2007-2008 scenario, and even if we are not, the economic cycle will prevail, and when it turns you want to be as flush with cash as you can be to ride out the bottom.
Have a happy Thanksgiving to our US readers, and we'll be back with you next week!
- Mark
"Many entrepreneurs today are very young and were not around in the late '90s [during the dot-com boom], so there's no institutional memory." - Navin Chaddha, Mayfield Fund