Silicon Valley Wildfires: The Effects of an Entrepreneur Arms Race

What are Burn Rates?
A few readers of my previous post expressed interest in learning more about burn rates and how startups are handling the large investment rounds they are raising. The term ‘burn rate’ refers to the rate at which a company deploys capital in a period of time. High burn rates are an inevitable side effect of investor and entrepreneur competition in Silicon Valley. Competition results in escalating cycles of investing and capital burning. This post investigates what startups are spending money on and the wider economic effects of increased spending, including the ecosystem’s influence on real estate prices.

Unicorns Aren’t As Rare as You Think
According the Wall Street Journal, at the beginning of March 2014, there were 49 VC-backed ‘unicorn’ companies valued at $1B or more. As of March 2015, there were 78 (Fig 1). In 2000, there were only 10 (Fig 2).

UnicornsMar14
Figure 1A. 49 Startups valued north of $1B as of March 2014
UnicornsMar15
Figure 1B. In just one year, the number of total unicorn companies has increased by 60% from 49 companies to 79 companies. “The Billion Dollar Startup Club.” WSJ (http://graphics.wsj.com/billion-dollar-club/).

This growth seems unlikely to slow down as venture becomes an increasingly attractive investment class compared to alternatives. Asset managers including hedge funds, mutual funds, limited partners, corporations, and sovereign wealth entities have begun pooling capital into the venture capital asset class. As mentioned in my previous posts, the growing pool of capital contributes to high valuations. Individuals within the investing ecosystem have sounded the alarm on the increasing frequency of high valuations, reminiscent of the dot-com collapse in 2000 (Fig 2).

Figure 2. Many fear the parabolic rise in unicorn valuations will eventually end with a substantial collapse reminiscent of the dot-com bubble that took place from 1999-2001. "Mega-startups go parabolic. Flame-out already happening." Wolf Street (http://wolfstreet.com/2014/10/09/priming-the-startup-scene-and-ipo-market-for-burnout/)
Figure 2. Many fear the parabolic rise in unicorn valuations will eventually end with a substantial collapse reminiscent of the dot-com bubble that took place from 1999-2001. “Mega-startups go parabolic. Flame-out already happening.” Wolf Street (http://wolfstreet.com/2014/10/09/priming-the-startup-scene-and-ipo-market-for-burnout/)

A strange, self-reinforcing paradox has taken over the entrepreneurial culture of San Francisco. As corporate investors offer high valuations to outcompete traditional venture firms, so too are entrepreneurs encouraged to spend large amounts in order to scale their product and teams quicker than competing startups. For venture investors such as Bill Gurley, the paradox lies in the challenge of investing enough capital in a startup for it to remain competitive while at the same time tempering valuations in order to control burn rates and receive a significant return multiple for limited partners. This results in a situation where, as Bill Gurley points out, there is a long list of investors ready to hand well-funded startups even more money than they actually need.

Burn Rates: What are Startups Spending On?
To put burn rates into perspective:

Bill Gurley writes in the WSJ’s Venture Capitalist Sounds Alarm on Startup Investing, “One, the average burn rate at the average venture-backed company in Silicon Valley is at an all-time high since ’99 and maybe in many industries higher than in ’99. And two, more humans in Silicon Valley are working for money-losing companies than have been in 15 years, and that’s a form of discounted risk. In ’01 or ’09, you just wouldn’t go take a job at a company that’s burning $4 million a month. Today everyone does it without thinking.”

Startups aren’t just spending this money on lean business practices and necessary resources. High valuations in tandem with high financing rounds gives startups padding to indulge in non-product/sales expenditures.

According to the WSJ’s piece, Free Spending by Startups Stir Memories of Dot-Com Era Excesses, “Startups feel the need to outspend on recruiting, marketing and designing their offices, echoing poor choices made 15 years ago when unprofitable companies overextended themselves, then crumbled when the market turned.” In order to attract and retain talent, startups are forced to offer competitive salaries, which have risen steadily since 2011 (Fig 3). These salaries are on top of perks including free catered lunches, retreats, and customized work spaces all purposed to entice recruits away from technology giants such as Google and Apple.

