When The Funding Bubble Bursts It Doesn’t Have To Mean Disaster

Hold tight. Wait till the party’s over
Hold tight. We’re in for nasty weather
~Talking Heads, Burning Down The House

One law of economic physics always holds true: what goes up must come down. Last week, my pal Alex Wilhelm pointed out that winter’s coming to Silicon Valley, not in the form of snow of course, but metaphorically. He was reacting to Bill Gurley’s recent comments that many startups were burning through cash at an alarming rate and it’s not sustainable. They’re both right of course, the bubble’s got to burst sooner or later, and all signs point to it happening sooner, but I’m here to suggest, that the impact will be strongest on existing companies, while the startup cycle of life will begin anew, and it won’t take long this time.

If you think about when the bubble burst in 2000 and 2008, we had a vastly different technology landscape. In 2000, cloud services, especially cloud infrastructure for all intents and purposes didn’t exist. If you had a brilliant idea, you needed a ton of capital to get started because you had to build out your own datacenter –and if you grew, you needed to go hat in hand and ask for millions more. Even when the economy went into a tailspin in 2008, the cloud market was still very much in its infancy.

Today, you don’t need millions in capital to get off the ground or to keep growing. In fact, if you have an idea these days, at least for a software product, all you need is a laptop, a credit card and some programming skills and you can launch a company –and if it’s successful, the cloud infrastructure will scale as you grow. The outlook is entirely different in that regard.

In theory, a person with a decent job or some cash in the bank (or simply modest living requirements) could hunker down, get started and get the product off the ground with almost no capital, something that would have been nearly impossible when bubbles burst in the past. When the oxygen got sucked out of the balloon back in the day, we went into a dark, slow period.

This time, it doesn’t have to be like that. When the winter Wilhelm describes comes, chances are it won’t be as cold or as long as in the past due to a number of factors beyond access to cheap cloud services. For one thing, there’s too much capital and too much momentum for it to come to a dead stop, but surely we still need to pay attention to Gurley’s red flag because it can’t go on forever like it is now.

In fact, one Silicon Valley insider told me that Gurley was just expressing what everyone else has been thinking for some time, and because he’s so influential it finally got everyone’s attention. This person believes that something is going to pop the bubble, whether a macro event like an economic or political crisis or more likely in his view, a trigger event like one of those companies burning through cash finally running out of luck.

Once a high-profile company goes belly up, the dominoes will start to fall. First of all, he believes the public market companies like Fidelity and T. Rowe Price, which have been showing up as investors with increasing frequency in recent funding deals will exit the business. That will have the most serious impact on later stage startups in Series C and D which hope to IPO sooner than later. They will find it harder to get funding and build that bridge to the stock market the public market companies provided for them.

Meanwhile he believes at the other end of the funding spectrum, Series A and B will be fine, although companies will see smaller amounts than they have up until now. But let’s face it, when VCs are giving companies like Docker $40M when they aren’t even asking for it, it’s fair to say we have probably reached a tipping point. The question is how do you fill that gap between early stage and later stage money to grow between the phase where you want to move out of your parents’ basement and maybe hire some people, and the point where you need serious cash to take the company to a higher level.

Unfortunately, this is where it’s likely to get most tricky for companies. The capital will probably still be there, but it’s not going to be as plentiful as it is now and that’s going to present a challenge for those companies trying to make that transition from early stage to mid- and late-stage status.

The foreign capital markets could start to fill in some of these funding gaps. I’ve heard there are foreign investment funds with money to spend, but to this point they have been mostly shut out of the US startup market because there is so much money right now. A downturn could be an in for these funders and a saving grace for the mid-to-later stage startups.

It’s also important to keep in mind that even if this trigger event happens, and the capital markets begin to tighten, U.S. VC firms and others with riches from deals past will still have money to spend, no matter what happens. It’s just they are probably going to get smarter and much pickier about their choices. Right now, from what I’ve been told, firms are all but tripping over themselves to get companies in their portfolios, even when it doesn’t make any economic sense whatsoever.

One VC told me they were walking away from good companies because the numbers couldn’t possibly work, not when the competition was so fierce competitors were funding projects as much as 30 percent over value.

Look around at the multi-billion dollar valuations out there, several at more than $10+ billion, and it’s not hard to see why Gurley is so concerned. Surely, not all these companies can possibly continue to justify these kinds of valuations, especially companies that don’t have a well-defined business model or are at risk of commoditization.

It’s worth noting that one possible positive outcome of thinning the start-up herd is the talent market could loosen up. One industry veteran told me that when the dot-com bubble burst back in 2000, it freed up a lot of talent that had been locked into the late 90s dot-com companies, and that helped Google in its early days assemble a top-notch engineering team. A similar dynamic could happen here for the companies that survive.

I remember talking to an electrician who was doing work on my house during an earlier economic downturn. I asked him if it was difficult to get work because of the economy, and he scoffed telling me an economic crisis simply weeded out the hacks. Maybe it’s time for us to weed out some of those hacks too, but it’s also worth remembering that when the bubble bursts this time, it doesn’t have to be as bad in the past because you don’t need a ton of capital to start a business anymore, and those that are further along could have access to a variety of alternative funding sources they just don’t need to tap right now.