Silicon Valley Needs Startup Drano

https://www.bloomberg.com/gadfly/articles/2017-01-11/silicon-valley-startup-pipeline-needs-shot-of-drano

by adventured • 10 years ago

133 103 10 years ago

jimmywanger2• 10 years ago

If the fed would raise interest rates, that'd go a long way to helping clear at least some of the backlog.

Right now you got a lot of dumb money behind a lot of startups with bad business plans because there's no other place for the money to earn reasonable yields.

ghaff2• 10 years ago

Higher interest rates aren't a magical elixir for investment returns though I agree that there's a lot of dumb money going into bad, me too business plans. However, the author seems to be most focused on how invested money gets out of the pipeline once it's in.

In may well be the case that there aren't enough worthwhile tech VC targets to absorb the money people want to put in. (see also the boatloads of cash some companies are sitting on.) But that's a different argument from companies unwilling/unable to exit.

Spooky233• 10 years ago

They're not magical, but there's literally nowhere to safely save liquid cash these days.

I have a 6% Capital One 360 CD that matured last year. My credit union is offering 2.75% auto loans on 2014 model year cars up to 72 months.

Clearly, money is too cheap when you're getting super low rates on terrible loan products.

jimmywanger2• 10 years ago

Well, there is a way for invested money to get out, as she points out. It's just that the incoming money is too great in volume.

If we restricted the incoming money, the money in the pipeline would drain out the normal way.

quanticle• 10 years ago

However, the author seems to be most focused on how invested money gets out of the pipeline once it's in.

The two problems are related. Money isn't being pulled out of the pipeline because investors are willing to let venture funds hold onto their cash for long periods of time. If investors had other opportunities for getting returns, they'd pressure venture funds to have shorter time horizons, and this, in turn, would lead venture funds to pressure companies to cash out or die.

obstinate3• 10 years ago

S&P 500 returned an inflation adjusted 9% last year (Dec '15-Dec '16). If that's not a "reasonable yield," what is?

zeroer2• 10 years ago

The S&P 500 returned 12.25% last year. Unless you're throwing money away, you have to count dividends, too.

https://dqydj.com/2016-sp-500-return/

neom8• 10 years ago

I've had this thought in my head for quite some time about what I call "bottom line companies" - That is, companies that add "substance" to the bottom line of society. When I think about bottom line companies, I think about GE, AT&T, CN, JetBlue, Mondelez International (Kraft) and the like. I often wonder about how these ventures got started. Over the past 20 years, have we seen many bottom line companies founded? Also, tangentially but interestingly: http://www.inc.com/magazine/19850501/495.html

ColanR2• 10 years ago

I'm going to remember that term. Do you think it's possible to quantify that concept?

neom8• 10 years ago

I'm a crappy economist. In theory I think it should be somewhat/somehow linked to productivity. If a company positively impacts national productivity the company would be a "bottom line" company?

niftich4• 10 years ago

These are all brick-and-mortar companies that were built around a single product (electricity, telephone, railways, airlines, dairy roll-up) and later expanded by merging with competitors or expanding into related fields. You can also add P&G, General Mills, Johnson & Johnson, PepsiCo, and many more.

In each and every case, these companies delivered a product or service in exchange for the customer's cash. This is the key distinguishing factor between companies like IBM, Microsoft, Apple, who deserve to belong on that list, and companies like your hyped SV unicorn that has no business model besides "eventually we'll introduce ads".

EduardoBautista• 10 years ago

"If we don't want to look like we are harvesting data for ad networks, we'll just sell to Google."

neom8• 10 years ago

Absolutely. Would you put companies like Facebook, Twitter, or companies that may struggle to fix unit economics like Uber or Lyft on this list?

sporkenfang• 10 years ago

If someone wanted to start a company with a definite product (not ads), maybe even a brick and mortar product, how does the process differ with starting a garden-variety startup?

ajmurmann• 10 years ago

What about Tesla, SpaceX and even Airbnb. Shouldn't those be allowed on the list as well? They have very clear business models and don't have to get acquired by anybody and are providing tremendous value.

adventured• 10 years ago

Over the last 20 years, thousands of these bottom line companies have been founded. You may not familiar with all of them, because much like AT&T or GE, they take decades to get big enough to show up on the radar of a distant viewer.

