Oct 27, 2015 · 19 minutes

For nearly ten years, Valley watchers have freaked out about a re-inflating of the dot com bubble.

And for the better part of that decade or so, there have been great explanations for why that was more of an emotional argument than an economic one.

Principally, there is a big difference between overheated prices in the public markets and those held by professional venture investors. Back in the late 1990s, the size of your startup…. manhood, if you will... was measured in how quickly you could go from company formation to IPO. Today, it’s about how long you can put it off.

But that single core difference, the one most of us have clung to for a decade as evidence that the same thing wasn’t going to happen, is exactly what has spiraled out of control: The desire–and ability– to raise near endless private money at escalating prices with little oversight or accountability.

Now nearly everyone seems to have agreed that startups are living in a time of crazy excess and a reckoning is coming. The difference today isn’t whether or not you think we’re in a frothy time. It’s what you call the coming phase. It’s a “correction” if you are a glass half full kind of VC, a “crash” if you’re half empty.

More VCs weighing in by the quarter: Mark Suster, Fred Wilson, Mike Moritz, and the king prognosticator of it all Bill Gurley who has spent much of the year trying to throw cold water on late stage mega rounds. (Despite his largest investments Snapchat and Uber being leaders of the trend.)

Even [Pando investor] Marc Andreessen – who spent much of the last decade diligently trotting out reasonable non-bubble arguments ranging from “when everyone is worried about a bubble you probably aren’t in one” to the historic low P/E rates of public tech leaders— recently Tweeted:

When the market turns, and it will turn, we will find out who has been swimming without trunks on: many high burn rate co's will VAPORIZE.

He didn’t use the capital “B” word (bubble), he used the less incendiary b-word, “burn rates.” Still, it’s a concession that what’s going on now is in no way sustainable.

The mounting evidence

Signs are starting to pop up, even though the overall amount of money going into startups is still increasing. Some of these are anecdotal. They include:

  • Struggles at several unicorns like Fab, Jawbone, Evernote, and reports that even Dropbox’s large mutual fund investors have written the investment down. Each of these can be explained as individual struggles of each company. But perhaps those were struggles that would have been anticipated in another funding climate, and the companies wouldn’t have gotten such massive valuations and the false sense of security that comes with them. Such stumbles also make the point that the higher a valuation, the more room a startup has to fall. Exits that would have been considered successes suddenly look like failures.
  • A growing gap between the amount of money going into companies– which is increasing– and the number of deals getting done– which is decreasing. As I wrote before, this is almost never a sustainable trend. It points to a climate where there is neither overall bearishness or bullishness in the venture and tech market, but instead a split decision. A foot on each side of a widening crack in the earth. We’ve all seen enough disaster movies to know you gotta jump to one side eventually.
  • Further to this point, numbers on early stage deal making in August showed a decline, not only in the number of deals but the dollars– to levels not seen since July 2014. It was the first time in twelve months that less than $1 billion was invested in early-stage deals. This reinforces the point about the gap between dollars and deals: People are piling into late stage deals before the music stops. Meantime, there’s less willingness to bet on new entrants, because tough times are widely anticipated, and they’re nervous the capital won’t be there to carry them through. Again: We saw exactly this in the immediate aftermath of the dot com crash. Early stage deals fell to historic lows in terms of the percentage of overall deals made.
  • More money is going into startups than is coming out in the form of exits as the IPO market is dramatically weakening. Check it out:

  • A big honking trend with red flags all over it: Acceptance, and even encouragement of startups with negative gross margins. As Gurley has written, these mega rounds aren’t simply “private IPOs” the way they’re billed. There is no banker to explain why the key revenue metrics they are fundraising against are bullshit, financials aren’t audited or released with the same regularity, and mega-rounds implicitly encourage mega-spending. (“So, what do you plan to do with this money?”) Moritz went further, coining the term “subprime unicorns” and comparing the “debt” of living off venture capital with the subprime mortgage crisis. This has caused some to predict that actual unicorns may just suddenly go bust like recent smaller blowups at HomeJoy, GigaOm, Quirky, and Zirtual. (In fact, months ago I too predicted more of this was coming because there’s such limited board oversight in the Valley right now.)
  • Increasingly onerous terms. In a story on Pando last week, we outlined the terms of 17 unicorns, and most of them contained some sort of downside protection to guarantee investors more shares if IPOs don’t price above a certain valuation. This wouldn’t matter so much if IPOs weren’t so abysmal. Consider the recent case of Pure Storage, which struggled to IPO even at its previous venture price and has traded down since.

