Investors Keep Giving Startups More Funding Than They Need. Here’s Why the All-You-Can-Eat Buffet May Cause Indigestion
In this installment of Command Shift: The investors behind the new wave of venture capital mega-rounds may not have their portfolio companies’ interests at heart.
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"This is the best time to raise money ever," Slack founder Stewart Butterfield told the New York Times in April 2015. "It might be the best time for any kind of business in any industry to raise money for all of history, like since the time of the ancient Egyptians."
In the months that followed, I and many other observers cited Butterfield's thoroughly rational exuberance as evidence of a historic tech bubble, one data point among many that private-company valuations had become untethered from reality to a degree that made a painful correction not just inevitable but imminent.
About those predictions: Um, maybe not. Sure, there was a momentary slowdown and some dying-off of also-rans in overcrowded sectors like on-demand delivery. But that was a blip. Three years later, even the Pharaohs would be jealous of the pyramids of capital piling up around Silicon Valley.
"Investors participated in a record 273 mega-rounds [defined as at least $100 million raised] last year, according to the data provider Crunchbase," reports the Times's Erin Griffith. "This year is on pace to easily eclipse that, with 268 completed in the first seven months of the year. In July, start-ups reached more than 50 financing deals worth a combined $15 billion, a new monthly high."
Mind you, this all-you-can-eat buffet isn't open to anyone. The investors driving it-- sovereign wealth funds, China's Alibaba and Tencent, and Softbank's $93 billion Vision Fund--are specifically on the hunt for startups that can ingest nine figures of cash without going straight into a diabetic coma. There's some trickle-down effect, with early-stage startup funding rounds getting bigger, but it's offset by a decrease in the number of such rounds.
Bubbles are supposed to burst when the market runs out of greater fools willing to bid up an asset. It seems like those of us who called a top underestimated the greatness of some fools out there, or maybe even missed a phase shift to a new stable equilibrium. Whatever. It's too soon to revisit the bubble question, so let's talk instead about what this new funding environment does to the startups that operate in it.
On the podcast "This Week In Startups," Randy Komisar suggested it's making them weak and stupid. "Most entrepreneurs fail from indigestion, not malnourishment," Komisar, a partner at of Kleiner Perkins Caufield Byers, told host and angel investor Jason Calacanis. "What happens is, when you've got too much capital, you're insulated from market information," he explained.
In other words, not having enough money is a potential sign that whatever you're doing might not be a great way of making money. It forces you to pay close attention to customer feedback and come up with creative solutions instead of just investing in a lot of Steelcase chairs and butts to fill them.
Not everyone sees it this way. Back in 2015, Bill Gurley of Benchmark Capital was one of the loudest voices calling the situation "speculative and unstable." He predicted the landscape would soon be littered with the corpses of "dead unicorns" and fretted that easy money without public-market scrutiny was rewarding startups for financial indiscipline.
But now Gurley is resigned to the new reality. With interest rates at or near zero for the past decade, there's just too much cheap money sloshing around. "No one in the history of business has seen what we are seeing right now," he says via email. "It truly is unprecedented."
Hunger might make you smart, but "[i]f your competitor is going to raise $150 million and you want to be conservative and only raise $20 million, you're going to get run over," he told Griffith.
That makes sense--except that businesses where the competition comes down to who can raise more money tend to be businesses where that competition inevitably drives margins down toward zero, and companies with tiny margins will have a hard time returning big multiples to their investors. That's an argument Peter Thiel makes in his book Zero to One, and Gurley should be familiar with it, since it more or less describes the arc of his most notable portfolio company, Uber, from its birth until now.
To escape from the infinitesimal-margin trap it has set for itself, Uber has long been counting on the arrival of self-driving cars, which will allow the company to pocket the full fare from each trip, not just the 30 percent left over after the driver's cut. But the development of autonomous vehicles has so far been nothing but a money sink, drinking up between $125 million and $200 million per quarter, reports The Information. Now Uber--and Lyft, its main rival--see a similar hope in electric scooters and bikes, another form of driverless transport. But with margins on those trips likely to be equally bad, Uber and Lyft are--ironically, given their rhetoric about taking on vested interests--hoping to entrench themselves from competition in at least one market by partnering with the local government. In other words, they're doing something not all that far from what they've always accused taxi fleet operators of doing.
"As VCs that compete at the top tier, we are involved with businesses going after big markets," Gurley says. "I don't think there is a single 'business model' that's 100 percent immune to a competitor blasting at you with hundreds of millions of dollars."
In any case, unless there are mega-funds on other planets, Uber and other beyond-late-stage unicorns will eventually have to move out of their parents' houses and get a job. They'll have to IPO, that is. But the real world is a harsh place for companies that never had to think about where money comes from until their first Wall Street earnings call. In Bloomberg, Shira Ovide notes that the proportion of young public companies with negative cash flow from operations has risen sharply since 2014, jumping from 29 percent to 37 percent.
You would think the investors writing $100 million checks would be keener than anyone to see the companies they fund generate profits. But they have other things on their mind. "These giant funds are looking for start-ups that can take large sums of money with one shot," reports Griffith. "Writing lots of small checks is too time-consuming, and the returns from small bets will not make a difference for a such a big fund."
We've always had smart money and dumb money. Now, apparently, there's lazy money. Investors insisting on giving startups more money than they need because figuring out what else to do with it is too much of a hassle may not be proof of a bubble, but it's definitely a sign their interests aren't aligned with those of their entrepreneurs. Even a healthy appetite can get indigestion from force-feeding.