This article originally appeared in the November 2015 issue of 425 Business.
The tech economy isn’t barreling toward a bust like the one that ended the dot-com era. But that doesn’t mean things are all rosy.
When Terry Drayton founded his latest startup, Livible, he hit up angel investors he’d worked with in the past, including Costco CFO Richard Galanti and former Microsoft CFO Peter Klein, pulled together $2.5 million, and was off and running.
Most startup founders would salivate at the thought of having that much money to work with, but Drayton says that sum is conservative. “I like capital-efficient models,” Drayton said. “Even though I think I could go out right now and raise, oh, $50 million, I just think that’s stupid.”
At first blush, Drayton’s restraint might sound bogus, but there’s legitimacy to his claim. Drayton may or may not be able to nab $50 million, but he definitely has experienced the pitfalls of being overfunded.
The strategy for most startup founders often is to grab as much money as they can. In the last few months, Seattle’s Adaptive Biotechnologies landed $195 million at a valuation that could approach a billion dollars. The numbers are far gaudier in Silicon Valley, home of the so-called “unicorn” startups valued at a billion dollars or more: Snapchat secured nearly $340 million on a $16 billion valuation; Airbnb got $1.5 billion on a $25.5 billion valuation. According to research firm CB Insights, the average early-stage funding round in the second quarter of 2015 was more than double Drayton’s haul.
The last time venture capital was flowing this freely was during the dot-com bubble of 1999 and 2000, which ended in a stock market crash that helped spark an economic recession. Most who follow the tech industry say today’s companies make more money, are built on better business plans, and have a larger customer base than those during the dot-com era; thus, another market-shattering demise of the tech sector isn’t imminent. But talk of a bubble lingers, and a growing contingent of investors and entrepreneurs think we’re headed toward a bubble burst. Drayton is in that group. He has seen it happen before.
Drayton founded seven companies before Burien-based Livible, and most of them were successful. The largest and best-known of his companies, though, was one of the dot-com era’s most notorious failures. HomeGrocer.com raised hundreds of millions of dollars from capitalists. It had a devoted customer base. The media and analysts hailed it. And it fell flat on its face.
What killed HomeGrocer, Drayton said, was an over-reliance on venture capital — a pattern he sees today’s startups mirroring. It’s easy to rely on the most free-flowing money source, though, and even those making the investments are unsure of how this all will turn out.
“We’re running a grand experiment,” said Cameron Myhrvold, a founding principal of venture capital firm Ignition Partners. “Venture capital has existed in an institutional form since the mid-’60s. There’s been a fairly well-established pattern through up markets and down markets for companies going public, and we’ve pierced the veil now.
“We’re in a new world, a world that says companies should stay private much, much longer. That they can take a nearly unbounded amount of private capital, and that it’s all going to be OK. And you know what? We don’t know the answer to that question. We don’t.”
BRENT FREI LEFT Microsoft in 1994 to make what was becoming an increasingly popular career move: founding a startup. The Idaho native and former Dartmouth defensive lineman left the company to start Onyx Software Corp., a customer-relationship management firm.
The ’90s was an important era in technology. Computers were becoming smaller and cheaper, and thus were entering the mainstream. These developments catapulted Frei’s former employer to a perch it held atop the tech world for a decade; a year after Frei left, the Windows 95 operating system made its debut.
Following the rise of the personal computer was the rise of the Internet, the data-sharing network that now underpins the economy and allows this story to be written without a hard drive, let alone a pen and paper, in sight. These technologies allowed the pace of innovation to quicken, and the people building those products felt they had the software chops to leapfrog their bosses, undercut their employers, or create a new sector themselves. A generation of entrepreneurs was born, one with ambition, confidence, and what sometimes proved to be a lack of business sense.
“Everybody was bulletproof. Everybody was the smartest person in the room. Everybody could tell you why they were worth your time, but they couldn’t tell you much about operating a company,” Frei, now cofounder and VP of marketing at Smartsheet, said.
