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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 10% 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 found that 47% of all stocks in the
Nasdaq have skidded at least 20% from their 12-month high; 40% of the stocks
in the Russell 2000 and, chillingly, 40% 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, 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, 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 the
“excessive amount of risk” piling up in Silicon Valley: “In some ways less
silly than ’99 and in other ways more silly than in ’99,” 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 60% or 70%, he said, “weren’t around in ’99, 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 ’99 and maybe in many industries
higher than in ’99. And two, more humans in Silicon
Valley are working for money-losing companies than have been in 15 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 OK 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 [read... How the Surge of Hot Money Pushes
San Francisco to the Brink].
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 behavior is
coincidental with the best of times in our field.” Excessive amounts of
capital nurtures this bad business behavior 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 10-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 10-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.
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… Pump and Dump: How to Rig the
Entire IPO Market with just $20 Million
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