Take this guy for example, the pillow king (as bottom line as Oreos):

https://www.bloomberg.com/news/features/2017-01-11/the-prepo...

Or Chobani, which most know about now:

https://www.bloomberg.com/news/articles/2013-01-31/at-choban...

Or Manoj Bhargava of 5 hour energy fame:

http://www.inc.com/ilan-mochari/5-hour-energy-billions-in-ch...

Or Monster Beverage (reinvented in the early 1990s), which has become, well, a monster ($25 billion market cap):

https://en.wikipedia.org/wiki/Monster_Beverage

Or Under Armour, founded in 1996, on its way to being a giant potentially.

Or Lululemon, founded in 1998.

Netflix and Tesla are also both bottom line companies.

Tory Burch is an example, as is Sara Blakely & Spanx. Fashion has a lot of significant bottom line stories from the last 20 years. Hard to tell which might grow into the next big fashion conglomerate, or just be acquired (as with Burch apparently).

There are a lot of these types of stories roaming about, and far more of them that have yet to break the media surface but will in the next five or ten years. You often don't hear about them until they get big enough to be picked up by the likes of Bloomberg, Forbes, Fortune, et al. It's also next to impossible to tell which one of them will go on to become a big conglomerate like Mondelez; we'll find out in 30 or 40 years.

rmattes• 10 years ago

I think another good example would be the craft beer industry. The brewers association directory[1] lists around 200 regional and large breweries in the US, and somewhere around 5000 microbreweries and brewpubs.

Granted, some of these are more than 20 years old, but the movement grew the most through the early 90's[2].

[1] https://www.brewersassociation.org/directories/breweries/

[2] https://www.brewersassociation.org/brewers-association/histo...

AndrewKemendo3• 10 years ago

Your analysis is essentially a different spin on "The US doesn't manufacture anything anymore." When you say "substance" what you mean is physical goods (edit: or infrastructure) - and the number of service companies founded is outpacing physical goods companies by far.

So when we say that "services" industries are growing faster than industrial manufacturing, this is exactly what we're talking about. It's not just dog walking, it's pinterest.

eganist• 10 years ago

When you say "substance" what you mean is physical goods

The citation of AT&T and JetBlue by OP seems to disagree with this, so I don't necessarily agree with this reinterpretation of the OP's analysis.

As an example, one could argue that companies involved in self-driving R&D could very easily meet this definition as a provider to the bottom-line of society as transportation to/from a location is a service not terribly dissimilar to providing data and communication. By that token, Tesla and soon Uber could soon fit this bill as service organizations (disregarding Tesla's manufacture of vehicles).

SilasX2• 10 years ago

It's not even true that the US doesn't manufacture; manufacturing output (by value) is the highest it's ever been[1]; it's just that far fewer workers are employed to do so.

(Same as the pattern with farming; there's a difference between "the US doesn't produce many crops" and "the US doesn't have a big fraction of workers in farming": the former is false and the latter true.)

[1] https://fred.stlouisfed.org/series/OUTMS

dharmon• 10 years ago

I don't know how this fits in with your "bottom line" concept, but the purpose of a business is to create some amount of value for its customers _and_ retain some amount of that value for the business owners.

As a big positive, we have seen large strides taken in SV on the former part the past 10 years. Creating value for your users / customers is standard advice pounded into entrepreneurs by YC and everyone else these days. This is great.

The problem is the latter half, capturing some of that value. Some of it is structural; many industries do not lend themselves well to wild profitability. Other is cultural; startups like building White House replicas in the lobby of their expensive new building.

