Employee Equity
Valuations

Startups And The Big Lie

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Gillmor Gang LIVE 07.25.15

A startup is hemorrhaging cash, and the VCs have yet to agree on terms for a capital infusion. The clock is ticking until deadpool, first weeks away then days. The founders, stress levels increasing to stratospheric levels, continue to sell their company to everyone, whether investors, employees, potential employees, or clients.

They have little choice. Funding is contingent on growth, but that growth can only happen if no one really understands the funding situation. Founders have to tell the lie – that everything is fine, that a feature is going to launch even though the engineer for that feature hasn’t been hired yet, that payroll will run even though the VC dollars are still nowhere on the horizon.

Lying is a requisite and daily part of being a founder, the grease that keeps the startup flywheel running. No one likes to put it that way of course. Instead, we use phrases like “hustling” and “fake it until you make it” to make the idea of lying more palatable. “Information control” is among the most important skills a founder has traditionally needed for success, and these euphemisms change nothing of the daily behavior.

But times are changing, and everyone is getting more sophisticated about startups. People know what questions to ask, and are not afraid to aggressively probe to get the answers they seek. That means that some of the key myths about success in Silicon Valley are at risk. We need a new transparent approach toward information, but we also need to understand that startups are inherently risky – and accept the lies as they come.

The Ignorance Bubble

Startups run on an alchemy of ignorance and amnesia that is incredibly important to experimentation. Most startups fail. The vast, vast majority of startup employees will never exercise their options, let alone become millionaires while doing it. Mathematically, talented individuals are certainly better off financially going into a profession or working at a large tech company, where pay is higher and more secure.

That’s not a lot of fun, though, is it? For one of the most hyper-rational populations in the world, Silicon Valley runs off a myth about startup success, of the lowly founder conquering the world. There are examples of this success obviously, but the probability distribution clearly shows that the company you start will almost certainly end up in the graveyard of bad ideas. Yet, we focus almost exclusively on the successes and not the failures, because that is the model of what we want to become.

This is Silicon Valley’s Big Lie.

Lying is inevitable in our industry – it’s unbelievable that founders can take a company from a few users to billions, and yet, it happens. Without a fake veneer of confidence, no sales would get done, and we would still be stuck with the tech of the 1970s. Hubris is in many ways a necessary quality to get a startup into orbit.

Unfortunately, this sort of lying isn’t as easy as it used to be. Gone are the days where sales targets and employees wouldn’t really understand the status of a startup venture firm or what questions to ask. Salespeople these days are peppered with questions about venture capital rounds and company stability, leading founders to try to legitimize as quickly as possible through fundraising.

As my colleague Connie Loizos wrote last weekend, employees are now asking questions about liquidation preferences and participating preferred shares before joining a company, forcing founders to confront the very real possibility that they can no longer just use a dose of confidence to get them out of that chicken-and-egg growth problem. People want to read the damn term sheets!

We have pierced the ignorance bubble, but that is leading to a whole new set of challenges. When people know more about a topic, they become more critical. Yet, focusing on the liquidation preferences misses the whole point about startups: it’s the process of believing that turns two people and a laptop into a global powerhouse.

Our Declining Infrastructure For Massive Succeess

People are getting smarter in part because they have to. The infrastructure for success for employees in Silicon Valley is becoming increasingly damaged. Not so long ago, if you joined a startup in the early years and it sold for north of a billion dollars, you might not be able buy an island and retire, but you at least could be assured of a beautiful home in South Bay and enough left over to maybe start your own experiment.

Today, a confluence of events imperils that dream. Valuations are spiking much earlier these days, which means that employees are getting their equity at much higher valuations than they have in the past. When a company is already a unicorn in its early years, there just is not that much additional room to grow in valuation to create the sort of millionaire factory that Google and Facebook’s early employees enjoyed.

It gets worse though. As Aileen Lee noted in her update on unicorns last weekend, the average capital efficiency of startups has markedly decreased in the past year. That doesn’t bode well for employees. Companies are avoiding the public markets by raising increasing levels of private capital, diluting employee equity. Plus, the liquidation preferences really do stack up, limiting the potential upside in a decent but not spectacular exit.

Finally, even when an employee does get early options and the company’s valuation zooms upward, they often get screwed by a Faustian bargain that requires them to pay taxes on their options even though they can’t exercise them to get the necessary cash. Uber is just one example of a company that has taken a hardball approach to its employees selling early in this manner.

Startup employees are seeing all of this in the market right now. They have friends who have been burned by startups, and the dense professional networks ensure that the most obscene cases travel quickly in the ecosystem. Our collective ignorance about startups and their financials is catching up with us, and we are solving it with cold, hard logic and a dose of realism if not cynicism.

Rebuilding Faith Through Transparency

We no longer live in a world where people lack the basic vocabulary to understand the health of a startup. There are so many panels, seminars, events, and info sessions describing what is going on, that we as a region have made people far more savvy consumers of startups. Every founder and investor is now facing a much more informed population, who are more than willing to cut off a negotiation if the numbers aren’t where they want them.

More transparency is the only way forward. Founders can’t expect to hide the term sheets and their liquidation preferences from employees who ask. The best startups won’t fear telling potential employees, and so the the answer to the question will simply become a screen on the health of a business. Informed employees have a right to know what they are getting into.

However, we still need that Big Lie to function. We still need to dream about the possibility of success in order to realize it. With greater transparency comes a responsibility on the part of everyone in the startup ecosystem to understand and empathize with the plight of founders trying to build their companies.

There is almost always a chicken-and-egg problem when starting a business. The very act of hiring an engineer may be just the last push needed to get a fundraising round done and secure the next few months for a startup. We can rationalize startups all we want, and read the cap table and preferences and run exit scenarios. But at the end of the day, we all have to believe in the success of a business in order for it to become true. Success is built, not modeled.

We used to do that by default through ignorance, but now we need to consciously commit to that through faith. That means we need to accept the overconfidence of a founder, even when the math isn’t completely adding up. We can now detect the lies better than ever, but now we might just have to lie to ourselves if we want to see startups succeed.

Featured Image: Scott/Flickr UNDER A CC BY-SA 2.0 LICENSE (IMAGE HAS BEEN MODIFIED)