Figure 3. Salaries have increased steadily since 2011, corresponding to the increase in tech valuations during the same time interval. "Free Spending by Startups Stir Memories of Dot-Com Era Excesses." (http://www.wsj.com/articles/startups-spend-with-abandon-flush-with-capital-1412549853)
Figure 3. Salaries have increased steadily since 2011, corresponding to the increase in tech valuations during the same time interval. “Free Spending by Startups Stir Memories of Dot-Com Era Excesses.” (http://www.wsj.com/articles/startups-spend-with-abandon-flush-with-capital-1412549853)

Increased Spending Increases Real Estate Prices
The most extravagant startup expense, however, is on real estate. San Francisco real estate agent, Jeffrey Moeller describes “‘A four-person startup will tell me, ‘We need a 10,000-square-foot office for future growth,'” he explains. “I’ll say, ‘No, you need 1,000 square feet.'”

In 2014, WolfStreet reported on Bloodhound, a mobile application for events, that blew 2.5 times as much rent as the previous tenant because it had the investment padding to do so ($31,700/mo from $13,000/mo). That’s $375K/year on rent. The conclusion was that the founders did not care much about expenses because profits were not on the horizon. When the startup ran out of money, the owners were evicted from the space which went back on the market for $37,500/mo. The startup had raised a $4.5M Series A round from Silicon Valley investors including 500 Startups, Rothenberg Ventures, and Peter Thiel’s Founders Fund.

Another notable example is online retail website, Fab.com, which raised $150M at a $1B valuation and burned through $14M/month, spending $250K/month just on rent in New York.  The company ultimately laid off many of its employees and pivoted into Hem, which now spends $125K/year on rent in Berlin.

The side effect of salary increases and overall spending by both employees and startups is a consequent increase in real estate prices (Fig 4). This is in part due to the multiplier effect, which posits that the sale of one space impacts the price of 60 others. The influx of capital has resulted in articles such as this Huffington Post piece, entitled America’s Most Expensive City Just Got More Expensive,” reporting the median rent of a one-bedroom apartment reaching a record high of $3,410/month. The article goes on to describe how the city is becoming increasingly unaffordable for its low and middle-income denizens as an influx of wealth floods the city:

Income inequality in San Francisco is so great that it’s on par with that of developing nations, the city’s Human Services Agency found last summer, and demand for affordable housing is so unmanageable in San Francisco that the city was just able to reopen its public housing waitlist last month for the first time in four years.”

Figure 7. Price per square foot has increased in the last decade. Does the shape of this graph remind you of any other figure in this post? Hint: See Figure 1. "Free Spending by Startups Stir Memories of Dot-Com Era Excesses." (http://www.wsj.com/articles/startups-spend-with-abandon-flush-with-capital-1412549853)
Figure 4. Price per square foot has increased in the last decade. Does the shape of this graph remind you of any other figure in this post? Hint: See Figure 1. “Free Spending by Startups Stir Memories of Dot-Com Era Excesses.” (http://www.wsj.com/articles/startups-spend-with-abandon-flush-with-capital-1412549853)
Who wouldn't love to work here? By the way, their food and assortment of desserts are excellent.
DropBox’s New Office Lease: Who wouldn’t love to work here? By the way, their food and assortment of desserts are excellent. (http://www.wsj.com/articles/startups-spend-with-abandon-flush-with-capital-1412549853).

High Valuations, High Burn Rates Discourage Lean Business Practices
The lack of transparency makes it difficult to gauge exactly how pronounced and widespread these spending habits are within the startup ecosystem. But high rounds of financing certainly don’t encourage efficient business practices.

Several investors including Bill Gurley have drawn an analogy between a company’s fitness and natural selection. I would like to expand on that idea further. A company’s development can be likened to evolution, where an idea evolves into a prototype and viable product through subsequent, hopefully several, rounds of natural selection that eliminate unviable iterations and direct the company towards achieving product-market fit, market share and IPO or acquisition.

Selecting events could include competing companies or technologies and/or the availability of limited resources needed for growth, namely investment capital.

The abundance of resources determines the maximum population size of a species, just as the abundance of funding  determines the maximum population of startups. The upper limit at which a population stabilizes due to limited resources is known as the carrying capacity. With the influx of capital via new investors and increased investor appetite, there are more resources critical for startup survival. This is equivalent to an upward shift in the carrying capacity of a species (Fig 5).