So let’s get this straight: Bad exit environment, 140 companies who’ve been told they are worth more than they are, entrepreneurs who have only known an environment of free money, and a completely false sense of security regarding how strong these businesses are. And the two main venture stats– dollars and deals– running in opposite directions from one another. Yep, seems pretty obvious something is gonna happen here.

So what will this [CIRCLE ONE: crash/correction] actually look like?

The obvious question is why-- in the face of all of this-- does cash going into startups keep escalating quarter after quarter? Because you only know in hindsight when you’ve hit an absolute peak. While people are still tacitly believing, unsure, or FOMO’ing on next rounds, there are fewer rounds– because there isn’t that much faith–  but every remaining company that can is raising cash, and every VC is telling their portfolio to load up. Some likely at any terms necessary.

We saw the exact same thing after March 2000. After the Nasdaq technically peaked, there was a similar flight to quality amid the investors who knew things were ending, but had to keep playing the game until it did. VCs are also advising all their companies to load up on cash while they can because no one knows exactly what’s coming or what it’s going to look like.

So at this point – some ten years into a bubble debate– there are only two questions left: When and what is it gonna look like? Or the selfish articulation if you work anywhere near the tech industry: When and who is gonna be decimated as a result?

“When” matters slightly less than “who,” because there’s not much you can do to prep besides load up on money and start moving to a profit-based model. That’s especially true if you rely on the broader startup economy for your revenues. Marketing spending by startups on startups, for instance, will almost certainly dry up. (That’s a big reason we made a shift six months ago to be more reader supported.) The answers to the “When” question are in a relatively narrow band: Is it next quarter? Or next year? It’s not years off, and companies should start prepping, now, no matter the answer.

No, the big question is “Who?” Who gets hit this time around and how. … or more to the point: How many of us?

Because of the nature of this techpocalypse, it’s hard to predict.

The one thing we know it won’t be like: The dot com crash. Entire companies valued in billions went bankrupt taking thousands of jobs with each one. There was mass market psychological carnage and anger as dot coms tanked the markets and people’s retirement accounts. It had an impact on the macro US economy. Lots of “wealth” immediately evaporated, because these stocks were liquid.  

Again, that’s because of the core difference in these two “bubbles.” Because so many of the companies were publicly traded, everyday people got hit. While venture capital has an outsized impact on the economy when it succeeds, it’s still a small percentage of the small business world. VCs fund just .19% of new businesses in the US, and are behind some 20% of IPOs, according to a recent report by Stanford on the impact of venture capital in the economy.

In terms of panic, there’s a key difference between public and private as well. When an investment is publicly traded, you can freak out and sell. When an investment is private you can’t do much but mark it down and worry. When you are a publicly traded company, an activist shareholder with a few percentage points of stock can make your life hell. When you are private, your investors – even those with huge stakes– can’t do much unless you need more money from them.

This oncoming correction could start a panic, for sure. But the panic would be more contained and subtle. It’s more of what we’re seeing in those early stage numbers: VCs pulling back on deals because they are worried. Spending by startups declining. Layoffs. A freeze on hiring. Things that are bad for individuals– maybe even San Francisco as a whole– but hardly devastating for the US economy or most people outside of this industry.

The concern is less about any one deal, but somehow the sum of all of them. Christopher Mims of the Journal was the latest to worry, writing yesterday:

What I worry about most in this climate isn’t the individual deals signed at questionable valuations and under potentially onerous terms, but the sum of all of these deals, and the unpredictable way they could all quickly unravel at once if companies are unable to go public, be acquired or continue through endless rounds of private financing.

Despite their fondness for playing them on Twitter, venture capitalists aren’t macroeconomists. And to those who seem to believe that the current state of affairs is sustainable, I would ask this: When in history has ever-increasing financial complexity, lack of transparency, perverse incentives and new ways to extend credit and increase leverage not eventually led to disaster? 