We have seen many companies that create a great amount of value, and can even retain some of it, but unfortunately not enough to meet investors' expectations. Twitter, for example. Medium, for another more recent case, would be a great small business, but can never live up to a $100M+ investment. They definitely create value, it's just questionable exactly how much, and it will be very difficult for them to retain a worthwhile portion of it.

taneq2• 10 years ago

The purpose of a business is to create value (usually financial) for its owners. Creating value for its customers is a means, not an end.

hodgesrm• 10 years ago

I would put Google in your list. Google search has been an amazing contribution to human productivity.

runako• 10 years ago

> GE, AT&T, CN, JetBlue, Mondelez International (Kraft)
> Over the past 20 years, have we seen many bottom line companies founded?

What's great about the list is that JetBlue was founded within the last 20 years. I would also consider Google (1998) and Facebook (2004) to be candidates for "bottom line companies" although I'm not 100% sure I know what you mean by that.

But yeah, it's hard to build a cash-spewing colossus with global reach in 20 years.

gozur88• 10 years ago

You wouldn't include Google in that category?

neom8• 10 years ago

Can't speak for anyone else in the thread but I probably should have included google, yes.

edblarney2• 10 years ago

This is called the 'free market' in action.

With very low interest rates, and ridiculous Fed policies (QE) designed to 'reinvigorate the economy', but which really just pumped tons of extra cash into stocks and bonds (i.e. mostly the 1%, and institutional holders like pension funds) - you have tons of liquidity chasing value creation.

It'd rather seem that 'the power' is now in the hands of those who can create value.

Or more cynically: money goes to those who can convince others that value is being created so they can 'collect money' for their product/service.

There's nothing inherently wrong with this situation, it just means VC's are getting squeezed, and their 'amazing skill' of being able to 'spot the best opportunities' might be being commoditized a little bit.

The 'risk' really is a sudden change one way or the other, i.e. fed-rate change, china-flop, tump-risk or just some general fear based panic causing a bubble burst.

CalChris• 10 years ago

Your second paragraph completely contradicts your first. Our very low interest rates are anything but free market. They are a Fed monetary policy.

jartelt• 10 years ago

Employees are also getting forced to wait much longer before their equity stakes become liquid. It can be tough on an employee if they cannot leave their job without either losing all their options or paying a large upfront tax bill to exercise options (which may not be liquid for a while longer).

marblar• 10 years ago

(which may not be liquid for a while longer).

(Or ever)

URSpider944• 10 years ago

I disagree. The article isn't at all about the returns that people are getting on their investments. It's more about the fact that there's a normal lifecycle for venture-backed companies that ends with going public or being acquired. That lifecycle seems to have stalled out with mega-companies staying private for long periods of time.

It's still highly likely that Uber's investors will make tons of cash when the company finally decides to go public, whenever that is. It's just that the VC money is staying locked up much longer, so that it's not available to fund other early-stage start-ups.

jhoechtl• 10 years ago

I still don't get the hype aroumd Uber or why would they IPO as they are not profitable at all, prevent the creation of proper public transport and helped destroy the otherwise profitable taxi business and weakened the unions? http://www.wired.co.uk/article/uber-finances-losses-driverle...

edblarney2• 10 years ago

"It's more about the fact that there's a normal lifecycle for venture-backed companies that ends with going public or being acquired. That lifecycle seems to have stalled out with mega-companies staying private for long periods of time."

No. There is no 'normal'.

There was X money going in Y coming out.

Now there is 2X money going in, and still Y going out.

It means a lower rate of return for those putting money in.

As for 'money not available to fund other startups' - clearly it is - the charts show actual investment is still high.

ryandamm2• 10 years ago

I hear QE being disparaged a lot, but I'm not sure why. The world economy has been in a doldrums, and QE was the only monetary lever left to pull (given that fiscal tightening, rather than expansion, was the political calculation).

Look, interest rates are low because the world has a deficit of assets that offer a good return. More to the point, dollar-denominated interest rates are low because the world seeks stability in the dollar. Capital flows reflect this, and Fed policy is only a tiny input to the overall system. In fact, QE and fed policy in general is reactive to global macro; we assume it has much more influence than it does, particularly when much of the developed world is in a liquidity trap.

