The Trouble with Bubbles

If you woke me out of a sound sleep, shoved this chart in my face, and asked me what it was, my limbic brain would recognize it in a millisecond: these are the boom and bust cycles in Silicon Valley over the last 20 years.

These cycles are ingrained in my mind since they’ve help define my career and that of most people I know. I’ve ridden these waves at five startups:

• I was the first employee of the first web analytics company, I/PRO, in 1994, before the Netscape IPO and helped grow to a 1998 acquisition.
• In 1997, I was the first employee and VP of Engineering at Kana, the first web customer service CRM company. We grew to 1,200 people, $150M in revenue, and a $10B market cap on NASDAQ, followed by watching the stock crash in 2000.
• At the nadir of 2001, right after 9/11, I co-founded Vontu, a security software company. We sold the company in 2007 for $350M, right before the tech slump caused by the financial crisis in 2008.
• I founded a company and ran it for two years in the interregnum of 2010–2012.
• I’m co-founding another company now, in 2015, in the middle of a five year boom market.

So I carry many reference points when it comes to the industry’s boom and bust cycles. Today I have days where I feel I’m living a sequel to the year 2000: valuations, salaries, and real estate price are climbing, celebrities and athletes are angel investing, and the same young bright things who would have clawed their way to Goldman Sachs or McKinsey in past years are now landing at SFO seeking fame and fortune.

The mainstream media, as well as big brain thinkers like Bill Gurley and Fred Wilson are starting to acknowledge high startup burn rates and bubble-level valuations, and I’m hearing the same from investors and founders I know. My own opinion? I don’t think we are due a crash anywhere near what happened in 2000, where even decent companies lost more than 99% of their value, but I do think we are due a correction in private company valuations of 50% or more.

So what’s the problem?

Most of the “are we in a bubble?” coverage doesn’t address the question, “would it be so bad if we were?” Companies are staying private much longer than they did during the dot com bubble, so you could argue that the financial impact of a slump would be limited to a handful of venture capitalists, private equity firms, and startup founders and employees, most of whom would easily find gainful employment elsewhere.

I argue that the problems created by high valuations and a surplus of venture capital are insidious and can have a long term impact on the health of the tech industry and its participants beyond just the dollars involved. Startups and their teams who are caught up in a bubble can end up worse off than those who navigated a company through saner times where money is harder to get and valuations are lower, even if they do raise a lot of money. A few things that happen during a bubble:

Startups get sloppy with hiring and firing

Startups have to apply extraordinary care building their teams. For each new hire, they have to ask not only if the person is highly skilled but also if that person has the right motivations and expectations, is a good communicator, works well with others, and fits the culture. This takes a few meetings with the candidate and some time for both sides to do their homework, reference each other, and consider the fit.

Today, the startup labor market is the tightest it has been for 15 years, so candidates go from “just starting to look” to “off the market” in days. They are inundated with multiple offers within a few weeks of starting a job search. Companies give “exploding offers,” telling a candidate she must accept or lose the offer within a few days of receiving the offer letter.

A a hiring manager, once you have missed out on a few candidates (my company has experienced this lately) it is tempting to jump into the fray and interview candidates quickly, make a quick offer, skip reference checks, and compete for talent by trying to beat other companies to the punch.

But fast decisions are often bad decisions: candidates can end up regretting they joined the wrong company, and companies can end up with the wrong team. The company can end up with a rotten foundation that it may never be able to fix, leading to poor performance and an awkward, damaged working environment.

Startups forget how to make choices

All companies, large and small, have limited resources, but startups are defined by constraints. By definition, a startup needs to place all of its bets on a single market opportunity. That willingness to focus gives it a tremendous advantage over incumbents and maximizes the odds of success.

But when tens of millions of venture capital dollars are on offer, even small startups are tempted to diversify too early. They may try to sell to both small and large businesses. They might invest scattershot across marketing channels, launch too many products, or open up multiple geographies before the first one is really working.