Companies won’t go under en mass sparked by an investor panic. They won’t go through the pain of “delistings” because their stock languishes under $1. They’ll go under if they run out of cash. And while several VCs have said they expect that to start happening this year, my guess is we won’t see as many as some of the bears expect. I have to assume, with all this ambient gloom, a lot of these companies are starting to batten down the burn rates already. Unlike the dot com bust, this is the most over-heralded correction of all time. Unlike the late 1990s, no one is saying this is a “new economy” with new rules. Everyone is writing checks from a crouched position under a desk.

The troubled companies – those whose premises wound up being inherently flawed, like Quirky, or those which didn’t have the right governance in place, like Zirtual, will go bust, and more will do so more quickly in a more cautious environment. But at some point they would have gone under anyway. Companies that have a business– and I have to imagine the bulk of the 140 unicorns have a business of some sort– can cut if they are disciplined enough.

Gurley and Andreessen (who rarely agree) are both right when they say these companies have a false sense of security. But if the founders aren’t smart enough to read all these tea leaves, and stop spending so much cash – well, those would have made for disastrous public companies eventually anyway. My advice: If your CEO isn’t worried, get a new job.

Write this on a PostIt and put it on the mirror, unicorn founders: I need to be more like TellMe

The real determiner of how bad things will get may be founder ego: Can they admit they were out over their skiis, and make changes quickly enough to survive? There’s failure and there’s failure. Things didn’t end the way Chegg or Pure Storage would have wanted but they are still in business.

Surviving a bubble is really just about buying time, and if they are smart, most of the unicorns should have enough cash to buy themselves time. Shit, if the past is any guide, companies may even be able to ride the storm out even if they don’t have a business, as long as they have scrappy management, a pivot idea, some luck and a shit load of mega-round capital.

Consider TellMe. You may not remember them, but I remember writing about their mega-round in 2000. Some $128 million for a company that was a few years old. Big even for the times. Back then, people said it was a sign that things hadn’t really crashed.

TellMe was supposed to be a consumer app using voice recognition software, kinda like what Siri eventually became. You could ask it for directions, restaurant reservations, it could “tell you” almost anything.

Then the world collapsed and they had to make it on that mega round or face a crushing downround. They became a enterprise service and seven years later sold to Microsoft for $800 million– completely avoiding the punishing down round. Far bloodier and more public, since it had IPO’d, was the Loudcloud/Opsware pivot. It was eventually steered to a $1.6 billion exit. Both were huge wins given the timing and what happened to so many contemporaries.

Pick your “failure,” unicorn founders. Current companies may not wind up worth as much as they imagine, but making it, staying in business and surviving with more modest staff and ambitions is different than an utter collapse.

I recently saw internal numbers of one middle-of-the-pack unicorn, shared by a friend who was working there so I can’t disclose the name of the company. It’s one of those companies everyone says is crushing it, with great investors, a mega round closed in the last six months… that I’ve never once used the service of. You know, your everyman unicorn if there is such a thing. This company was essentially burning a Series A each month, with aggressive expansion plans in the fourth quarter. Without that expansion, it had enough capital to get through a few years. It’s easy for VCs to continue to invest in high priced deals even as they see a crash coming– they are diversified. But entrepreneurs need to weigh their own “investment” in expansion much more carefully.

Burn rates are the focus of so much of the conversation because that is the befuddling issue this time around. Because they are private, we simply don’t know the burn rates of these 140 companies or whether their leaders have the fortuitousness and resilience of a Mike McCue of TellMe or a Ben Horowitz of (then) Opsware.

But if many of these companies can swallow their pride and slow the land grab, there’s no reason they need to go under wholesale. Many may even band together to pool customers, salvage what’s left of their cash and build more critical mass. Others are cheap acquisition targets.

The biggest victims? Founders’ stock value, laid off employees, and sub-corns. (Sorry, everyone not in tech, San Francisco housing prices likely won’t crash.)

Does that mean there won’t be carnage? No. Many, many founders will get fucked. The “lucky” ones to go public or get acquired will likely do so for smaller amounts than their private rounds– and many of their investors have downside protections if that happens. Depending on how small an acquisition is, liquidation preferences could mean most employees get nothing.

VCs by and large will come out of it fine. It’s their job to take risk and there are enough winners in this crop that the best investors will win, while plenty will fare worse than they’d hoped. But they’re at least diversified, unlike founders. They get the game. That’s why they’re all talking about the downturn so much. They want to point out that they knew it all along.

