Silicon Valley Needs Startup Drano
bloomberg.com
bloomberg.com
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 ...
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.
The funds I'm in don't take board seats, though they do offer access to its network of investors and contacts to the companies it invests in. Different funds are run different ways. The GPs of the funds I'm in do not do this as their primary job, other funds have principals (GPs or other forms of partners) who draw their income from the funds in one way or another.
Other considerations: the funds have a limited lifespan (I believe each of the three I'm in are 10 year limited partnerships with an option to extend by simple majority vote of LPs). Because they're limited partnerships, the returns get reported as income to the IRS, and I'd owe taxes on them, even if they were not distributed, which is another reason not to re-invest returns (if the returns were re–invested, you could potentially pay taxes on income which then gets "lost" when re–invested in a startup which fails).
I commented elsewhere in this thread that so far across three funds we're seeing the 33% fail, 33% break even (modest returns) and 33% either have returned the fund or have potential to do so, which is a pattern I've seen repeated by many venture funds over the years I've been following or investing in them.
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.
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.
Or even better, is that comparative performance, i.e. 10% better than a vanguard index fund?
Depends on what you promised those investors and how the fund is doing. Nobody complains about being in SpaceX or Uber.
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".
[1] http://www.forbes.com/sites/chrismyers/2017/01/09/why-entrep... [2] https://www.cbinsights.com/blog/vc-investing-in-consumer-goo... [3] https://en.wikipedia.org/wiki/Maveron
Brick and mortar products are less likely to have this property than social-network-of-the-month, so the process can be very different.
[1] https://news.ycombinator.com/item?id=13332005#13333251 [2] https://news.ycombinator.com/item?id=12313908#12314672 [3] https://news.ycombinator.com/item?id=11962282 [4] https://news.ycombinator.com/item?id=12089604#12089686 [5] https://news.ycombinator.com/item?id=12799794#12800418 [6] https://news.ycombinator.com/item?id=12514062#12519121 [7] https://news.ycombinator.com/item?id=12514062#12515149 [8] https://news.ycombinator.com/item?id=12784274#12784601 [9] https://news.ycombinator.com/item?id=13166882#13168804 [10] https://news.ycombinator.com/item?id=12904216#12905032 [11] https://news.ycombinator.com/item?id=12888287#12893852 [12] https://news.ycombinator.com/item?id=12784274#12784473 [13] https://news.ycombinator.com/item?id=12187262#12188289 [14] https://news.ycombinator.com/item?id=13234265#13234809 [15] https://news.ycombinator.com/item?id=12354407#12355656
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.
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.
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...
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.
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).
Other than that--or by explicitly considering only manufactured goods for example--you're effectively making value judgements about what products and services contribute to society and which don't. You could equally as well argue (though I wouldn't) that the 50th new rebranded and repackaged laundry powder doesn't contribute either.
I distinguish services vs infrastructure based on if they are fundamental needs, not how they are provided. So water treatment is technically a service, but it's a fundamental piece of life so it's infrastructure.
Personally, I think the distinction is in how it is provided. The copper/fibre line to your home is what AT&T has to bring to the table. JetBlue brings their fancy flying machine. The water treatment plant has their water treatment system. While people are certainly involved in the process, the defining feature of these businesses are related to the machines/technology that they possess.
On the other hand, McDonalds certainly has a kitchen, but so does everyone else. They are literally found in almost every home. What McDonalds, and restaurants in general, bring to the table is a person willing to do the cooking and other related activities for you. Because the defining feature is related to human labour (for now, at least), these are services.
(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.)
>> 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.
Most of them were blocked from actually becoming horizontal or vertical monopolies by governments in order to protect consumers and foster innovation.
But that didn't stop them from acquiring tangential companies and becoming multinational conglomerates - every country in the world needs Kraft's consumer goods and GE's industrial equipment.
Software startups follow an entirely different business model - extremely low costs to entry, entering new markets with high rates of failure. Also, in many successful acquisition exits the startups are acquired and the brand disappears.
Not really - a natural monopoly occurs where early entrants have such a huge advantage in providing goods or services that competitors are not able to sprout up. It may be due to high capital costs, regulation, distribution channels, or even controlling material supply. Companies like Jet Blue are clearly not natural monopolies - in fact as a relatively young airline they were able to establish that the Airline industry is not subject to natural monopolies (although the capital costs to start up are very high).
Kraft on the other hand has a ton of competition, with more new food producers popping up every year. The capital costs to start are not that high, and distribution channels are open enough that lots of smaller companies can get exposure to customers.
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.
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.)
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.
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.
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.
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.
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.
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.
If we restricted the incoming money, the money in the pipeline would drain out the normal way.
I'm not sure what your calculator is measuring -- the date selection has a precision of one month. But swings of 5% in a month are common, so I would not immediately discount the idea that there are endpoint dates you could choose to get a 17% return.
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.
I don't think that the problem of collecting too much is now primarily a byproduct of careless regulation. The problem of collecting too much arises from the fact that the future of capitalism is in the data mining and control of its customers. When capitalist societies begin to depend more on consumption than they do on production for their overall economic health, and the GDP of the United States has been primarily consumption for more than 15 years now, then knowing how to control consumers becomes as important as knowing how to control productive machines was when the GDP was primarily based upon production rather than consumption. What is happening is that we are automating and instrumenting the portion of the economy which is most powerfully important, namely consumption.
Collecting information about consumers is the same thing as knowing how the mill machines worked to the capitalists of the 19th century. So what we are confronting is not the accident of perverse incentives created as a byproduct of unintended consequences of regulation. We are facing the fact that doing the wrong thing is the basis of future economic growth.
We are not trying to destroy future economic growth, we are trying to compromise among values. That's what regulation is. It's a messy process. Of course it has unintended consequences. Naturally it creates perverse incentives, because it's imperfect. But understanding the objective has to be clear: productive capitalism met ecological constraints. It dirtied the water too much, it dirtied the air too much, it created too many difficulties that had to be constrained as negative externalities produced by production. The attempt to regiment and govern consumption through data mining raises ecologic problems we must solve.
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.
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.
How does anyone determine with certainty that a bust is "about due" as you have?
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?
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.
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.
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.
(Or ever)
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.
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.
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"?
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.
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.