Yesterday, over on Quibb, I commented on an article about the alarm sounded by Bill Gurley in a recent Wall Street Journal article, then echoed by Fred Wilson and Marc Andreessen. They warn how the increase in startup burn rates could lead to spectacular flameouts. I’ve decided to join the conversation and share my view on what I speculate is happening.
As a pure spectator, entrepreneur and investor, I’ve witnessed changes in early stage venture capital and the startup liquidity cycle. These changes have been widely reported by Mark Suster from Upfront Ventures and other notable VCs. To summarize, investing has changed because startups have changed.
Here is how:
1 — What once took $3 million and 20 engineers to build, now cost $30k and only requires two good engineers to build. With 100x cost reduction comes 100x more startups. Most startups don’t fail because they weren’t successful at building a product, they fail because they aren’t successful at gaining traction and growing users and revenues.
2 — When companies are successful at #1, money becomes a commodity. When you can show that customers in a large or rapidly growing market are adopting your product, and your customer lifetime value (CLV) exceeds what it costs you to acquire that customer, you can almost always raise capital to fund growth.
3 — For startups, the market values growth, not profitability. As a result, startups that are successful at #2 choose to grow at unreasonable rate, as opposed to growing at a reasonable rate that keeps them borderline profitable. Since the market values growth, startups are in an arms race to gain marketshare. Consequently, they’re driven to raise money on a near continual basis to invest in customer acquisition to “own their market.”
The cycle goes like this: raise a round; invest in growth; show growth data to VCs; then let them compete to fund your next round - which leads to a much higher valuation. Rinse and repeat! When you’re successful, your startup is on its way to the unicorn club.
With the above mentioned changes in entrepreneurship, venture investing has changed accordingly:
1 — Early stage VCs that make initial investments in companies at Series A or Series B typically reserve 50% of their investment funds for follow on rounds. Historically this has been enough to maintain a decent pro-rata percentage ownership to limit dilution as portfolio companies raise later-stage rounds to accelerate growth. Many venture funds are now finding that their reserves aren’t nearly enough to maintain pro-rata in the wake of multi hundred million dollar late stage rounds. Some early stage VCs have raised additional funds reserved specifically this purpose.
2 — Due to the changes in startup growth described above; a significantly larger growth opportunity due to a growing market of mobile consumers with credit cards on file; and the propensity for startups to remain private longer, the funding landscape has changed accordingly. Many large institutional investors that historically invested only in public equities have now started investing, pre-IPO, in unicorns. Uber’s recent $1.2 billion raise at a $17 billion pre-money is the premier example of this — but not the only example.
3 — If I were an early stage VC trying to maintain pro-rata as my portfolio companies doubled down on fundraising due to the arms race for growth fueled by a new crop of eager late stage investors, I’d be very uncomfortable as well. Growth for most companies typically requires more headcount. In addition to payroll growth, increased headcount almost always requires more office space — leading to significant long-term lease commitments and other fixed expenses. When and if this new crop of late stage investors retreat back to public equities, the late stage funding bubble will pop. Massive layoffs and in some cases insolvency will ensue, resulting in spectacular flameouts.
For early stage investors like Bill Gurley, Fred Wilson and Marc Andreessen who have lived through the dot-com down cycles of the past, follow-on investing to maintain pro-rata in the current environment must feel like a game of high stakes poker.
