Debt is Coming to Silicon Valley and some Startup Tailwinds Vanish. Startups are changing. What’s a founder to do? Having started a company in a tough, buyer-controlled, enterprise, regulated industry and grown it to VC scale and growth trajectory, this is my perspective. It’s not a covid-driven approach, even though the current environment makes it seem obvious; it’s the way I’ve approached building TrueAccord to be sustainable and make a meaningful difference while keeping investors and employees happy and well compensated.
Thank you to the people who reviewed drafts of this post in the past year (!) You know who you are.
This is where I started
2009 or 2010 was the first year I’d heard the phrase: “This is a bubble, and it can’t go on this way.” I had no idea whether it was true. It was a wild ride that I wanted to be a part of: 106 Miles had monthly meetups that founders of unicorns-to-be showed up to. Startups felt subversive and cool. Facebook had around 1000 employees and Jack Dorsey was pitching Square to fifty people at Yishan’s co-working space. The options felt limitless and money started pouring in. In May of 2009, DST invested in Facebook at a $10B valuation and people sniggered and thought they were insane. Startups were founded out of Palo Alto and Mountain View, and San Francisco seemed too far and too foggy to care about.
A decade later the startup world and its undisputed capital, the San Francisco Bay Area (“Silicon Valley” or “SV” from now on), are completely different beasts. The abundance of startups, the money invested in them, and the constant moving of goal posts for what it means to be successful have transformed expectations and dynamics. Money, its engineering, and the riches it can bring have overshadowed the area’s roots in technology and design, and are reflected in the ideas behind, and the tremendous growth of the behemoths of present days.
We don’t often talk about this change. Tech companies’ early success and the narrative they propped up have changed SV into a distributed corporate world where middle and top management, VC fund managers, fund and encourage a production line of startups that grow and mostly flame out, chewing up and spitting out generations of would-be founders and employees in the process (also see Alex Danco’s excellent Twitter thread about VC as “production capital”). This production line was created to reduce risk and improve returns for portfolio-optimizing fund managers and corporate buyers. Facebook’s purchase of Instagram was seen as outrageous, but only two years later, its purchase of WhatsApp made complete sense. Big tech is still printing money, and its ability to buy market share, pay to block competition, or simply hire and retain top talent with golden handcuffs has never been stronger.
The production line of startups wasn’t created by some evil mastermind, but by alignment of incentives between many different players. However, while it’s arguably net good for the technological advances it brought to the world, it is both bad for the average founder and discourages innovation that doesn’t fit specific patterns. Yet startups that don’t fit this production pattern can be both profitable and incredibly world-positive, by solving problems that are acute and large, but don’t lend themselves well to blitz-scaling or turning into a unicorn in just a few years. To protect themselves and their ideas from being crushed by the machine, founders who must raise VC need to engage in planned and defensive fundraising.
I am not a tech skeptic. I started, helped start, and sold a few companies myself. I am running a VC-funded technology company right now, and I live among tech people and investors. My wife is a partner at a VC fund. This is my reference group. I think technology is a net-positive power that has changed the world for the better, even if I quibble with the definition of what that change is or should be. The positive effect of tech behemoths is clear even if they also need to be kept in check, and I hope to see most of the current crop of large companies persist and succeed. At the same time I find that the zeitgeist creates structural challenges for companies that try to make a difference without sticking to the acceptable growth playbook, whether by choice or by the limitations of the markets they operate in. No one is essentially a bad actor in this ecosystem; everyone has to respond to market dynamics and opportunities they are presented with, resulting in blind spots and inefficiencies that are important to recognize and, if you’re exposed to them, minimize the risk of their impact.
The rise of startup factories
The last recession led to historically low interest rates, and large pools of money were looking for returns, making money significantly cheaper and more risk-taking. That trend has only intensified in the past decade. Endowments, retirement funds managing an impossible task of showing at least some match between their future liabilities and growth in assets, and even high net worth individuals, are all looking for investments with high return profiles. VC funds sucked up a lot of that capital. The rate of new funds getting started quadrupled in the past decade, vastly outpacing the pace of creation of great investment opportunities.
