Excessive amounts of Capital Doom the Start-Up Bubble.

by Wolf Richter

Wolf Street (September 16 2014)

Not everything is hunky-dory in the world of stocks. The S&P 500, which has been hovering near its all-time high and hasn’t experienced a decline of ten percent in three years, has been the focal point of breathless media coverage. But beneath the surface, the stocks of smaller companies are being put through the meat grinder.

Bloomberg {1} found that 47% of all stocks in the Nasdaq have skidded at least twenty percent from their twelve-month high; forty percent of the stocks in the Russell 2000 and, chillingly, forty percent of those in the Bloomberg IPO index have made that same trip south. They’re now languishing in their own bear-market purgatory. Investors have been fleeing these companies for months. I wrote about that phenomenon in May {2}, but it has gotten worse since.

Yet, 44 startups that have not yet gone public and have not yet been acquired have valuations of over $1 billion {3}, with five of them in (or nearly in) the $10 billion club. Uber tops the list with a valuation of $18 billion. And Snapchat, one of these $10-billion outfits, doesn’t even have revenues yet.

It’s at this confluence of excess and exuberance on one side and sub-surface carnage on the other that a voice from the venture capital world speaks up: Bill Gurley, a partner at Benchmark and investor in Uber, Zillow, OpenTable, and others, lamented in an interview with the Wall Street Journal {4} the “excessive amount of risk” piling up in Silicon Valley: “In some ways less silly than 1999 and in other ways more silly than in 1999”, he said.

That comparison to the final outburst of craziness of the dotcom bubble before it blew up is ominous, even for him. But not for the entrepreneurs out there today, of whom perhaps as many as sixty percent or seventy percent, he said, “weren’t around in 1999, so they have no muscle memory whatsoever”.

And he pointed at the result of nearly free money sloshing into Silicon Valley, and why all excesses end badly: when startups are raising hundreds of millions of dollars, as they are these days, they’re encouraged to spend it, and so they speed up their “burn rate”.

And I guarantee you two things: One, the average burn rate at the average venture-backed company in Silicon Valley is at an all-time high since 1999 and maybe in many industries higher than in 1999. And two, more humans in Silicon Valley are working for money-losing companies than have been in fifteen years, and that’s a form of discounted risk.

These “excessive amounts of capital” lead to trouble as startups are getting used to reckless spending.

And that can be seriously, negatively reinforced by the capital market. In the software-as-a-service world, where the risk is potentially among the highest, Wall Street has said it’s okay to lose tons of money as a public company. So what happens in the board rooms of all the private companies is they say, “Did you see that? Did you see they went out and they’re losing tons of money and they’re worth a billion? We should spend more money.” And there are people knocking on their door saying, “Do you want more money, do you want more money?”

They do want more money. To justify the additional capital, these companies, which often don’t have revenues and can’t even imagine what it would be like to generate enough cash internally to survive, increase their burn rate. They move into digs with more expensive leases, and hire more people and increase their compensation, and they serve delicious free lunches … Excessive capital reinforces every mortal sin a business can commit {5}.

And so Gurley rephrased what bankers have known for eons – that bad loans are made in good times. The way he sees it “bad business behaviour is coincidental with the best of times in our field”. Excessive amounts of capital nurtures this bad business behaviour and covers it up and distracts from the core of what a business should do. Incentives get distorted and priorities take a turn for the bizarre. Everyone who has been around the scene with open eyes has seen the symptoms “So, the crazier things get, the worse people execute”, he said.

Excessive amounts of capital lead to a lower average fitness because fitness, from a business standpoint, has to be cash-flow profitability or the ability to generate cash flow. That’s the essence of equity value. And so I think we get further and further away from that in the headiest of times.

The excesses are spreading around. Now landlords in San Francisco that are charging “two or three times what the rent was three years ago” are demanding ten-year leases, he said. If they thought rents would continue to go up, they wouldn’t try to lock in the current rates for ten years. They know something the startup world has learned in 2000 and 2001 but has already forgotten. But their strategy won’t work.

When the money flow dries up, “the types of gymnastics” that these companies would have to do “to readjust their spend is massive”. When the prior tech bubble imploded, “half the companies went bankrupt, and they couldn’t pay the lease over the ten-year period”. Many of these companies simply evaporated after they’d blown through their investors’ money. In 2001, tech companies announced nearly 700,000 job cuts {6}. And this time? Excessive amounts of capital thrown around willy-nilly by giddy investors with grandiose hopes at companies with puny if any revenues and endless losses always ends badly.

How much does it cost to manipulate the entire IPO and startup market? Not much. And it’s getting cheaper! It was leaked that VC firm Kleiner Perkins Caufield & Byers would sprinkle $20 million on Snapchat. But the tiny deal would raise Snapchat valuation to $10 billion. Read {7}.

Links:

{1} http://www.bloomberg.com/news/2014-09-14/record-s-p-500-masks-47-of-nasdaq-mired-in-bear-market.html

{2} http://wolfstreet.com/2014/05/12/the-brutal-beneath-the-surface-slo-mo-crash-of-stocks-2/

{3} http://wolfstreet.com/2014/05/12/the-brutal-beneath-the-surface-slo-mo-crash-of-stocks-2/

{4} http://online.wsj.com/articles/venture-capitalist-sounds-alarm-on-silicon-valley-risk-1410740054

{5} http://wolfstreet.com/2014/07/22/what-a-storm-surge-of-hot-money-does-to-san-francisco/

{6} http://wolfstreet.com/2014/09/05/big-tech-sinks-into-trouble-may-sack-most-people-since-2009/

{7} http://wolfstreet.com/2014/08/28/how-to-rig-the-entire-ipo-market-with-just-20-million/

http://wolfstreet.com/2014/09/16/excessive-amounts-of-capital-doom-startup-b

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