This cavalcade of smart founders rode the wave of the Internet, e-commerce in particular, to an IPO frenzy that has never been matched. In 1998, 113 tech companies held an initial public offering. The next year, 371 companies did so, and 261 more followed in 2000. By comparison, 53 tech firms offered stock in 2014.
“It all felt free,” said Marchex CEO Peter Christothoulou, who briefly worked for InfoSpace before it underwent one of the biggest dot-com plunges. “Anything would work. I remember looking at stock prices, and every company would go up by five or 10 dollars a day.”
Those ascendant stock prices, we now know, weren’t sustainable. On March 10, 2000, Drayton’s HomeGrocer, after securing more than $170 million in venture funding, held its IPO. That same day, the Nasdaq would crest slightly over 5,000, setting a new all-time high for the third consecutive day. HomeGrocer netted just shy of $270 million in the IPO. The following Monday, the selloff began.
Within a month of its peak, the Nasdaq plummeted nearly a thousand points, shedding a trillion dollars in value; the Nasdaq’s value halved in a year. At the time of its IPO, HomeGrocer had eight warehouses in operation, and Drayton said 24 more were in the works. The money raised in its IPO wasn’t going to cover the cost, and HomeGrocer’s revenue couldn’t keep pace with the planned growth. (In 1999, HomeGrocer posted an $85 million loss on $21.6 million in revenue.) The Kirkland-based company was planning on getting another $230 million or so in financing, and that might have been possible a year prior, but the capital markets evaporated as stocks plummeted.
What followed was one of the Seattle region’s most famous flameout stories. Just three months after the IPO, Drayton’s company with a precarious bottom line was swept up by a bigger, but even more precarious, company: Webvan, HomeGrocer’s Silicon Valley counterpart that had grown its market cap to $8.8 billion. Webvan stripped HomeGrocer of its branding, ditched its proprietary technologies, and Drayton left the company before the acquisition.
“We built an incredibly complicated system, successfully deployed a logistical model, and a fulfillment model, and hiring — to watch that thing die was a really painful,” Drayton said. “There are lots of things now about entrepreneurs dealing with depression; yeah, I was really (expletive) depressed.”
In July 2001, Webvan, a conglomeration of two dot-com darlings, filed for bankruptcy protection and auctioned off its assets.
TECH IDOLATRY IS at a fever pitch not seen since the days of HomeGrocer. Boston and New York, global leaders in education, medicine, and finance, are boosting themselves as startup hubs. Silicon Valley companies compete for talent with others in Silicon Beach (Los Angeles), Silicon Forest (Portland), and Silicon Slopes (Salt Lake City). Prone as startup folks are to goofy nomenclature, one can only fathom how many more silicon-prefixed geographic appropriations await us.
This fever isn’t necessarily a precursor to dot-com disease, though. For one, far more people actually use the Internet these days. In 2000, there were some 400 million people using the Internet; today, there are more than 3.2 billion. The Internet was tantalizing at the beginning of the century, and optimists were prescient about its importance; the federal government, in some ways, regulates the Internet as a utility.
Problem was, the e-commerce crowd of the late ’90s and early 2000s jumped the gun. “A lot of the ideas that happened back then, people are doing them now,” Christothoulou said. Pets.com, HomeGrocer, Kozmo, “all those things from the ’90s that didn’t work — it wasn’t that they were wrong. They were just mistimed.”
But excitement in e-commerce blinded investors to bad strategies, and suspect business plans led to suspect balance sheets come IPO time. According to data compiled by University of Florida finance and economics professor Jay Ritter, the companies going public during the dot-com era, at least by today’s tech-industry standards, were woefully unprepared. They were young (median age of 1999 tech companies holding IPOs: 4 years old; 2014 companies: 11) and were generating very little revenue (median revenue, in 2014 dollars, then: $17.2 million; 2014: $90.5 million).
