burning-money

The tech world has been put on notice.

Shortly after Benchmark’s Bill Gurley expressed concern about the tech community given bloated cash burn rates and valuations of companies, a16z founder Marc Andreessen expressed even stronger trepidation with the industry, offering up terms such as “vaporize” and “worry”.

Coming from industry titans like Bill and Marc (along with USV’s Fred Wilson who relayed similar sentiments), these words carry substantial weight. Not surprisingly, bubble whisperers have increased exponentially within private market circles.

While I’m not interested in tackling bubble talk here, I do want to double click on the core issue surfaced by Bill and Marc. Without a doubt, they are right. Companies that continue to punt on basic core principles in blind pursuit of rocket ship growth are playing a dangerous game of Russian roulette.

And while the companies they were referring to were primarily mid-late stage companies, the reality is that the burn bubble is found at all stages of development, with hiring and expending occurring at alarming rates.

Obvious but nonetheless ironic, the cash burn bubble is unmistakably enabled by the capital funding environment. Companies of course can’t incur massive cash burn rates without investors first lining up their vaults. Through the lens of behavioral psychology, people (and companies) typically operate at near capacity of the means they are enabled.

I’ll use an analogy to illustrate.

In the 1950’s, the average adult in the United States weighed 26 pounds less than the average adult today. That said, it’s no surprise that one of the biggest problems we face now as a nation is rampant obesity – Today 78.6MM Americans are classified as obese. While many factors undoubtedly play a role in this, the striking factor is the massive increase in portion sizes, as depicted by the chart below.

cdc-new-abnormal-infographic

Countless studies have provide a direct correlation between portion size and consumption behavior. More surprising however, recent studies have revealed that higher consumption rates have been recorded with larger portion sizes even when the consumed food was severely disliked! Behavioral scientists associate this phenomenon to evolutionary genetics – our minds, which retain survival instincts from the past when meals were scarce, still trigger us to consume as much as we can when offered the opportunity.

This takes me back to the original issue. In the first half of the 2014 of this year, ~$23B was funded by VC’s into companies (life science companies included in the #). Keep in mind this number does not account capital funded through private late stage focused hedge funds, angels, corporates, and crowd funding platforms. Contrast this with 2010, when $24B was funded by venture capitalists during the entire year, with relatively little capital flowing in from hedge funds and corporates.

Yep, the portion size theory applies to the tech market as well – it’s basic human psychology. Not convinced? Try to walk around with a hundred-dollar bill in your pocket for 30 days without spending it. Coming from someone who rarely uses cash, a hundred-dollar bill for me is gone within a week, and invariably spent on items I would not otherwise purchase.

Let me extend this to the tech industry through a story.

A CEO friend of mine that I deeply respect, called me recently after closing a relatively large seed round at a very friendly valuation ($10MM+). I asked him what his plans were post-financing and he told me that it was too hit the all systems go button on hiring and marketing in advance of a planned Series A in 2015. He further went on to say that he wanted to raise at least $8MM in his Series A as anything less “would be a sign of weakness” in today’s market. And while he was savvy enough to recognize that the top venture funds needed to engage in larger series A rounds for their own fund portfolio construction requirements, I couldn’t help shaking my head around the core premise he was using to formulate his strategic business plan. After all, here was a company that hadn’t really achieved true product market/fit, and up to this point had made phenomenal progress with a very lean operating model. In fact, the beauty of his company was a business model that didn’t look to require much capital at nearly any scale.

After some thought, I realized that the current seed and Series A landscape (portion size) had triggered an evolutionary reaction in him that had nothing to do with his business (appetite). The implicit message the friendly seed round had provided was “you’ve made it and it’s now time to eat”. His understanding of  today’s super-sized A round market further solidified this message. He knew that in order to get there, the business was going to need to hit certain growth and revenue metrics, especially with the hordes of other start-ups exercising hyper growth strategies. Whether he was doing this in a way that was conducive to long-term business sustainability wasn’t driving his decision-making – keep in mind that this guy is borderline brilliant. It was clear that the capital supply had triggered an innate behavioral reaction, and his business logic around his plan represented simple rationalizations of a decision that was unconsciously already made.

His business might ultimately work out fine. But it might not. Regardless, excessive risk will be taken.

At any rate, the root issue of the excessive burn rates is far more involved than heaping blame on the management teams that incur high burn rates. Equal culpability should be assessed to investors and, to our basic behavioral instincts. Of course, appropriate burn is undeniable a necessary means when creating truly disruptive businesses.

Sometimes getting to the right number requires us challenging our visceral coding.

 

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