
Silicon Valley Needs Startup Drano - adventured
https://www.bloomberg.com/gadfly/articles/2017-01-11/silicon-valley-startup-pipeline-needs-shot-of-drano
======
URSpider94
The real significance of this article is related to the inside baseball of how
most venture funds work. See this:
[http://www.theequitykicker.com/2011/01/12/how-does-the-
struc...](http://www.theequitykicker.com/2011/01/12/how-does-the-structure-of-
the-vc-industry-impact-investment-strategy/) to learn more.

In brief: Most venture funds are closed-end funds, with a certain amount
committed up front from LP's, where each dollar can only be invested once. The
fund stops making investments after 5-7 years, then closes down entirely after
10 years. After 10 years, the managing partners stop collecting their 2%
management fee, and any additional returns aren't typically included in the
performance of the fund.

As such, there's a huge incentive for fund managers to invest early, and find
an exit within the time horizon of their fund. A VC who pumped a ton of money
into an early stage Uber in 2014 in year 6 of their fund, is going to be
pretty screwed if Uber decides not to go public for another 5 years from now.

Where this could go sour is that these same fund managers are spending years
9-10 passing the hat to raise money for their next fund. If the typical pool
of investors still have a lot of money tied up in previous funds, then they're
going to be less likely to ante up for the next fund, since they'd have to
double down on VC as a proportion of their portfolio. It's also going to be a
tough road show if your story is that you invested millions of dollars in your
last fund and it's all still tied up ...

~~~
vessenes
In practice, this is not the major pain point I think you are calling it. The
letters I read often have variants of "We've returned [0.8-2.5x] capital and
still have [Uber] in the portfolio!"

What may be painful is not being able to at least return capital by the end of
the fund without a WONDERFUL story about coming liquidity.

Current industry average 10 year IRR is 10% according to Cambridge Associates.
You've really fucked things up badly if you can't return capital in year 9/10
on a 10% IRR.

~~~
uiri
To save others the trip to Wolfram Alpha:

Assuming money is put into the fund in year 0, a return of 2.35x capital in
year 9 or 2.6x capital in year 10 is required to get a 10% IRR.

------
neom
I've had this thought in my head for quite some time about what I call "bottom
line companies" \- That is, companies that add "substance" to the bottom line
of society. When I think about bottom line companies, I think about GE, AT&T,
CN, JetBlue, Mondelez International (Kraft) and the like. I often wonder about
how these ventures got started. Over the past 20 years, have we seen many
bottom line companies founded? Also, tangentially but interestingly:
[http://www.inc.com/magazine/19850501/495.html](http://www.inc.com/magazine/19850501/495.html)

~~~
niftich
These are all brick-and-mortar companies that were built around a single
product (electricity, telephone, railways, airlines, dairy roll-up) and later
expanded by merging with competitors or expanding into related fields. You can
also add P&G, General Mills, Johnson & Johnson, PepsiCo, and many more.

In each and every case, these companies delivered a product or service in
exchange for the customer's cash. This is the key distinguishing factor
between companies like IBM, Microsoft, Apple, who deserve to belong on that
list, and companies like your hyped SV unicorn that has no business model
besides "eventually we'll introduce ads".

~~~
sporkenfang
If someone wanted to start a company with a definite product (not ads), maybe
even a brick and mortar product, how does the process differ with starting a
garden-variety startup?

~~~
niftich
It doesn't, really. It's just that these companies tend to draw more modest
valuations, generating a more subdued kind of excitement. Forbes just wrote
about how VCs should invest more in B2C startups [1]. A different piece from
CB Insights last year [2] argues the same point. There are some VCs who
specialize in B2C stuff, Maveron [3] being notable on the West Coast. Mostly,
though, this capital does not concentrate in a small area like SV.

[1] [http://www.forbes.com/sites/chrismyers/2017/01/09/why-
entrep...](http://www.forbes.com/sites/chrismyers/2017/01/09/why-
entrepreneurs-need-to-h-a-l-t-before-making-important-decisions/#3d66a5263e45)
[2] [https://www.cbinsights.com/blog/vc-investing-in-consumer-
goo...](https://www.cbinsights.com/blog/vc-investing-in-consumer-goods-
companies/) [3]
[https://en.wikipedia.org/wiki/Maveron](https://en.wikipedia.org/wiki/Maveron)

------
gumby
The downside of this lack of liquidity is the loss of fees flowing to the
investment banks, the key constituency of Bloomberg.com. Oh no!

Most financing documents allow the preferred investors to force a
registration. And of course the investors want liquidity. So if it's not
happening it's because they believe (and can convince their customers, err,
LPs to believe) that the return will increase significantly if they wait. I
say "significantly" because volatility increases value in the Black-Scholes
equation, so forgoing it better be worth it!

In the "old" days companies were essentially forced to do an offering when
their staff got high enough, as they had enough shareholders that they had to
file public reports anyway, so why not do a share offering and get some cash
in return for the obligatory hassle. I say "old" days because this applied to
FB.

Nowadays you can do quite a lot of business with fewer employees so this
forcing function is not as powerful as it used to be.