And remember: For all the pain of the dot com bust, the bubble also spawned many of today’s most valuable companies. Some of which are among the most valuable in the world, like Google and Amazon. VCs in aggregate will have invested in some of the greatest companies of the next 50 years.

In terms of San Francisco, there’s the psychological toll of thinking you are worth a certain amount and realizing you likely aren’t. That could trickle down to impact spending power in San Francisco. Commercial real estate will – hopefully – become slightly less insane. But housing will be another matter, in my opinion. Rents may cool, but I doubt there will be a collapse given overall how strong tech is in San Francisco, well outside of unicorns and startups.

Consider this: In 2005, the top five tech companies were worth a combined $760 billion. Today, the top five are worth $2.15 trillion. Those companies– and dozens more below that top five – aren’t going anywhere. And unlike last time around, the bulk of the companies have been headquartered in San Francisco or have shuttle busses to run San Francisco residents to Silicon Valley campuses. In a recent article, Zillow pointed the finger at Apple– not startups-– for driving up prices in many neighborhoods.

The biggest –and most unfair – impact of a correction may be on smaller, younger companies who haven’t yet had the chance to get their sea legs, and don’t have close to enough differentiation to justify more cash in a time of investor panic. The many “Ubers of” everything that just don’t have large enough markets or repeatable enough use cases. As I wrote here, I would be stunned if a company like Handy thrived. Elsewhere Gurley has thrown shade at companies like Shyp, Instacart, and Postmates. (We should note, some of these tangentially compete with Uber, and Gurley has a history of denigrating Uber competitors by bringing up their burn rates. That doesn’t mean he’s wrong.)

Consider a wildly overcrowded space like food delivery. Postmates isn’t the one I’d worry about. One-third of the entrants have only raised initial money in the last year, and most have negative gross margins. They are spending heavily on marketing, if my Facebook feed is any indication. I can’t imagine a world where the many Blue Apron derivatives ever get another round if there’s a whiff of a correction. We’ve been testing half a dozen of these for a series, with almost no differentiation between most. If we enter a crash, no one will come close to matching BlueApron’s fundraising or valuation. Maybe even BlueApron couldn’t. I can’t see most of them surviving.

And we’ve seen an increase in offline ad spending by startups– whether food companies, razor companies, or other commerce companies. Sure, a lot of it is remnant late night TV. Still, I know one VC who recently took the opportunity to cash out of a commerce company that is chasing unicorn status, precisely because the projected marketing budget was so heavy on TV.

Every founder is trying to time when to stop aggressive offense and move to defense. Like warding off dehydration in a desert, if you wait until you feel thirsty, it’s probably too late… especially if you haven’t raised $100 million in the last few months of mega-deal mania.

Sub-unicorn founders mean well and are working hard, but they were founded and funded in a different era. The rules for them have been unfair: Invest in growth or become irrelevant next to larger competitors. The truth is many of them should have never raised money to begin with. I recommend they find soft landings now, or start focusing on getting profitable if they are determined to survive, even if it hurts growth. (Again, that’s our plan. Tech media will no doubt be one of the first categories hit.)

One thing will be a welcome and shared result of the last crash: Douchebags will leave. Others are calling them “tourists” – which irks me. It implies that the only people who are making wise decisions are those who’ve already been in the market. There are plenty of long-time VCs making horrible moves right now. Remember Yuri Milner? He was at one time a “tourist.” As Fred Wilson put it in a recent blog post:

The question I always try to ask myself about new entrants in a market is “are they stupid or do they actually know something we don’t?” … So I’m not sure I would go there with Mark [Suster]. It’s tempting but might be the wrong place.

It’s not when you arrived in the ecosystem that dictates whether you’ll leave when times get tough. It’s typically: how easy did you expect it to be? It’s not so much the “tourists,” as the “opportunists” you want gone.

I’m solidly in the camp of believing a correction is coming and within a few quarters. But for those waiting for cheap houses and lacing up their tap shoes for the tech graveyard, I’m not sure it’ll be as satisfying or quick as they’d like. Unicorns and sub-unicorns need to get over their egos and adjust their businesses now. The world has already changed, those changes just haven’t worked their way to the surface yet.


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