Throwing Rocks at the Google Bus: How Growth Became the Enemy of Prosperity (24 page)

When investing gets so separated from real economic activity, finding funding for a company—without falling into the growth trap—is hard. Entrepreneurs must play the same abstracted game as investors but from the other side of the board.

One of the smartest technologists I know, a young woman from the West Coast I’ll call Ruby, decided to launch a company on a whim. She
was not interested in making money or even promoting a new technology; she wanted to test her theories about how the ebbs and flows of the startup market worked and whether she could win at the game by getting herself acquired.

So Ruby did exhaustive research on emerging interests and keywords in the technology and business press, as well as conference topics and TED subjects. What were venture capitalists getting interested in? Moreover, what sorts of technical skills would be valuable to those industries? For instance, if she concluded that big data was in ascendance, then she would not only launch a startup related to big data but also make sure she created competencies that big data firms required, such as data visualization or factor analysis. This way, even if her company’s primary offering failed, it would still be valuable as an acquisition—for either its skills or its talent, which would be in high demand if her bet on the growing sector proved correct.

She ultimately chose geolocation services as the growing field. She assembled teams to build a few apps that depended on geolocation—less because the apps themselves were so terrific (though she wouldn’t complain if one became a hit) than because of the capabilities those apps could offer to potential acquirers. Working on them also forced her team to develop marketable competencies as well as a handful of patentable solutions in a growing field with many problems to solve. The company was purchased, for a whole lot, by a much larger technology player looking to incorporate geolocation into its software and platforms. The employees, founder, and investors who believed in her are now all wealthy people.

Ruby is not cynical; she is a hacker by nature, and merely gamed a system that she knows is already a game. She reverse engineered a startup based on market conditions, industry trends, and nascent investor fads. I asked her if she could do it again—with me as a partner or investor this time. She shook her head. “I’m glad I did it, but it was kind of boring,” she replied. “Besides, we’re at the wrong moment in the cycle right now. Maybe next year. If you need funding for anything in the meantime, though, just let me know.”

Her success may be unique in that she did it as a fun experiment, but Ruby’s approach of retrofitting a company to the startup market is all too common. The smartest hackers understand that their skill at hacking technology may be less important than their skill at hacking the digital marketplace. To them, it’s all just code—and even if it’s not, it’s more like code every day. The economy is less a place to create value than a system to game. Hell, everyone in finance and banking is already gaming the system, extracting money from what used to be the simple capitalization of business ventures. Why not create business ventures that game the gamers at their own game?

Besides, most young technology entrepreneurs who come out of college with an idea they truly believe in quickly learn that getting capitalized means sacrificing whatever vision they came in with to the priorities of the investors’ game. It’s a slow, disillusioning process. Most fail, but failure usually reinforces the need to submit to the game more fully next time. Like devotees of a quack healer, they decide that their poor results must be their own fault and not that of the crazy system to which they have committed themselves and their futures.

The startup game hasn’t always characterized Web development. Back in the early days of the net, hackers would create companies almost accidentally. This was the slacker era of the 1980s and early 1990s, when software wasn’t particularly valued and life wasn’t particularly expensive. Developers could gather in someone’s garage and live on pizza and soda as they wrote software and games or prototyped devices and hardware.
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These were generally ideas that could not get investment capital because they depended on consumer demand that didn’t exist yet.

Two kids and a decent computer didn’t really need capital to build the next big thing. And while their inventions changed the culture, the companies created by Steve Jobs, Steve Case, Bill Gates, and Mitch Kapor made millionaires out of their founders and first employees. Sure, there were a few friends and industry insiders who had thrown in a little seed money and reaped real rewards, but the process was opaque to the vast majority of the investment community, who were generally shut out of all
this until shares became public. By then, many of the companies had peaked, anyway.

As in any pyramid scheme, the real money gets made by those who get in early. So existing venture capitalists, as well as scores of freshly minted ones, came on the scene. This was the late 1990s, when
Wired
said we were in the “long boom,” and the Internet development landscape had taken on the quality of a second California Gold Rush. Finding an “angel” with ready cash was easier than finding a kid who knew how to mark up a Web page.

Over the next decade, a basic playbook was established for how a startup gets to IPO or acquisition. Get an idea in college, find a programmer in the same dorm, build a prototype, write a business plan, present it at a conference, do an “angel round,” hire a couple more programmers to get to “minimum viable product,” raise a “Series A” round of investment, launch on the Web or App Store, achieve or manufacture huge numbers, write a new business plan with some scalable vision, raise a “Series B” round (if you absolutely need more funding), then get acquired or do an IPO. Terms such as
angel round
and
Series A
are now as common in programmer vocabulary as
client
and
server
. And, as young college-dropout CEOs quickly realize, this business vocabulary is more important than coding languages to their success in the startup game.

At one well-meaning Southern California fitness app startup I visited regularly, the young founders held weekly meetings at which the chief technology officer would educate his engineers on different aspects of the development process. But as time went on, he grew less likely to lecture on programming biofeedback interfaces than on business strategy. It was as if he had cracked a new sort of code. He spoke of scalable solutions, long-term contracts, and high switching costs—steps they could take to ensure “defensible outcomes” and achieve a “platform monopoly.”

He had fully accepted the startup playbook’s emphasis on massive growth above all else and was now turning his tremendous capacity for programming toward that singular, highly limited ambition. The product was less important now than the prize. He and his partner were not in a
position to entertain a true disruption of the marketplace, anyway. They had won one of those pitch-your-idea contests by coming up with an idea literally overnight. The venture capital flowed in days later, and these kids were—like so many other young entrepreneurs who accept tens of millions of dollars up front—obligated to build a company worth a billion dollars.