What you’ve got in today’s stock market is a roster of tech companies that were far more established when they held an IPO, companies that are making far more money, and ones with healthier valuations. The median price-to-earnings ratios of companies that went public in 2000 was 31.7. But today’s companies are offering stock at a healthier P/E of 6.2. Furthermore, particularly in Seattle, startups are dealing in sectors that have potential, but aren’t as nascent as e-commerce was in the 1990s.
“I think most people would say that cloud computing, analytics, Internet marketplaces, mobile computing — those are areas where we’ve just scratched the surface of how big those opportunities can be,” said Madrona Venture Group partner Len Jordan.
So the bubble talk should burst, right? Deflation might be warranted, but concerns remain. All of the aforementioned evidence deals with companies that have gone public, which highlights the key difference between today’s tech ascension and the bubble of the early 2000s: Today’s companies are experiencing growth in the private markets, while dot-com companies enjoyed their (albeit brief) growth in the stock market.
“Lots of young tech companies, including venture capital-backed companies, will never go public. Instead, they’ll sell out in a trade sale to a bigger tech company like Oracle or Cisco Systems or Microsoft, etc.,” Ritter said. “And I think there’s been a permanent change there. … Getting big fast is more important than it used to be. Going public and growing organically just takes too long.”
It’s also important to note much of what’s said of startups’ finances is speculation. These companies don’t have to disclose their finances as they would in the public market, meaning the only ones who know of their financial state are executives and their investors. Many argue that companies today are sacrificing profits in the name of rapid growth and quickly can become profitable, but, according to Ritter’s data, just 17 percent of the tech companies that went public in 2014 were profitable. That’s by far the lowest percentage since 2000, when 14 percent of tech firms were in the black.
THOSE WAREHOUSES HOMEGROCER was on the hook for, Drayton said, came at the urging of his financiers, the most prominent of which were Amazon.com and Silicon Valley venture firm Kleiner Perkins Caufield & Byers. “I never wanted to have 24 warehouses under construction,” he said. “I remember one of our (funding) rounds; I wanted $10 million.
I couldn’t get 10, but I could get 50. But I could only get 50 if I agreed to make $100 million more in expenditures. The best way for VCs to control you is to make you always need more money.”
Today’s unicorns and their funders aren’t settling for $10 million rounds, either, as evidenced by the prevalence of large late-stage IPOs. Per CB Insights data, the 20 largest funding deals in 2014 netted more than $11 billion dollars; in 2000, that number was $3 billion. Late-stage investments outpaced IPO funds threefold in 2014, but in 2000 they were less than half what IPO funds were.
And with the VC community so willing to invest, there is no reason for companies to shy away — they get their money and don’t have to answer to thousands of shareholders. “The public market is a terrible place to evolve,” Smartsheet’s Frei said. “You should be in the public market when you have a predictable business … it’s not a place to cash out your old investors and put the risk on the new investors and hope you figure it out while you’re there.”
One consequence of this, for better or worse, is that companies are undergoing the bulk of their growth in the private markets, leaving the lion’s share of earnings to be realized by early investors. As notable Silicon Valley VC firm Andreessen Horowitz has pointed out, for Facebook to provide as large of a return to its IPO investors as has Microsoft, which went public in 1986, Facebook’s market cap would have to exceed a trillion dollars.
In order to capture some of this growth, mutual funds — which are relatively low-risk — and hedge funds have started leading startup financing rounds, thus exposing their customers to the volatility of startup investments (mutual funds can devote only 15 percent of the fund to private-market companies). Last year, Fidelity, BlackRock, Janus, and T. Rowe Price invested in 29 startups.