Figure 5. The critical resource for startups is funding capital. The increase in funding across the entire ecosystem allows a larger population to survive. My graph is based on the concept of carrying capacity for a biological species. As more funding pours into the ecosystem, the carrying capacity shifts upward (marked by the dotted and solid red lines), and the maximum population size increases from P1 to P2. Read more about carrying capacity here: Wikipedia: Carrying Capacity.
Figure 5. The critical resource for startups is funding capital. The increase in funding across the entire ecosystem allows a larger population to survive. My graph is based on the concept of carrying capacity for a biological species. As more funding pours into the ecosystem, the carrying capacity shifts upward (marked by the dotted and solid red lines), and the maximum population size increases from P1 to P2. Read more about carrying capacity here: Wikipedia: Carrying Capacity.

This also means the threshold for natural selection through increased financing has been lowered, allowing previously unviable startups the ability to secure funding and proliferate, simply because there is more funding to be invested. Bill Gurley warns this results in a lower average fitness for companies, writing “‘Excessive amounts of capital lead to a lower average fitness because fitness from a business standpoint, has to be cash-flow profitability or the ability to generate cash flow.'”

The increase in potential startup population is good from the perspective that it allows a wider variety of startups to proliferate. However, this wider range includes previously unviable startups that would likely not survive without the capital influx. These startups lack sustainable business models, but are kept alive by increased capital. When the maturation of a company can take 5 to 7 years before investors reap liquidity through IPOs and acquisitions, the notion of positive cash flows can seem illusory and distant for founders. In fact, specialized debt vehicles and secondary shareholder marketplaces encourage companies to stay private longer, further relieving pressure for management teams to yield returns.

Pressure on CEOs Lifted: Delayed IPOs and the Private Stock Market
The timeline to IPO has been lengthening according to CB insights, from 70 months in 2007 to 80 months in 2013 (Fig 6).

Figure 6. The average time to exit has increased significantly between 2007 and 2013. The timeline to IPO has been on the upward trend while the timeline to M&A has decreased over the past few years. "It's Definitely a Marathon--Venture-Backed Tech IPOs Take Seven Years from First Financing." (https://www.cbinsights.com/blog/venture-capital-exit-timeframe-tech/).
Figure 6. The average time to exit has increased significantly between 2007 and 2013. The timeline to IPO has been on the upward trend while the timeline to M&A has decreased over the past few years. “It’s Definitely a Marathon–Venture-Backed Tech IPOs Take Seven Years from First Financing.” (https://www.cbinsights.com/blog/venture-capital-exit-timeframe-tech/).

Why is the timeline toward IPO increasing? This is due in part to increased regulations making IPOs more difficult (Sarbanes-Oxley Act of 2002) and the JOBS Act of 2012 which makes it easier for companies to stay private. The JOBS Act allows companies to increase the shareholders from 500 to 2,000 while exempting employee shareholders who can liquefy their vested shares as part of their compensation. Private stock market exchanges including SecondMarket have arisen to handle these secondary share transactions with company clients averaging 7 years in age, $950M in valuations, and $150M in raised capital.

Beyond secondary share marketplaces, asset management firms such as JP Morgan have created a new debt vehicle called an SPL (“Stay Private Longer”) allowing prominent startups such as Survey Monkey and Jawbone to delay IPO. Disclaimer: We are secondary shareholders in Jawbone.

Andreessen’s Scott Kupor confirms in the WSJ, “More and more of the appreciations of these companies will happen in the private markets…It has become increasingly unattractive for a company to be a small-cap public stock.” Jyoti Bansal, CEO of AppDynamics writes in the same article that “he doesn’t feel pressure from early investors to cash out in part because they expect the value of his company to keep growing. ‘No one is interested in liquidity’ Mr. Bansal said, adding that as long as revenue is increasing, his investors are fine with waiting.” However, history has demonstrated that the longer these companies stay private in the hopes of outclassing previous prominent IPOs, the greater the risk of fizzling in the public markets upon IPO. Zynga, the largest IPO since Google at the time debuted at $10/share at IPO, down from $14/share pre-IPO. In five months, the valuation decreased from $20B pre-IPO to $8.9B post. If the only way to reach higher valuations is to keep these companies private, does that mean these companies are being overvalued initially?

Delaying IPO can benefit companies in the short-term, but delays can prove stressful for venture capital investors who require liquid returns in time with their own fund maturity timelines. Each delayed year results in a decreased annual return on investment for venture investors (Fig 7). Despite Mr. Bansal’s remarks, increasing revenues do not necessarily indicate profitability, and when $1B+ valued companies are still running in the red, investors are left with no choice but to prolong exits, hoping the business will eventually be able to turn a profit.