~~~
JumpCrisscross
> _Most financing documents allow the preferred investors to force a
> registration_

Registration rights are _not_ a standard part of Silicon Valley financing.
Voting rights agreements--which grant the Board or certain members of
management your voting rights until IPO--are more prevalent.

~~~
gumby
> Registration rights are not a standard part of Silicon Valley financing.

I am surprised that you write this. Demand registration rights have been part
of every equity financing I've done for the last 25 years in the Valley and in
NYC.

------
jimmywanger
If the fed would raise interest rates, that'd go a long way to helping clear
at least some of the backlog.

Right now you got a lot of dumb money behind a lot of startups with bad
business plans because there's no other place for the money to earn reasonable
yields.

~~~
ghaff
Higher interest rates aren't a magical elixir for investment returns though I
agree that there's a lot of dumb money going into bad, me too business plans.
However, the author seems to be most focused on how invested money gets out of
the pipeline once it's in.

In may well be the case that there aren't enough worthwhile tech VC targets to
absorb the money people want to put in. (see also the boatloads of cash some
companies are sitting on.) But that's a different argument from companies
unwilling/unable to exit.

~~~
Spooky23
They're not magical, but there's literally nowhere to safely save liquid cash
these days.

I have a 6% Capital One 360 CD that matured last year. My credit union is
offering 2.75% auto loans on 2014 model year cars up to 72 months.

Clearly, money is too cheap when you're getting super low rates on terrible
loan products.

~~~
toomuchtodo
If the car lasts at least 72 months, and you stay ahead of the depreciation,
it's not a terrible loan product. It's a benefit of the world being awash in
capital.

------
bertil
For anyone not American: Drano is a drain cleaner brand common in the US.

------
draw_down
As a developer and therefore a person who benefits when lots of companies have
demand for the field I work in, it's unclear to me why I should want "Startup
Drano". I'm not a VC nor an LP, I don't mind if VCs waste their money funding
"Uber for dog food" or whatever.

People starting businesses with bad business models don't offend me on a moral
level. It's their funeral, let them make bad decisions if they want.

~~~
Analemma_
> People starting businesses with bad business models don't offend me on a
> moral level. It's their funeral, let them make bad decisions if they want.

If you want a good explanation of why you should be offended and why you
should want Startup Drano, try:
[http://idlewords.com/talks/internet_with_a_human_face.htm](http://idlewords.com/talks/internet_with_a_human_face.htm).
Here's the key quote:

 _" But investor storytime is a cancer on our industry.

Because to make it work, to keep the edifice of promises from tumbling down,
companies have to constantly find ways to make advertising more invasive and
ubiquitous.

Investor storytime only works if you can argue that advertising in the future
is going to be effective and lucrative in ways it just isn't today. If the
investors stop believing this, the money will dry up.

And that's the motor destroying our online privacy. Investor storytime is why
you'll see facial detection at store shelves and checkout counters. Investor
storytime is why garbage cans in London are talking to your cell phone, to
find out who you are."_

When all the free money is chasing advertising-driven business models, the
advertising has to get ever more invasive in order to justify valuations. I'm
all for letting business stand or fail on their merits if no one but the
investors are harmed, but this is a very destructive externality that affects
everyone.

~~~
draw_down
Hmm. Indeed that is bad, but I have a feeling what we're really talking about
here is capitalism.

~~~
sedachv
Eben Moglen said the same thing during the Q&A at his HOPE 2012 talk:

 _I don 't think that the problem of collecting too much is now primarily a
byproduct of careless regulation. The problem of collecting too much arises
from the fact that the future of capitalism is in the data mining and control
of its customers. When capitalist societies begin to depend more on
consumption than they do on production for their overall economic health, and
the GDP of the United States has been primarily consumption for more than 15
years now, then knowing how to control consumers becomes as important as
knowing how to control productive machines was when the GDP was primarily
based upon production rather than consumption. What is happening is that we
are automating and instrumenting the portion of the economy which is most
powerfully important, namely consumption.

Collecting information about consumers is the same thing as knowing how the
mill machines worked to the capitalists of the 19th century. So what we are
confronting is not the accident of perverse incentives created as a byproduct
of unintended consequences of regulation. We are facing the fact that doing
the wrong thing is the basis of future economic growth.

We are not trying to destroy future economic growth, we are trying to
compromise among values. That's what regulation is. It's a messy process. Of
course it has unintended consequences. Naturally it creates perverse
incentives, because it's imperfect. But understanding the objective has to be
clear: productive capitalism met ecological constraints. It dirtied the water
too much, it dirtied the air too much, it created too many difficulties that
had to be constrained as negative externalities produced by production. The
attempt to regiment and govern consumption through data mining raises ecologic
problems we must solve._

[https://www.youtube.com/watch?v=vY43zF_eHu4](https://www.youtube.com/watch?v=vY43zF_eHu4)
at 54:20

------
chplushsieh
Startups take several years to exit.

So isn't it perfectly normal that it also takes several years for the total
value of IPOs and acquisitions, i.e. money that flows out of startups, per
year to catch up with the rising trend of total startup investment, i.e. money
that flows into startups, per year?