ASK TECH FOLKS for evidence of today’s market superiority over the dot-com era, and there’s a good chance Uber will come up. Drayton calls his new company the “Uber of self-storage,” making Livible part of the Uber-for-X sector of startups. Capitalists and executives alike praise the rideshare pioneer’s business plan, one of the few that can be called disruptive without evoking cliché. Uber, many claim, is a solid business, unlike the myriad that suffocated in the dot-com era.
Uber certainly is King Startup — its $51 billion valuation is highest in the world — but a few stilts supporting its supposedly rock-solid business plan are looking increasingly finicky. Drivers, the company’s human interface, are all contract workers paid a percentage of fares, but some — namely the California Labor Commission, the Florida Department of Economic Opportunity, and the plaintiffs in a class-action suit against the company — think Uber’s drivers do qualify as employees. Uber also is losing money. Leaked financials obtained by Gawker show that Uber lost $56.5 million in 2013, and its losses swelled to $161 million on $102.65 million in revenue in the first half of 2014 (though it did have $1.16 billion in cash stockpiled).
For his part, Drayton’s making sure his Uber-for-storage isn’t a second take of his former company. He has plans to take Livible international, but he’s expanding slowly, starting with Portland operations this year. Also, Drayton is avoiding the indebtedness that comes with liquidity preferences, agreements protecting VC’s investments in the event of an undervalued exit.
“Uber’s kind of funny,” Drayton said. “Everybody wants to give them money, to pile into the thing that’s going to be successful. So now, Uber … I’m not sure how prudent you are to take all that money. Everyone says, ‘Oh, look, they’re worth ($51 billion) now,’ but … until you have a liquidity event like an IPO or a sale, it’s worth nothing.”
That’s the strange cycle with startups and venture firms. Ritter said liquidity preferences inflate startup valuations — investors must pay a premium for that protection — yet a huge valuation will make it more difficult for a startup to reach its full value upon exiting.
Uber also casts light on a major difference between Seattle and Silicon Valley, one that could insulate the Puget Sound area when the tech economy does recede. Silicon Valley breeds unicorns, but Seattle breeds the digital infrastructures those unicorns and other large companies use. So instead of apps and ride-sharing services, Seattle companies are far more invested in enterprise platforms and services.
“On the enterprise side, it’s a lot easier (to become profitable) because a lot of these companies employ more predictable revenue models,” CB Insights analyst Matthew Wong said. “On the consumer side, it’s definitely more fascinating. When the money runs dry, a lot of these companies that have been using this money to push the pedal on sales and marketing and advertising — it’s going to be a big change for them.”
Enterprise businesses can enjoy a silver lining during economic downturns. Should the market tumble, companies are more likely to ditch employees than platforms that facilitate core business functions; smaller workforces can even spark demand for new, employee-replacing software, which Puget Sound companies specialize in.
“Tableau, (Amazon Web Services), where Microsoft’s going, and Concur, and Inrix — it’s all B2B,” Frei said. “It would be very difficult for people to stop using our software. It’s running their business.”
If the economy tanks, fewer people will use Uber — there won’t be as many folks going to work in the morning or dining and drinking in the evening. But the same can’t necessarily be said about Smartsheet or Apptio. Uber’s product costs people money; Smartsheet and Apptio might save companies money.
All told, any troubling trends in the startup world are in their early stages. There are more than 130 unicorns in the world, but that’s a small number when you consider the total number of startups. Mutual funds are investing in these companies, but only to a small extent. If there is another tech bubble underway, a burst tomorrow wouldn’t have an effect of dot-com magnitude.
“The big difference between ’99 and now is that the bubble was in the public market,” Ignition’s Myhrvold said. “Today, the bubble is in the private market. I believe that’s superior because it’s a lot harder for the private market to take down the public market than vice-versa.”
When the VC money does dry up — it will happen eventually — and startups have to liquidate in some fashion, an interesting dynamic will play out. Either Uber and the Uber-for-X startups like Drayton’s will realize success, or they will fail, joining Drayton’s former startup, HomeGrocer, as chronological markers of a failed market.