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How easy access VC funding has softened the startup world

TechCrunch TechCrunch 4/04/2016 Michal Stencl

The last decade has seen a period of extremely high venture capital activity, with a record peak of investment reached in 2015. This period of high VC investments has led to many amazing new products and companies, but it also has sparked a “Hollywood” era of high spending for early-stage companies.

This glitzy big-budget period in Silicon Valley and further afield led influential tech investor Marc Andreessen to predict that unless young companies begin to curb their flamboyant spending, they risk being “vaporized” by a crash or market turn.

Seasoned entrepreneurs who grew their companies before the age of open-plan offices and meditation sessions may well say that startup culture has become soft. So how much responsibility for these changes do VC investors hold? And how hasstartup culture changed as a result?

The root of the problem

The post-dot-com bubble crash period has seen a massive surge in venture capital investment, which peaked in 2015 with an incredible $59 billion invested — more than twice the amount of total investment witnessed in 2010 — with much of this fundinggoing to early-stage tech startups with amazing ideas and products, but without established customer bases.

Whisperings of a tech bubble developing were heard as far back as 2010, yet VC investment continued to grow to dizzying new heights until the end of 2015. Why? Because of inherent flaws in the whole venture capital system.

Unlike with angel investors, VC investors are not motivated by negative motivation. Negative motivation in business is — put simply — the fear of losing something. At current, venture capitalists are gung-ho with their investments as they are not risking any of their own money.

VC’s motivation to invest in startups lies in the fact that they are paid depending on the total value of funds invested, rather than based on the real ROI from these investments. On average, VCs earn roughly 2-3 percent of the total funds they are managing. As a result, there is almost zero risk for VC investors, who can invest freely and still receive extremely high wages at the end of the year, regardless of how many of their startups have crashed and burned.

The negative effects on the startup culture run much deeper than opulent offices and free organic coffee.

Consequently, the past few years have seen multi-billion dollar evaluations of companies, such as GrabTaxi, Southeast Asia’s answer to Uber, which received a $1.6 billion valuation — and $890 million in equity funding, despite only having 620,000 monthly active users.

These ludicrously high valuations have a butterfly effect, as other VC’s benchmark with each other, basing valuations on the figures set by other companies with similar profiles, rather than realistic predictions of revenue and growth. The result, more high early-stage funding, and more companies added to the vicious circle.

How startup culture has been softened

Traditionally, the initial growth stages of a company of any shape or size, be it a sandwich shop or Silicon Valley startup, have been characterized by back-breaking hard work, skeleton teams working long hours for low pay and shoe-string budgets, as the company tried to establish itself, build contacts and develop a customer base. However, a walk around Palo Alto today reveals a very different story.

The huge investment in early-stage startups has seen a “Hollywood” era of high startup burn rates, with startups “living fast and dying young.” Early-stage companies with bursting bank accounts spend exorbitant amounts on modern offices, high salaries to attract the best staff and new age perks for employees, which one billionaire VC investor scathingly described as “window dressing.”

The situation has been further compounded by the emerging tech talent shortage. Demand is outstripping supply for professions such as data scientists, IT workers and programmers, and the amount of professionals going freelance is rising quickly, and offering huge salaries of $200,000 plushas become the norm.

Industry experts warn that this is attracting the wrong employees, a new breed of high-paid, in-demand mercenaries who companies are constantly at risk of losing to a better offer. Miriam Diwan, co-founder and CEO of NowMoveMe, states: “The employees looking for Facebook or Google levels of perks are not the best fit. The early years are a complete roller coaster, so it’s essential to have a team that’s in it for more than that.”

Huge salaries, grand offices and added perks like massage sessions, gym memberships and free transport don’t exactly fit with the traditional image of hardworking, cash-tight early-stage businesses, and rely 100 percent on the life-source of huge investments from VC firms.

This creates a vicious circle, as high wages and fancy offices force competitors to match these to stay competitive, and cause rent prices in startup areas to skyrocket.

Startup founders will keep on accepting this “free money” for as long as it is offered.

However, the negative effects on the startup culture run much deeper than opulent offices and free organic coffee. The luxuries offered by the influx of easy capital distract companies from their big wins and cause them to focus on little wins such as snagging the best staff, open-plan offices and office Segways. Put simply, instead of focusing on the superficial “window dressing,” startups should be developing products and selling them to real customers.

The future for these companies looks bleak. Research from the Startup Genome finds that 90 percent of early-stage investment startups fail mostly due to “self-destruction rather than competition,” as they try to obtain “the cart before the horse.” The root of the problem lies in premature scaling, when a company skips natural steps in progression due to an influx of capital, and tries to evolve too quickly, spending money they aren’t earning, hiring staff they can’t afford and trying to acquire new customers when they aren’t ready to do so — none of which would be possible without “free cash” from VC investors.

According to John Cook, companies that scale properly attract more capital and customers, and eventually hire more employees. Based on the Startup Genome report, none of the startups that scaled prematurely passed the 100,000 user mark.

None of the extravagant spending outlined above would be possible without the seemingly free-flow of VC investors biting at the bit to throw money at tech startups. Unfortunately, there is no quick fix for this problem. The damage has been done, and changes will not really come around until the inevitable crash occurs.

In the aftermath, thousands of startups will crash and burn; hopefully lessons will be learned. As interest rates rise, VC funds will invest less into the market and the valuation of companies will decrease as venture capital investment slows dramatically. As capital becomes more expensive, less money will flow into startups, instead flowing back into banks.

As things stand, regardless of the warnings, startup founders will keep on accepting this “free money” for as long as it is offered. The weakening of startup values is all part of a vicious cycle related to VCfunding, which simply won’t change unless negative motivation plays a part in enterprise investment.

There is no magic wand to fix the problems that are seen throughout the startup ecosystem, but times of economic hardship and tight belts are sure to set companies on more traditional startup values, and more natural paths of growth and progression.

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