The Hubris of Venture Capital - Pacific Standard

The Hubris of Venture Capital

It’s venture capital firms, not necessarily start-ups, that are lighting money on fire in pursuit of the next unicorn investment.
Author:
Publish date:
(Photo: Slack)

(Photo: Slack)

On a recent episode of the HBO television show Silicon Valley, the young start-up founder at the center of the story, Richard, finds himself in a dilemma. It’s the sort of quandary that many of us would dream of being caught in. When taking an initial round of investment, Richard has to decide whether his nascent compression algorithm company is worth $100 million or a fraction of that, figuring out how much investors will have to pay for a small slice of equity that thus far has only a very theoretical value.

Richard eventually goes with the fraction, deciding that it’s not worth the risk of failing to fulfill a massive valuation—becoming a unicorn, as Silicon Valley calls companies with a valuation of over $1 billion—and disappointing investors. Fact followed fiction last week as Stewart Butterfield, the CEO of Slack, a workplace chat environment, raised $160 million in funding for a valuation of $2.8 billion, a double-plus unicorn. The feat is almost unheard-of for a company less than two years old. The question is, is Butterfield falling into the TV show’s trap?

Slack’s funding is a hedge against future instability and an investment in its own operation that comes with little risk. On the other side of the equation, venture capitalists are risking a lot.

He clearly doesn’t think so. “This is the best time to raise money ever,” Butterfield told the New York Times. “I think it would be almost imprudent for me not to accept $160 million bucks [sic] for five-ish percent of the company when it’s offered on favorable terms.” In other words, if investors want to throw money at him because they think his company is the next huge thing, he’s not going to say no. After all, they just might be right. And if they aren’t? Their loss.

ps_break1.jpg

There’s an arrogance to the recent rash of venture capital flooding through the tech industry, which topped $48 billion in 2014, the highest level of Internet-specific investment since 2000, according to a report from MoneyTree. The software category, where Slack finds itself, was a particularly strong one for funding, increasing 77 percent over 2013 to $19.8 billion. As Butterfield suggests, the money is there for the taking, and if one company doesn’t take it, then funding will just go toward shoring up a different business.

In part, companies feel they need so much investment because running a start-up is extremely expensive. “Burn rates,” the term for how much money a company is going through, are topping $1 million a month even for digital start-ups with less staff than a more traditional company. That cash goes to paying salaries for developers who cost more than ever, kitting out deluxe office space designed to attract even more developers, acquiring server space to run massive online platforms, and buying ads that attract customers to a nascent service.

So perhaps hundreds of millions of dollars isn’t unreasonable. Slack’s funding “increases the value of our stock and can allow potential employees to take our offers, and it reinforces the perception for our larger customers that we’ll be around for the long haul,” Butterfield told the Times. The decision follows a rule of thumb for taking venture money. “What is okay is to spend money for productivity,” Sam Altman, the head of the Silicon Valley start-up incubator Y-Combinator, told Business Insider. “What is not okay is just to light money on fire."

Slack’s funding is a hedge against future instability and an investment in its own operation that comes with little risk. On the other side of the equation, venture capitalists are risking a lot. Marc Andreessen, of the highly respected venture capital firm Andreessen Horowitz, outlined his gamble:

We see about 3,000 inbound referred opportunities per year we narrow that down to a couple hundred that are taken particularly seriously. There are about 200 of these startups a year that are fundable by top VCs. About 15 of those will generate 95% of all the economic returns. Even the top VCs write off half their deals.

It’s venture capital firms, not necessarily start-ups, that are lighting money on fire in pursuit of the next unicorn investment. Hyping this risk has a way of exacerbating it, however. As more and more venture capitalists pile on, the product everyone is seeking isn’t so much an effective, profitable company as it is the idea of a sexy start-up itself. Getting a 100-percent return is boring. Being profitable, in fact, is boring, since it means a company might not be spending enough money to grow as large and as fast as it can.

The only way to win is to hit the jackpot, that 100-times return that happens with a company like Uber or Snapchat, both of which are feverishly raising and spending capital in a race both to sate their own ambitions and to placate their investors, who expect nothing less than to be buying in to a unicorn.

ps_break1.jpg

That the level of venture capital funding is the highest it’s been since 2000 doesn’t exactly inspire confidence, since the dotcom bubble is said to have popped right in 2001. In the long-term sense, however, Slack is in a good position. It obviously has plenty of money already in the bank should the well dry up. It also has over half a million customers paying for its service, meaning it doesn’t have to rely on fickle advertisers or media reach to survive.

(Photo: Slack)

(Photo: Slack)

In trying to replace work email and chat, Slack is creating an environment for digital connection far more immersive than platforms like Facebook or Twitter. It’s a holistic, interpersonal system that demonstrates some of the best advantages of the Internet, particularly when it comes to business. “Very quickly Slack embodies what makes a company unique,” Butterfield told me last year. “Slack is a conduit for culture.”

Yet optimism around the service and the viability of the business is tempered by a certain anxiety over the arrogance of venture capital. In trying to hit it big as much as possible, making ever riskier bets, the funding industry—distinct from the technology industry itself—is failing to publicly support initiatives that might do more than help us chat in yet another format. One can’t help but feel all those hundreds of millions of dollars might be better invested elsewhere. Medicine, for example. Food production. Or maybe ameliorating the ongoing environmental crisis.

Disruptions is Kyle Chayka’s weekly column for Pacific Standard about personal technology and the way it influences our daily lives.

Related