C&B Notes

Venture Capital Speculating

During a recent interview, Bill Gurley, who is a partner at Benchmark Capital, talked about the valuation “silliness” and the high cash burn rates he is seeing in the current VC environment.

I think that Silicon Valley as a whole or that the venture-capital community or startup community is taking on an excessive amount of risk right now.  Unprecedented since ’99.  In some ways less silly than ’99 and in other ways more silly than in ’99.  I love the Buffett quote because it lays it out.  No one’s fearful, everyone’s greedy, and it will eventually end.  And there are reasons, which might take all night to explain, why this business is cyclical over time, and the more chance you have to see different cycles and to see how it slips away, you can see it.

There’s a phrase that I love: “discounted risk.”  Do people discount risk?  Right now you’ve got private companies raising $200, $400, $500 million.  If you’re in a competitive ecosystem and you raise that amount of money, the only way you use it — because these companies are all human-based, they’re not like building stores — is to take your burn up.

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.  In ’01 or ’09, you just wouldn’t go take a job at a company that’s burning $4 million a month.  Today everyone does it without thinking.

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I’ll give you something that’s tactical.  Part of it is why it’s cyclical right.  For the first time since ’99, in the past 12 months, I’ve been in board meetings where the company says, “Our only option is a 10-year lease,” at record pricing on a per square foot basis here in San Francisco, which is two or three times what the rent was three years ago.  And so this is why it’s all cyclical — because the landlords get greedy.  They wouldn’t do a 10-year lease if they thought that the rates were low.  So they’re implicitly telling you they want to lock this in for 10 years, which is its own form of greed because what happened in ’99 is half the companies went bankrupt and they couldn’t pay the lease over the 10-year period.

Anyway, it’s those kinds of things that happen.  The most obvious one is just the acceptable burn rate.  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?”  So it takes the burn rate up.

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So I took my family down to the Galapagos this summer and read this book on the way down there called “The Beak of the Finch” which is about this couple that has lived on Daphne Island for 20 years studying the finch.  And, amazingly, when there are huge El Niño years and floods bring tons of food to this island, the finch population goes up like three or four times.  Inevitably, when the rains are normal the next season there is massive death.  Simply because once you get the food level back to a sustainable level.  So, from a fitness perspective, excessive amounts of food lead to a lower average fitness and I think the same thing happens here.

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.