With the establishment of corporate VC arms and M&A activity by traditional companies looking to buy innovation, SV has become a solution for large cos’ innovator’s dilemma: outsource market and product risk to startups, funded by VCs, and buy them up when they mature for much less than the time, money, and pain involved in developing said products and markets in house. Flipping small engineering teams to Google and Facebook for $10-50m was a distinctly 2009-2011 phenomenon. Selling unprofitable companies’ stocks to public market investors at scale is a recent trend that may already be waning. Pushing risk down the hierarchy then selling whatever emerges back to corporate America is a profitable and effective value creation process.
Markets are efficient, and SV is characterized by highly efficient if not overtly explicit information sharing. Simply follow VC twitter and read the blog posts: there is enough competition to squash any antitrust argument, but the VC twittersphere does an incredible job of reporting, repackaging, and enforcing trends in valuation, hot product segments, and financial management. VCs talk and deal with other money managers, leading to deals between firms. In addition to corporate buyers, secondary sales became much more structured: as Felix Salmon of Axios reports, 20% of VC returns in the past year have been to PE buyers, converting high growth into cash flow, while others sold to other VCs who had earmarked more late-stage capital. And so, faced with an influx of cheap capital and established exit mechanisms to buyers with clearly defined incentives, like any efficient market, SV responded. It did so in two ways: the rise of startup factories, and a valuation arms race.
Startup factories were a natural evolution, since the rest of the value chain was already professional and at-scale, and startup supply needed to catch up. Startup creation was never just a serendipitous event, but it has become significantly more specialized and commoditized in the past decade. SV’s long track record bred professionalism and structure in sourcing, attracting, and funding startups and founders, many of them still flock to SV to start their companies. Larger funds keep tabs on the market through smaller, stage-focused funds, external feeder funds, and through venture partners and scout programs. The larger, legacy ones even go back and manage their partners’ and successful founders’ personal wealth through specialized vehicles. It’s funds all the way down, staffed by incredibly ambitious and intelligent people, and they needed startups to fund. It’s not a surprise, then, that the most iconic VC ever, Sequoia Capital, has funded the most iconic startup factory ever, Y Combinator.
Startup factories evolved through the years to meet market requirements, and in the process have commoditized entrepreneurship. The most successful of them scaled to thousands of companies, many more alumni founders, and a support network like no other. They screen candidates, offer coaching and initial traction through cross selling to their network, and even imply higher valuations and better treatment from investors since the corporation has an iterative, multi-round game relationship with these investors that founders can’t develop. Their credentials are now being compared to Ivy league schools, and if one is focused on the signaling value of having attended a factory, that comparison makes complete sense. Being accepted into YC has a value in and of itself, and doesn’t imply anything about the value of the team, their idea, or what problems they’ve managed to solve for their current enterprise. In fact, many founders are encouraged to focus less on their initial idea, pivot through the program, and follow many truisms that create that type of companies that the factory knows how to market effectively to upstream investors.
When value is not as strongly coupled with product or company performance, stock prices and valuations become much more important metrics. Higher valuations serve many different purposes in SV, the least of them luring employees, uneducated about equity, with the promise of vast riches. What’s measured and rewarded gets optimized for, and private market valuations, not relying on any established formula, are very easy to optimize and increase through either simple hyperbole, VC FOMO, or structured rounds. Since valuations are shared without any discount for complex terms, even in VC reports to limited partners, they prop founder egos as well as fund markups. VCs rely on these markups to raise subsequent funds that pay 2+20, some founders run a private secondary round, and most win.
