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Tuesday, October 15, 2019

Start-Up Madness: Is Sanity Returning?

In search of some good news, I was pleased to come across this story about a possible, welcome shift in the way start-up companies are born. The article plays off a viral blog by the venture capitalist Fred Wilson, who argues that the age of unicorns (rapid-growth, huge-payout companies) is being replaced by more value investing.

Wilson’s point is so obvious that it’s stunning and needs repeating.  Software companies generate massive profits because they have extraordinarily high gross margins. When you sell something for a dollar, and it only costs you 20 cents to make it, you have 80 cents left for R&D, marketing,  profits, rapid growth, whatever.  In WeWork’s case, the latest unicorn to come to grief, the ratio is the opposite.  They only have 20 cents on the dollar to fund all that growth and profit. That’s not special.  That’s common.

In the 1841 book, “Extraordinary Popular Delusions and the Madness of Crowds,” one learns that you can’t just keep repeating that you are tech company, and become one. The WeWork swoon, after steroidal growth, was about as predictable as the Dutch Tulip Craze of the 1600s.  

As for the broader market, the shift to more disciplined, slower-growth, enduring-value companies might just be a cyclical shift based on current economic fears, not a tectonic one. We’ve been down this road before when Sequoia Capital in 2008 spread word in a famous presentation, RIP Good Times. That bit of bad news spread through tech communities in the Bay Area and Seattle like a tsunami.

But looking back, it was just a smart and temporary response to the downturn in the economy. Sequoia Capital knew it was going to be hard to get limited partners to kick in more money, so wanted their portfolio companies to shift gears and be more economical to survive a multi-year downturn.  It didn’t hurt that the presentation put a chill on other investors, and caused competitive startups to spend less, and thus lower the odds of overtaking Sequioa’s portfolio companies. 

But that was a decade ago.  The recession passed, the party re-started, and all of these unicorns have come on the scene since then.  

So what may be different this time? It helps any analysis to separate the public market returns from the returns for angel and venture-capital investors, investment bankers, and others who get in early, in the pre-public market. These sectors are thinly related, but wildly different.  One angel investor, David Cohen, invested $50,000 in Uber. After going public, that turned into $248 million, a mind-blowing gain. Many of those folks cashed out, and they likely don’t worry much that a bunch of random people the angel doesn’t know lost money in the public markets. Is every single angel investor in Seattle, the Bay Area, and beyond dreaming that one day they might achieve a fraction of this return? Probably. 

Some percentage of angel investors are legitimately in it to help launch the next generation of entrepreneurs, but once you get to the VC firms, it’s all about returns.  So a couple highly visible flops, fears of a “Trump slump,” and an inverted yield curve for bonds understandably have caused a little caution. A few big winners will help the market forget these failures. Greed will return. The insanity will return after a pause.

So says the cynic in me. The more hopeful part of my brain hopes that fewer startups will go the VC route, where they are just a company in a portfolio and therefore likely to face premature death when they don’t look like a toddler unicorn. That pattern has cost us a lot of fine companies, who used to have conventional capital to sustain steady growth. So I hope, a bit forlornly, that the current pause turns into a chance for getting more eggs out of the early-investor, get-big-fast basket. That will work better for all of us than WeWork.

Image by SnoockyCookie from Pixabay

Steve McCracken
Steve McCracken has been a CEO, entreprenuer, investor and advisor for more than 20 years. Today he is a part-time consultant to a small handful of companies.

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