That’s the big conundrum facing developers today, and the reason we see so little technological development that goes against the dogma of platform monopolies and other “defensible” outcomes. As we saw with Uber, it’s not enough for an app to support a sustainable business; it has to have a path to owning its entire marketplace, presumably forever, with a means to take over still others. Otherwise it can’t ever justify the venture capital it has accepted.

Early-stage technology investors aren’t looking merely to be paid back with a bit of interest; they want their winning picks to be multiplied
hundreds
of times. That’s because they know that only one out of a hundred may end up a winner, and that winner must offset the scores of losers. The earlier and correspondingly more risky an investment, the bigger the required upside. Angel investors, generally the first ones in, may spread out a million dollars over hundreds of different startups—a shotgun-spray approach to high-stakes, low-probability investing. The winning investment must end up paying back at least a million dollars. But to do that, the company has to be worth a whole lot more than that.

Let’s say five angels each put $10,000 into a company in return for 5 percent ownership. That’s a $50,000 total investment. But the founders want to keep half the company for themselves and their employees, so that means it must begin with a valuation of $100,000. For the angels to earn one hundred times their money, the company must get to a valuation of $10 million before executing an “exit” through which the investors can sell their shares.

Of course, most companies can’t exit at that point, anyway. They barely have a product or market yet. The $10 million valuation is based on how promising the company looks to the press, analysts, and the next
round of investors. That round, the “Series A,” is where bigger venture funds come in. These investors may put in several million dollars, this time according to a company valuation of $10 million to $50 million. The investors at this stage make a similar calculation, spreading their tens or hundreds of millions of dollars across a wide range of startups. They may hope to limit their downside by developing a “thesis” about the kinds of companies they think will succeed, such as “social smartphone apps,” “gamified sharing economy,” or “health, medical, and fitness entertainment.”

But in the end, venture capitalists invest with low expectations of any single company surviving. Their business model is still based on the rare big winner offsetting a dozen or more losers. If they invest $10 million in a company at a valuation of $50 million, then they need that company to become worth
half a billion dollars
in order to see a $100 million return. Even at that, such a return is hardly capable of offsetting the losses throughout the rest of the portfolio. A “win” of that size is the minimum they can justify. In the gamified lingo of the venture capital firms, they can’t settle for a “single” or a “double” but must push for a “home run.”

That’s why those firms usually demand a seat on the board of directors, from which they can steer company policy away from moderately successful outcomes and toward winner-takes-all conclusions. Most venture capitalists would rather drive a company into the ground than let it settle in as a sustainable operation. As long as there is a chance, however small, for a company to become a billion-dollar supersuccess, the investor would rather push on. This means abandoning even surefire profit models if they aren’t going to generate the outlandish returns required by the venture capitalist’s overall portfolio strategy. He or she would prefer to let the company die, squeezing out every possible megawin, than let it carry on as a moderately successful enterprise. Without a major exit through acquisition or IPO, it is worthless on the level that venture capitalists are playing the game.

I’ve sat in on more than one board meeting, watching as investors teach their young company founders about the realities of the startup landscape and why they have to shoot for the stars. Every company must
become the universal solution in its vertical—or more.
You are not just a personal health app; you are the platform through which all health apps will be executed! You are not just a game; you are a gamification operating system and social network!

A company is not allowed to reach total dominance incrementally. Venture capital is not patient money. If a company doesn’t hit in two or three years, it’s considered cold and may as well not exist at all. So instead of developing a long-term strategy, companies make quarterly and semiannual plans—each with its own fantasy megaexit. If they don’t get immediate traction, they are supposed to “pivot” to another option next quarter, again and again, until they either hit the jackpot or spend all the money that’s been invested. The speed with which the startup burns through its pile of investor cash is called “burn rate.” The more employees a company takes on, the more attractive it is as an “acqui-hire,” but the faster the burn rate and the shorter the “runway” it has to reach liftoff. If it burns through the cash, it either dies or does another round of fund-raising—something the original investors approve of only if the valuation of the company is raised so high that the paper value of their initial investment actually goes up. The higher the valuation, the bigger the subsequent home run must be.

Throughout this whole period, the company must be careful not to show any revenue. That’s right: if a company starts taking in money, then it can be judged on its profits or losses. It starts looking like a business rather than a business
plan
. That can kill the all-important valuation right there. Instead, companies need to maintain pie-in-the-sky outlooks about
potential
revenue, once the universal promise of their technology or platform becomes clear to the world—or at least to a buyer like Facebook or Google.

Remember, the venture capitalists got burned by a lot of these kids early on—in either the dot-com bust or the first social media startup bubble. They did not understand digital technology or networking—only that there was something going on that would be big someday. They were forced to nod and accept whatever young tech mavericks like Steve Jobs or
Sean Parker were telling them. Not so anymore. Today, it’s the funders who call the shots and the young developers who hang on their every word. These kids, who may have been in a college classroom just a few weeks earlier, now treat their investors with the same reverence they once bestowed upon their professors. Actually, more.

So they accept the hypergrowth logic of the startup economy as if it really were the religion of technology development. They listen to their new mentors and accept their teachings as gifts of wisdom.
These folks already gave me millions of dollars; of course they have my best interests at heart.
After all, these are young and impressionable developers. At age nineteen or twenty, the prefrontal cortex isn’t even fully developed yet.
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That’s the part of the brain responsible for decision making and impulse control. These are the years when one’s ability to weigh priorities against one another is developed. The founders’ original desires for a realistic, if limited, success are quickly replaced by venture capital’s requirement for a home run. Before long, they have forgotten whatever social need they left college to serve and have convinced themselves that absolute market domination is the only possible way forward. As one young entrepreneur explained to me after his second board meeting, “I get it now. A win is total, or it’s nothing.”