The problem with this pattern is that it both creates and reinforces the power law distribution of VC returns, focusing VC and founders on a smaller number of ideas and companies that can demonstrate the traits that lend themselves to production line dynamics, rapid top line growth, and valuation manipulation. It creates a thin layer of successful founders, propped up by tech blogs who are rewarded with eyeballs for drumming up stories of success (and sometimes, the eventual fall from grace) of multi-millionaires and billionaires. Along the way it crushes companies that seemed, early on, like they fit the patterns, raised too much money and mismanaged it, and burned out or ended up as zombies with a preferred stack that no one wants to touch. Those companies could have a positive impact on the world, they could make their founders and early employees rich, and they could have a legacy. Instead, they’re another logo scrubbed from a fund’s portfolio page, their founders fired or feeling trapped in a role that doesn’t fit them anymore. I am not giving examples intentionally, because this isn’t about skewering a specific fund or company. It’s a market dynamic to pay attention to.
What if you still want to start a company?
What do you do if you’re a founder starting a business that requires venture capital to get started, but don’t want to get chewed up by the machine? What if you accept, as you should, that the high growth, high margin days or the Internet’s early expansion days are over? Many companies need external funding to exist, whether because they need to build meaningful technology, because of fierce competition or a tough market, or because its founders can’t take the financial risk of starting a company. One option is to sacrifice one go-around to the gods of the virtual corporation, prove yourself, get those Nouveau Ivy League creds, then do it again your way. One for them, one for me. The other option is, alas, more complex.
That is why I’m proud to announce Other Option Ventures, a $100m fund–
Just kidding!
Debt focused or revenue-based-financing funds argue against the power law-chasing VC funding, a futile effort that misses the point. The funding market is becoming more sophisticated and better segmented. The days of founders automatically being fired after series A are gone, but so are the days of complete founder control. To take that to the other extreme of solely profit-based funding is short sighted. The market offers multiple vehicles and structures, whether equity or debt based, to fund operations. Founders have to be smart about how, when, and who they take funding from, because there are more, not less, options. Therefore, my top advice for founders raising money is this: raise defensively.
Raising defensively means finding the right path between growth-at-all-costs mentality and the low stakes, low conviction world of lean startups. Companies need capital and (relatively) cheap capital is available; there’s nothing wrong with raising money to grow. However every company, even the most successful ones, runs into roadblocks and company threatening events. You can’t plan for them, especially if your market presents fundamental structural issues, you’re proven too early, or luck just isn’t on your side. A defensive fund raising strategy means protecting your future self, the one that has to deal with this company threatening event, more options. Less investors on the board to reduce board drama and conflicts, lower average valuations that keep everyone calmer, lower burn that lets you make adjustments without forcing a RIF, and a friendly equity holder base that won’t object to a 4-year re-up of your equity position to make sure you don’t get diluted to oblivion. Raising defensibly means prioritizing control over valuation, choosing your VC partners very carefully, and being as capital efficient as possible.
Raising defensibly also means resisting market signaling and expectations around round size and valuation increases. Valuations should converge to reasonable multiples of revenue by your series B or C, and round sizes should decrease, not increase. 409A valuations will remain defensibly low, allowing you to compensate with equity, but you will need to continuously explain to employees why structured, inflated valuations hurt them. You will not conform to “traditional” round milestones and timing, often raising once a year in controlled valuation increments, using convertible note “bridges” between equity rounds to capture available funding without forcing a priced round too often. You’ll embrace the proven unhelpfulness of most money managers, opting to raise money from mostly uninvolved investors, punctuated by a small number of highly involved, high leverage ones. You’ll need to exercise tight financial control and pay close attention to margin. You may need to explain to employees why you can’t just hire to solve issues; you’ll need to let underperformers go instead of hiring above them. You may never publicly announce a round (gasp!). Generally speaking, the traditionally laissez-faire management approach many startups demonstrate cannot apply, because it will set you up to fail.
Building defensible businesses isn’t necessarily better than any other approach. It is probably the wrong approach in highly competitive markets that work well with blitzscaling and effectively convert investment dollars to top line growth. It is, however, an adjustment in management and fund raising practices that can increase your chances of long term financial success, better returns for patient investors, and an enabler for innovation that wouldn’t exist otherwise if we all focus on how to reach a $1B valuation as quickly as possible.