We need to talk about startups…
“Man, Kevin Systrom really fucked up selling Instagram for a billion.” I was at SFO, about to fly home after a couple days in San Francisco, and couldn’t help but overhear the guy behind me talking loudly to his nodding friend. There’s a weird phenomenon happening right now in tech: a billion dollars just doesn’t seem like a lot of money anymore. A couple years ago, our collective jaws would drop when a startup got acquired for $25 million. Now, people don’t even bat an eye until well into the billions.
Maybe a billion really is the new million. After all, the world is changing at an accelerating pace. The internet and mobile computing have taken hold, and it seems like a new era of exponential growth has arrived. Every day, entrepreneurs are unseating taxi czars and hotel magnates using little more than smart phones and a healthy disregard for the rules. In this crazy new world, it seems like just about anyone can build the next billion-dollar startup, whether it’s Uber for dry cleaning, or AirBnB for dogs.
If this seems strangely familiar, that’s because it is. In 1999, at the height of the dot com bubble, there were billion dollar IPOs and acquisitions happening weekly, often of startup companies with non-existent business models based on “eyeballs” or “stickiness”. Who can forget Yahoo’s bonehead acquisitions of Geocities for $3.57 billion, and Broadcast.com for $5.7 billion? Or food delivery startup WebVan, which with just $5 million in revenue and negative margins, went public and achieved a market cap of over $8 billion before floundering and declaring bankruptcy just two years later.
This time it’s a little different. Most of these companies have some revenue. Some even have a little profit. Fewer companies are rushing to IPO, and instead staying private for longer. But in many ways, it’s starting to feel like we’re partying like it’s 1999. We may not be there yet, and it may not take the same form, but something is most certainly brewing. As Mark Twain once said, “history doesn’t repeat itself, but it does rhyme”.
Here’s a couple fun facts:
• This year, The Super Bowl had the most new advertisers since the dot-com boom, many of them venture backed technology startups. Remember these?
• Today, there are 114 startups valued at over $1 billion by venture capitalists. A year ago, there were 40. And once again, low-margin food delivery startups and businesses whose revenues are reliant on startups are fetching huge valuations.
• In the past year alone, Forbes has added 23 newly minted tech billionaires to The Rich List.
“Silicon Valley as a whole or that the venture-capital community or startup community is taking on an excessive amount of risk right now. Unprecedented since ’99. In some ways less silly than ’99 and in other ways more silly than in ‘99. No one’s fearful, everyone’s greedy, and it will eventually end.”
- Bill Gurley, Benchmark Capital
• The stock market is significantly overvalued by almost every conceivable metric, and has a Shiller P/E of 27, inline with 1929 and 2007 levels, and exceeded only by 1999. Once again, companies are going public at a breakneck pace and without profits. In 1999, 80% of companies that went public were unprofitable. Last year, it was 71%, up from 46% in 2012, and that doesn’t bode well for future investor returns.
• Instead of going public — which is subject to rigorous auditing and regulation — many companies are raising massive private rounds based on dubious math. And many of the tech companies that have gone public are proudly trumpeting profitability but aren’t actually profitable based on GAAP accounting standards. Despite that, they are still trading at high P/E and sales multiples, driving up private valuations.
• There are hundreds of new startups launching daily, so many that there are popular startups dedicated to keeping track of them. One such startup, ProductHunt, just raised money at a $22 million valuation. Many of these startups rely on other startups and startup founders for all of their revenue.
Don’t take this the wrong way. I love startups and technology, and regardless of all this, there are a lot of amazing things happening. Artificial intelligence is showing signs of life. Self-driving cars are on the way, and drones may soon be delivering our toothpaste. There’s no doubt that there is an incredible amount of innovation happening right now.
This isn’t to say that what all these startups are working on is necessarily bad, only that the underlying financials create a situation that will likely lead to a correction. The mean is up and to the right — innovation is alive and well — but I’m concerned that these valuations are completely unsustainable and a lot of investors, founders, and hundreds of thousands of employees, are going to get clobbered in the coming years.
But hey, who knows? Maybe history isn’t going to repeat itself and exponential technology growth has kicked in. Maybe Uber is worth $500 billion. Maybe I’ll look back at this post in five years and cringe. All I know, is that I’m putting my swim trunks on…
“You only find out who is swimming naked when the tide goes out.”
— Warren Buffett
Appendix A: The Defensive Playbook
So, you’re concerned your startup might be at risk? Don’t panic. If the companies who lived to tell about the last bubble are any indication, here’s a couple steps you can take to help weather any potential storms:
- Diversify your customer base
If the majority of your revenue comes from venture backed startups, tell your sales team (or redirect your marketing efforts) to focus on later stage, secure, longterm businesses that have staying power.
- GARP (Growth at A Reasonable Price)
There are many business models where it’s a no brainer to continue to funnel cash back into customer acquisition and growth (if LTV>CAC, for instance). By all means, keep drinking your competitor’s milkshake, but you want the ability to hit the brakes and skid to a stop instead of careening over the red line and off a cliff. Fred Wilson recently wrote a great post where he shared a formula for burn: your year over year growth rate plus your pre-tax operating margins need to be at least forty percent. It could mean the difference between some layoffs/budget cuts and liquidation.
- Watch out for fixed costs
Employees can be laid off, but your $100,000/mo office space that sports a games room and cafeteria with an executive chef is locked into a 5-year lease and isn’t going anywhere. Every dollar of fixed costs weighs you down from being able to take evasive action in the event of a crisis. There’s a balance to be made between space to grow and impress new recruits vs. what you actually need to run the business.
- Cash is king
If you’re operating on the idea that you’ll be able to raise another round whenever you want, you may want to consider drafting a backup plan. Run the model: if you could never raise another round of funding, what would happen to your company? A healthy balance sheet and low burn gives you the longevity to weather the storm as you watch your competitors run out of cash, and, if you so desire, buy their technology out of liquidation at pennies on the dollar. Think of your bank balance as the moat around your castle, protecting you from the mongol hordes coming over the hill.
A lot of this is just common sense business fundamentals, but I’ve always been surprised by how few people in the tech world pay attention to this stuff. The past seven years have been good to startups — it’s been a non-stop feast. It’s easy to slip into thinking a huge round, lucrative acquisition, or IPO is just around the corner, but it’s a valuable exercise to think through what would happen if the music stopped.
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