~~~
runamok
Much more than a few years these days. So there should be at least a 3 to 5
year offset between comparing money in to money out.

------
choxi
I'm surprised the author didn't mention anything about megarounds. I thought
most of the increase in venture capital has been going to megarounds, and that
these rounds are being raised exactly because companies want to delay their
IPO and remain private longer. That would perfectly explain why there's a lag
in the returns on these VC funds, right?

------
ryandamm
You wouldn't expect the uptick in venture financing to immediately result in
an uptick in venture exits. Using the 'pipe' metaphor, the flow takes time.
The pipe has nonzero length.

In fact, the pipe's length should be roughly the length of the average time to
exit for a startup (weighted by exit size). So the latency in the system
should be much longer than one year.

This is the problem with semi-quantitative thinking. And lazy journalism. Then
again, I did click on the link and read the article, so maybe I'm
misunderstanding the point: the author got what she wanted out of me.

------
NelsonMinar
I feel like I've read this same "there aren't enough IPO exits" about the
startup scene since at least 2002. What periods of time in the last twenty
years have been considered _good_ for tech VC IPOs?

~~~
obstinate
I think the period between and including Google and Facebook's IPOs were
considered good.

------
edblarney
This is called the 'free market' in action.

With very low interest rates, and ridiculous Fed policies (QE) designed to
'reinvigorate the economy', but which really just pumped tons of extra cash
into stocks and bonds (i.e. mostly the 1%, and institutional holders like
pension funds) - you have tons of liquidity chasing value creation.

It'd rather seem that 'the power' is now in the hands of those who can create
value.

Or more cynically: money goes to those who can convince others that value is
being created so they can 'collect money' for their product/service.

There's nothing inherently wrong with this situation, it just means VC's are
getting squeezed, and their 'amazing skill' of being able to 'spot the best
opportunities' might be being commoditized a little bit.

The 'risk' really is a sudden change one way or the other, i.e. fed-rate
change, china-flop, tump-risk or just some general fear based panic causing a
bubble burst.

~~~
URSpider94
I disagree. The article isn't at all about the returns that people are getting
on their investments. It's more about the fact that there's a normal lifecycle
for venture-backed companies that ends with going public or being acquired.
That lifecycle seems to have stalled out with mega-companies staying private
for long periods of time.

It's still highly likely that Uber's investors will make tons of cash when the
company finally decides to go public, whenever that is. It's just that the VC
money is staying locked up much longer, so that it's not available to fund
other early-stage start-ups.

~~~
edblarney
"It's more about the fact that there's a normal lifecycle for venture-backed
companies that ends with going public or being acquired. That lifecycle seems
to have stalled out with mega-companies staying private for long periods of
time."

No. There is no 'normal'.

There was X money going in Y coming out.

Now there is 2X money going in, and still Y going out.

It means a lower rate of return for those putting money in.

As for 'money not available to fund other startups' \- clearly it is - the
charts show actual investment is still high.

~~~
URSpider94
You are missing the fact that the amount of money tied up in the companies is
growing. 2x is going in, x is coming ng out, but the missing x is still
(mostly) in there tied up in unicorns. The rate of return is dropping, but not
because the money is gone, just because it's taking longer to come back.

~~~
fourthark
If those untested valuations are correct.

------
taneq
Is this not what a bubble burst looks like? It's still easy to pour money into
the bubble, but it suddenly gets a lot harder and a lot less certain to pull
that money back out?

------
kriro
I'm not sure it's that wise to look at this years money in and this years
money out. Wouldn't it make more sense to look at say the last 5 years of
money out and the last 5 years-X of money in (X being 6-10ish, whatever the
average time to exit is)?

I also only realized what Drano is halfway through the article (non-US guy).
Why not use a more generic title that more of the world understands like
"Silicon Valley Needs a Startup Plunger"?

------
blazespin
The pipe is too short in those graphs. I think 10 years would be better than 5

------
paulpauper
Looks like data mining by the author to skim though 5 years of data and
extrapolate a single inference from it. Just because something seems like
something doesn't mean its important or significant or predictive of anything.

------
Floegipoky
tl;dr: _plugs ears and closes eyes_ "there is no bubble, there is no bubble,
there is no..."

The author does not once address the possibility that less money is flowing
out the other side of the pipe because so much of the money going in is being
spent on companies that provide no value and will never be profitable.

~~~
snowpanda
Your comment is spot on with my experience with clients from Silicon Valley.
When they bring up their product, there is absolutely no sense of
responsibility that their product might fail.

Not sure if its a result of entitlement, or living in Silicon Valley for too
long. Come to think of it, one might be causing the other.