There are serious macro debates going on (secular stagnation? decreasing productivity returns from tech?). But whether or not QE is "ridiculous" isn't actually a serious debate. Unless you care more about equity prices than overall growth -- but I think that's missing the forest for the trees. Railing against QE without understanding the context (including the lack of alternatives) isn't particularly illuminating.

gumby2• 10 years ago

The downside of this lack of liquidity is the loss of fees flowing to the investment banks, the key constituency of Bloomberg.com. Oh no!

Most financing documents allow the preferred investors to force a registration. And of course the investors want liquidity. So if it's not happening it's because they believe (and can convince their customers, err, LPs to believe) that the return will increase significantly if they wait. I say "significantly" because volatility increases value in the Black-Scholes equation, so forgoing it better be worth it!

In the "old" days companies were essentially forced to do an offering when their staff got high enough, as they had enough shareholders that they had to file public reports anyway, so why not do a share offering and get some cash in return for the obligatory hassle. I say "old" days because this applied to FB.

Nowadays you can do quite a lot of business with fewer employees so this forcing function is not as powerful as it used to be.

steffan• 10 years ago

Another factor is that contemporary companies more often will issue RSUs instead of options. This (afaik) allows a company to avoid hitting the shareholder threshold which would require reporting.

IIRC, Facebook didn't have to go public when they did, but once they hit the threshold they would have to start reporting, and at that point there's not much reason to not be a public company.

(Another reason cited was allowing early employees to take advantage of the value of their shares without otherwise having to leave the company.)

JumpCrisscross2• 10 years ago

Most financing documents allow the preferred investors to force a registration

Registration rights are not a standard part of Silicon Valley financing. Voting rights agreements--which grant the Board or certain members of management your voting rights until IPO--are more prevalent.

gumby2• 10 years ago

Registration rights are not a standard part of Silicon Valley financing.

I am surprised that you write this. Demand registration rights have been part of every equity financing I've done for the last 25 years in the Valley and in NYC.

bertil• 10 years ago

For anyone not American: Drano is a drain cleaner brand common in the US.

draw_down2• 10 years ago

As a developer and therefore a person who benefits when lots of companies have demand for the field I work in, it's unclear to me why I should want "Startup Drano". I'm not a VC nor an LP, I don't mind if VCs waste their money funding "Uber for dog food" or whatever.

People starting businesses with bad business models don't offend me on a moral level. It's their funeral, let them make bad decisions if they want.

Analemma_• 10 years ago

People starting businesses with bad business models don't offend me on a moral level. It's their funeral, let them make bad decisions if they want.

If you want a good explanation of why you should be offended and why you should want Startup Drano, try: http://idlewords.com/talks/internet_with_a_human_face.htm. Here's the key quote:

"But investor storytime is a cancer on our industry.

Because to make it work, to keep the edifice of promises from tumbling down, companies have to constantly find ways to make advertising more invasive and ubiquitous.

Investor storytime only works if you can argue that advertising in the future is going to be effective and lucrative in ways it just isn't today. If the investors stop believing this, the money will dry up.

And that's the motor destroying our online privacy. Investor storytime is why you'll see facial detection at store shelves and checkout counters. Investor storytime is why garbage cans in London are talking to your cell phone, to find out who you are."

When all the free money is chasing advertising-driven business models, the advertising has to get ever more invasive in order to justify valuations. I'm all for letting business stand or fail on their merits if no one but the investors are harmed, but this is a very destructive externality that affects everyone.

draw_down2• 10 years ago

Hmm. Indeed that is bad, but I have a feeling what we're really talking about here is capitalism.

Spooky233• 10 years ago

Because you're an engineer in a boom-bust industry that hasn't had a real bust in a long time, and is about due.

75% of startups today are at best Facebook features. Engineers get fucked hard when that happens. Ask a former aerospace guy what the 90s were like.

sah2ed• 10 years ago

Because you're an engineer in a boom-bust industry that hasn't had a real bust in a long time, and is about due.

