Silicon Valley startups are terrified by a new idea: profits

Everyone in the Valley is reading a post by venture investor Bill Gurley that spells out in detail how the tech bubble is bursting.

In it, he’s explained why the startup world is freaking out about a strange new idea they have never had to consider before: profits.

Gurley writes:

“In Silicon Valley boardrooms, where ‘growth at all costs’ had been the mantra for many years, people began to imagine a world where the cost of capital could rise dramatically, and profits could come back in vogue. Anxiety slowly crept into everyone’s world.”

Gurley has been the rare VC who’s been warning about the tech bubble for a couple of years.

No one was listening in 2015 when the money was flowing so freely that the number of startups valued at $1 billion or more mushroomed to over 160.

Other VCs publicly pooh-poohed his warnings.

VC Scott Nolan, a partner at Founders Fund — best known as Peter Thiel’s venture firm — said a year ago that he wouldn’t even invest in a company that wasn’t burning through cash because it meant those companies “don’t have enough ideas about what valuable things to do with more money.”

But the VC investing game goes something like this. Invest in a company. Tell the founder to grow to $100 million as fast as possible, operating at a loss to grab market share. $100 million in revenue used to be the magic number for an IPO or for a hefty acquisition by a bigger company, whereby the investor is profitably cashed out and able to invest again.

The sharks are here

But unicorns have a unique problem. They can’t exit like that.

Katy perry dancing sharks

Often an IPO won’t value them as highly as their last private round so investors risk losing money on an IPO.

In fact, there hasn’t been a single tech startup that’s gone public yet in 2016.

And an acquisition isn’t possible because bigger companies aren’t going to buy them at their high valuation prices.

And, as Gurley points out, there’s a limit to how much venture investors are willing (and able) to keep these cash-guzzling startups afloat.

The VCs, who can’t cash out, are out there trying to raise more money for their funds, he says.

Unicorns risk running out of money with no place to turn.

And that’s when “the sharks arrive with dirty term sheets,” meaning investors with terms that range from dangerous to unscrupulous.

Once a CEO accepts a “shark’s” term sheet, he’s poisoned the company, Gurley warns. No other investors will want to invest in the company and get tangled up.

“Any investor asked to follow a dirty offering will look at the complexity of the previous offering and likely opt out,” Gurley says.

The obvious solution terrifies startups

There’s a solution, of course, Gurley points out: profits.

Or As the CEO of unicorn startup Gusto so eloquently said, “You can’t keep spending $5 to make $1.”

Gurley quotes Gavin Baker, a high-profile portfolio manager at Fidelity who tells startup CEOs: “Generate $1 of free cash flow, and then you can invest everything else in growth and stay at $1 in free cash flow for years.

Baker adds: “I get that you want to grow and I want you to grow, but let’s internally finance that growth.”

Both Gurley and Baker say that profits are really the “only way to control your own destiny.”

Still, startups are terrified of the thought. It takes very little management skill to hire like mad to flood the zone with sales and marketing efforts, losing money.

They have been taught to believe that this is the best way to run a young company, an “aggressive ‘spend-to-win’ mentality,” as Gurley describes it.

Creating a desirable product that can be sold at a price that will sustain a company, that’s something else.

In the meantime, there’s a new term for what’s happening: the unicorpse. Or as Salesforce CEO Marc Benioff, a prolific angel investor who has also been warning about the dangers of unicorns, once put it: “there’s going to be a lot of dead unicorns.”

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