I experienced this at one of my previous companies: after a large round of funding we expanded from one product to four. The results were predictable: the burn rate spiked, management attention was split, and we burned lots of cash trying to nuture four small businesses instead of building one large one.

Today I see startups starting to do the same thing. If you ask them how they will succeed, many will show you an “all of the above” plan that tries to do it all vs. placing a few bets with high conviction. This leads to lack of management focus, muddled strategy, and ramps up burn rate.

Startups engage in zero sum game competition

Great companies in great markets always have some competition, both from incumbents as well as from other startups. But when an excess of venture capital is available, sectors get overfunded by investors who feel they need to have “a play” in exciting new markets, like Bitcoin, big data, drones, and Internet of Things.

This can lead to a “piling on” where new categories can attract 5–10 well-funded entrants. Often egged on by their boards and investors, each company competes by out-raising and out-spending the others. Burn rates become unsustainable, and the market, which may not even be that large, ends up with too many suppliers.

The “get big fast” strategy of the dot-com bubble is back again, and we are starting to see many promising but small companies raising hundreds of millions of dollars before they are ready. A few will go on to be the next billion dollar success stories, but many are destined to end up as (with apologies to Shakespeare), “tales told by idiots, full of sound and fury, but signifyinig nothing.”

Botched cap tables

You joined a startup that just raised $250M in its Series H financing at a $1B valuation? Congratulations! If the company goes on to exit at anywhere close to that valuation, you’ll do well.

But what if your numbers go flat, the venture market dries up and you need to sell the company for a few hundred million dollars? Still not bad, huh? Whoops: investor liquidation preferences may render the common stock worthless, even for the founders and early employees, not to mention the later employees whose options have a higher strike price. One bad round of funding can erase all of the prior years’ worth of wealth generation.

Money is never free. Even if you can handle the dilution, premature valuation can make it hard for anyone to make any money from a company, even if that company exits at a value that would be very attractive in normal markets.

A generation gets turned off from startups

Musical-chairs layoffs, dysfunctional teams, underwater stock options, big dreams and broken promises. This doesn’t sound like a whole lot of fun for anyone, but if it represented your first career experience, you might write off the entire industry as a corrupt scam and seek gainful and stable employment at a “real” company.

I left Kana in 2001, traveled in Europe for most of the year, then came back to start Vontu in September, 2001. I remember being struck by my conversations with new college grads at the time. Many had no interest in joining a startup — their older classmates had so many “churn and burn” stories of poor management, broken promises, and traumatic flameouts that word had spread not to get caught up in the mess.

I believe this is also why Google was able to scoop up so many grads of top schools in the early 2000s: many new grads saw getting recruited by a small startup as a “sucker’s game” and wanted to join a “real company.”

So what should a startup do?

The industry has more opportunity than ever, and more capital is available than it has for a very long time. I believe it is a great time to start a company, but with the following caveats:

• Take advantage of the strong venture market by raising the money that you need to grow your business, but be choosy about what firm you bring on board and which partner joins your board.
• Do not ramp up spending until you are close to product/market fit and ensure your board and co-founders are aligned with that strategy.
• Create an efficient recruiting process that responds to candidates quickly and moves them along, but do not skip steps and make fast decisions. When in doubt, say no, and never compromise on cultural fit.
• Spend time coaching and mentoring employees, but don’t be afraid to address bad hires. Never let the logic “it will be hard to replace them” allow you to procrastinate moving along someone who you just know isn’t right for your company.
• Seek focus — avoid “all of the above” when faced with tough choices. Even if you think you have the money to spend to launch multiple products and channels, don’t underestimate the cost of defocusing your management team and confusing your strategy by not making choices.
• Don’t believe your own hype: raising a big pile of angel money or venture capital “feels” like success and is an accomplishment worth celebrating, but don’t forget that hundreds of other teams will achieve the same thing in 2015, and only a few will create large companies. Celebrate for a day, then move on and build your business one brick at a time.

Good luck in 2015!