How does anyone determine with certainty that a bust is "about due" as you have?

rodgerd• 10 years ago

People starting businesses with bad business models don't offend me on a moral level.

In a pure sense, I'd like to agree with you, but there are a couple of things I see as being problematic at the moment:

1/ In many countries businesses or investors are often able to aquire political support to prop up failing businesses at the expense of broader society. When my pirate-themed restaurant goes broke, well, such is life. When someone like, say, a venture capitalist with the ear of the president of the US has a bunch of endangered investments you may well find your pockets being picked to prop up his bank balance.

2/ The trend for "disruption" means that the failing businesses may well have already destroyed previously-viable businesses (often as a result of running at a huge loss, not necessarily because they offer better product); that's an especially huge hazard in areas like education. The collapse of the VC-funded punt after it's already demolished what already existed leaves a smoking hole in the ground. If that's "one less restaurant in town", that's one thing. If that's "we ran down public transport and education because unicorns told us they'd solve the problem and now we have neither transport nor schools", well, that's a bit different.

accountface• 10 years ago

If all you want to do is acquire money in the short-term that makes sense.

chplushsieh• 10 years ago

Startups take several years to exit.

So isn't it perfectly normal that it also takes several years for the total value of IPOs and acquisitions, i.e. money that flows out of startups, per year to catch up with the rising trend of total startup investment, i.e. money that flows into startups, per year?

runamok• 10 years ago

Much more than a few years these days. So there should be at least a 3 to 5 year offset between comparing money in to money out.

choxi• 10 years ago

I'm surprised the author didn't mention anything about megarounds. I thought most of the increase in venture capital has been going to megarounds, and that these rounds are being raised exactly because companies want to delay their IPO and remain private longer. That would perfectly explain why there's a lag in the returns on these VC funds, right?

Floegipoky• 10 years ago

tl;dr: plugs ears and closes eyes "there is no bubble, there is no bubble, there is no..."

The author does not once address the possibility that less money is flowing out the other side of the pipe because so much of the money going in is being spent on companies that provide no value and will never be profitable.

snowpanda• 10 years ago

Your comment is spot on with my experience with clients from Silicon Valley. When they bring up their product, there is absolutely no sense of responsibility that their product might fail.

Not sure if its a result of entitlement, or living in Silicon Valley for too long. Come to think of it, one might be causing the other.

URSpider944• 10 years ago

The real significance of this article is related to the inside baseball of how most venture funds work. See this: http://www.theequitykicker.com/2011/01/12/how-does-the-struc... to learn more.

In brief: Most venture funds are closed-end funds, with a certain amount committed up front from LP's, where each dollar can only be invested once. The fund stops making investments after 5-7 years, then closes down entirely after 10 years. After 10 years, the managing partners stop collecting their 2% management fee, and any additional returns aren't typically included in the performance of the fund.

As such, there's a huge incentive for fund managers to invest early, and find an exit within the time horizon of their fund. A VC who pumped a ton of money into an early stage Uber in 2014 in year 6 of their fund, is going to be pretty screwed if Uber decides not to go public for another 5 years from now.

Where this could go sour is that these same fund managers are spending years 9-10 passing the hat to raise money for their next fund. If the typical pool of investors still have a lot of money tied up in previous funds, then they're going to be less likely to ante up for the next fund, since they'd have to double down on VC as a proportion of their portfolio. It's also going to be a tough road show if your story is that you invested millions of dollars in your last fund and it's all still tied up ...

JumpCrisscross2• 10 years ago

It's also going to be a tough road show if your story is that you invested millions of dollars in your last fund and it's all still tied up

Depends on what you promised those investors and how the fund is doing. Nobody complains about being in SpaceX or Uber.

vessenes• 10 years ago

In practice, this is not the major pain point I think you are calling it. The letters I read often have variants of "We've returned [0.8-2.5x] capital and still have [Uber] in the portfolio!"

What may be painful is not being able to at least return capital by the end of the fund without a WONDERFUL story about coming liquidity.

