It was the best of times, it was the worst of times, it was the age of Minecraft, it was the age of Square, it was the epoch of burn, it was the epoch of crash, it was the season of growth and it was the season of collapse.
Or so Dickens might have written if he had lived in San Francisco.
The bubble is back in the news again following comments made by Bill Gurley, the well-known Benchmark venture capitalist, who warned that some startups have increased their burn rates so much, that they are reaching perilous levels of risk. So quick is capital flowing through startups that, according to Gurley, “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.”
He’s been backed up by other luminaries like Union Square Ventures VC Fred Wilson, who similarly frets startups are getting way ahead of themselves in their quest for growth. “Valuations can be fixed. You can do a down round, or three or four flat ones, until you get the price right. But burn rates are exactly that. Burning cash. Losing money. Emphasis on the losing.”
The two have a point. Unlike other metrics, burn rate is the ultimate measure of the health of a startup. It’s literally life itself, the sustenance that fuels a founder’s vision from zero to one. Most startups need at least a little cash to get off the ground, money that is invested into the business in order to potentially secure a future profit. Without burn, startups are forced to bootstrap and slowly build their startup over a period of years, potentially against far more aggressive competitors.
But burn rates are like water in a glass: reasonable people can hold diametrically opposed views on the subject without contradicting each other. It’s sort of the Silicon Valley equivalent of the old saw about economists. If you put five of them in a room, you get six answers.
For Gurley, burn rates have become out-of-control. Discussing the periods following the 2000 and 2008 contractions, he says that “you just wouldn’t go take a job at a company that’s burning $4 million a month.” That’s normal enough now, according to the investor, that “[t]oday everyone does it without thinking.”
The cash argument has been percolating more loudly in startup circles than it has in the past. Limited partners, the investors into venture capital firms, have been forced out of many traditional types of investments over the past few years. Bonds, a mainstay of many balanced portfolios, have had bad performance for a number of years now, and hedge fund management has become so complicated, and its performance so low, that the largest pension fund, CalPERS, announced this week that it is going to stop investing in the asset class entirely.
For investment managers, that available capital has to be invested somewhere, and one attractive location is venture capital. NVCA data shows that 2014 is off to be one of the strongest years for fundraising in years. Already, VCs have raised more dollars in the first-half of the year than in all of 2013, and if the current rate of new funds continues, 2014 could be the largest year for venture capital since 2005.
All that new money causes VCs to feel pressure to spend capital faster, leading to larger valuations for startups and larger round sizes. Since that money doesn’t do anything sitting in a bank account, founders increase their burn rate to compensate for their oversized round, leading to the current debate about high burn rates.
Other economic issues are also fueling this trend. Interest rates are near record lows, a consequence of policies like quantitative easing that essentially put more money in the economy to be used by investors. That easy money has caused equities to soar in value, giving more power to companies like Microsoft and Google to acquire startups.
But this monetary chain of events belies a much more fundamental change in the culture of Silicon Valley. Discipline, once the core asset of startups in their fight against much wealthier incumbents, has now been replaced by profligacy. Startups are willing to spend on almost anything, from lavish meals prepared by world-class chefs, to offices that rival those of the whitest-shoe law firms on Wall Street.
That’s the negative view. Spoiled children, flush with cash, are spending like their credit cards are going to expire. Everyone in the startup ecosystem is running around in madness looking for any opportunity for growth without a real understanding of the potential for different companies to succeed.
There is a very different take on the data that I think better represents reality. More and more people are using smartphones, not just in the United States, but throughout the world. As more of our economy happens online, there is huge potential for new entrants (i.e. startups) to compete with the largest companies in the world for business. How often can we completely reinvent spaces like book publishing, movie production, finance, communications, and all in just a couple of years?
And while massive valuations for companies have certainly garnered their fair share of headlines, they are hardly the norm in the industry. Dropbox, Uber, Airbnb and other high-valuation companies are real businesses with significant revenues based in important markets with great growth characteristics. Even Snapchat, which is the poster child of the overhyped valuation crowd, is competing in a space with many case studies of business success like Facebook and Twitter.
Indeed, if there is any trend to be worried, it is that the data revolution in venture investing is causing more investors to compete over a very narrow set of deals that are perceived as winners, and neglecting a number of companies with smaller potential who could easily make great products and have handsome exits as well.
Let’s not also forget also that the people who benefit the most from high valuations are not the capitalists, but the entrepreneurs themselves, who have to give up less equity for the same venture dollars. If capital is becoming cheaper, then the profits of these businesses are going to be directed much more to the creative founders who are building the businesses. On the surface, that doesn’t seem all that bad.
In short, I do believe there is a logic to this madness, as I have argued before.
Ultimately, the future is contingent on any number of factors, only some of which we control. As the Federal Reserve cuts back on quantitative easing over the next few months, investors will carefully downgrade their views on equity prices in line with the changes in the interest rates. Money is likely going to become more expensive. In discussions with limited partners, there has already been increasing hesitation among some toward new investment firms and larger fund sizes.
But a little bit of water on the fire is not necessarily a bad thing. There is a lack of discipline among startups, and Silicon Valley should not lose its thrifty and technical-oriented culture. But the growth of the internet and its power is secular and increasing. We would be foolish not to buy into that future, even if the burn rates are higher than they should be.