Fig. 5 Annual return on investment decreases as the number of years to exit increases for 10X and 30X return multiples. The minimum VC return is ~20% per year. "Venture Capital Exit Times." (http://www.angelblog.net/Venture_Capital_Exit_Times.html)
Figure 7. Annual return on investment decreases as the number of years to exit increases for 10X and 30X return multiples. The minimum VC return is ~20% per year. “Venture Capital Exit Times.” (http://www.angelblog.net/Venture_Capital_Exit_Times.html)

Scrappy and Successful: It’s Possible
Young entrepreneurs do not remember the dot-com bust and ride the wave of startup enthusiasm without necessary caution or wisdom. I certainly don’t remember the dot-com bust–I was still in elementary school.

Startups should be focusing on achieving market fit as soon as possible. Yet many of them are distracted by the competitive environment which results from high financing and an overabundance of competing startups also funded on high valuations.

As these startups mimic the vibrancy and warmth of their corporate analogues, are they calculating the revenue gained from each of these extra expenditures? How does an investment in retreats and swag purchases translate to improved company culture and greater work efficiency? Can that be quantified or justified during the nascent stages of a company’s development?  While Bay Area companies are known for their vast open work spaces, chic décor, and company paraphernalia, early startup founders need to accurately weigh the cost-benefit ratio of owning property in expensive areas such as San Francisco. Many are simply spending too much.

There are ways to be thrifty and successful, as many startups have demonstrated. These companies often bootstrap their way through the early stages, sleeping and working in the same room like the Verbling and Pixlee founders while living off ramen and 24-hour Fitness showers.

Forbes offers some advice on lean–and perhaps less drastic–business practices. This includes:

  • Prioritizing tools which save hours every week
  • Outsourcing CFO, HR, or Accounting services
  • Saving large expenses for a great lawyer and in-house web development.

Can you Smell the Smoke?
VCs are sounding the alarm yet still investing in high valuation and high burn rate companies. In the competitive investing climate, it is unreasonable for investors to sit back and pass on attractive investments because of high valuations and burn rates. As Fred Wilson puts it, “our portfolio is not immune to it.” Our portfolio is not immune to it. Neither is yours. Most investors’ portfolios are not immune. Valuations are not caused by any particular individual, investor or entrepreneur, but a cultural mindset and economic conditions that are socially escalating and self-reinforcing.

You can’t afford to sit out, but at the same time, you want to be careful with the money you are investing. VCs, Angels and entrepreneurs, are not doing enough to control burn rates. Increased capital has allowed for the proliferation of unviable startups and increased timelines to IPO have decreased the pressure on CEOs to achieve business sustainability. It is imperative that entrepreneurs and investors alike begin discussing the wider problem of high valuations and burn rates and their effects on the economy as a whole.

For investors, they need to be wary of increased investor appetite and the effect of increased capital on valuations and high rounds of financing. High valuations, especially with no standard across investment groups, are an unreliable indication of future venture returns. Instead, they should be looking more closely at portfolio companies achieving particular business development milestones before subsequent rounds of financing.

For entrepreneurs, they need to be sensitive of the balance between developing a company culture and attractive work place with financial responsibilities to their investors and the families of their employees. When employees join a startup, they are taking a bet on the vision and operational capability of the management team. No one wants to work for a startup that can’t achieve profitability, and that should be the priority for any CEO: creating a business. Furthermore, I think it would behoove entrepreneurs to increase transparency when it comes to expenditures outside of direct company development and marketing/sales. Although not always required in the term sheet, having an open dialogue with investors can benefit both parties in regulating burn rates.

This dialogue is important. Otherwise, if nothing changes and if the unicorns begin to fall, investors will become more risk-sensitive, venture capital financing will top off, and companies unable to find a sustainable business model after years of searching will end up desiccating and withering away. The unfortunate side effect of this will be a decline in interest for entrepreneurship and scrappy innovation that we’ve come to revere and aspire towards. I certainly don’t want that. Do you?

One thought on “Silicon Valley Wildfires: The Effects of an Entrepreneur Arms Race

  1. Kenny Fraser (@kennyfraser1746) March 24, 2015 / 6:24 am

    Interesting analysis. There is a lot of speculation about a potential bubble. I feel that a correction is bound to happen at some point. What will the impact be? How can startups plan to survive?

    Liked by 1 person

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