Current industry average 10 year IRR is 10% according to Cambridge Associates. You've really fucked things up badly if you can't return capital in year 9/10 on a 10% IRR.

uiri• 10 years ago

To save others the trip to Wolfram Alpha:

Assuming money is put into the fund in year 0, a return of 2.35x capital in year 9 or 2.6x capital in year 10 is required to get a 10% IRR.

prostoalex• 10 years ago

Distributing shares of a private company at fund liquidation is not unheard of either. In some cases (Box, Groupon, LendingClub) distributing early at private valuations allows to record a better IRR than subsequent public valuations.

benmathes• 10 years ago

Is that real return? (i.e. adjusted for inflation)

Or even better, is that comparative performance, i.e. 10% better than a vanguard index fund?

epc3• 10 years ago

I'm an LP in three venture funds. Typically there's an initial capital call when we commit to the fund, then 25% per year (you can end up with two capital calls in the first year depending on timing). The funds I invest in focus on very early rounds (seed or Series A) for initial investments, keeping $ in reserve for follow–on investments.

After about 18-24 months they raise the next fund.

With the GP I work with there's almost no overhead, just two GPs and the annual accounting. The annual accounting and tax filings can cause additional capital calls (small amounts, US$1500-2000).

As an LP (and a tiny one at that), one of the problems I'm seeing is that companies are raising ever larger up rounds at ever increasing valuations, giving away massive preferences to the later investors. This boxes the companies into seeking either grandiose exits justifying the valuations, or they wipe out the early investors (and employees) because of the preferences overhang with the finial investors (typically institutional money).

It's been an eye opening experience, I've learned a lot. Unsure how much more money I'll commit to investing this way though.

ma2rten• 10 years ago

How do you get into this line of business, do you need to have a lot of connections to Wall Street already?

TuringNYC• 10 years ago

Could you speak more about why re-investments cannot be made? It seems the inability to re-invest would skew decisions towards 10x and 100x returns rather than a series of 1.5x returns done many times. My background is mostly Wall St, and for us, a 1% return on a small horizon is great -- since you can just keep repeating it. Why would GPs be blocked from doing something similar where they aim for quick base hits rather than a grand slam?

joshwcomeau• 10 years ago

For others wondering what an LP is: http://www.investopedia.com/terms/l/limitedpartnership.asp

NelsonMinar• 10 years ago

I feel like I've read this same "there aren't enough IPO exits" about the startup scene since at least 2002. What periods of time in the last twenty years have been considered good for tech VC IPOs?

obstinate3• 10 years ago

I think the period between and including Google and Facebook's IPOs were considered good.

paulpauper• 10 years ago

Looks like data mining by the author to skim though 5 years of data and extrapolate a single inference from it. Just because something seems like something doesn't mean its important or significant or predictive of anything.

ryandamm2• 10 years ago

You wouldn't expect the uptick in venture financing to immediately result in an uptick in venture exits. Using the 'pipe' metaphor, the flow takes time. The pipe has nonzero length.

In fact, the pipe's length should be roughly the length of the average time to exit for a startup (weighted by exit size). So the latency in the system should be much longer than one year.

This is the problem with semi-quantitative thinking. And lazy journalism. Then again, I did click on the link and read the article, so maybe I'm misunderstanding the point: the author got what she wanted out of me.

blazespin• 10 years ago

The pipe is too short in those graphs. I think 10 years would be better than 5

kriro• 10 years ago

I'm not sure it's that wise to look at this years money in and this years money out. Wouldn't it make more sense to look at say the last 5 years of money out and the last 5 years-X of money in (X being 6-10ish, whatever the average time to exit is)?

I also only realized what Drano is halfway through the article (non-US guy). Why not use a more generic title that more of the world understands like "Silicon Valley Needs a Startup Plunger"?

taneq2• 10 years ago

Is this not what a bubble burst looks like? It's still easy to pour money into the bubble, but it suddenly gets a lot harder and a lot less certain to pull that money back out?

Silicon Valley Needs Startup Drano

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