We’re gonna need a bigger round...

After 15 years of staggering declines, the cost of building a company in San Francisco is rising sharply

By Sarah Lacy , written on July 30, 2015

From The Money Desk

I moved to San Francisco in the peak of the dot com bubble.

As a result, for pretty much my entire reporting career the story in Silicon Valley has been “the cost of building a company is decreasing.” That was not only driven by the gigantic decrease in wages, real estate and free spending that came with the crash. It was helped also by technology.

Thanks to plummeting server costs, AWS, open source software, outsourced talent, new platforms like the iPhone— the commonly cited stat is that the cost of starting a company fell by about 90% from the late 1990s to the dawn of Web 2.0.

That fall has had insanely complex, unpredictable, and mostly beneficial ripple effects. There was the rise of incubators and seed funds and even the viability of something like AngelList. Startups could get to product so much cheaper than ever before, they could put off the hassle and time of raising a Series A until they knew they had something. As a result, founders were able to own way more equity and have far more control over boards than ever before. And as a result of that, founders were able to take money off the table in later stage funding rounds, because they had so much equity to give.

I could go on-- and I have for the past ten years, in nearly any analysis piece about funding trends.

But now, for the first time since I started covering Silicon Valley, I’m able to write the following sentence: The cost of building a company in San Francisco is substantially increasing.

This increase is changing the economics of the industry, slightly but importantly. I don’t just mean capital efficiency. We all know deal sizes and valuations are up. As reported before, companies are half as capital efficient today as they were a year ago. And most VCs— while railing against high burn rates— have blamed entrepreneurs for being too aggressive, too wasteful, buying market share in unsustainable ways. Essentially, making the choice to spend more money simply because they could raise it.

But yesterday at lunch SoftTech VC’s Jeff Clavier — one of the pioneers of the seed fund trend— described something different: “You used to be able to build a company and get it to Series A on $1 million. You can’t today.” He said the 2008-ish equivalent of $1.2 million is now $2 million. $2 million doesn’t sound like a lot when you have companies raising $1 billion in single rounds. But percentage wise, that’s a rapid increase in costs in seven years.

The biggest culprits he cited weren’t surprising for anyone living in San Francisco: Employee costs and real estate costs. One of his portfolio companies recently wrote an offer for office space in San Francisco at $85 a square foot, and they were told to up in and throw in warrants. The problem is the mega-corps in the startup world now are swallowing so much real estate, and nearly every industry— hardware, SAAS, consumer— is headquartered up here for the first time in Valley history. And the city is — yunno— only seven miles by seven miles.

Sure, you can always go to Oakland, and many companies are. But for a startup, that’s a risk too. With the competition for talent, a commute is in the con-column of any job applicant. That said, Clavier says he has more portfolio companies in Oakland than in Palo Alto— mostly because Palantir has made Palo Alto real estate untenable. (That’s gotta be a first for a top firm in Valley history as well.)

Part of this trend towards necessarily higher seeds is that it sets the bar to raising a Series A higher, given that previously low costs of starting companies has lead to such an explosion in the number of seed deals.

All of this is part of why the average seed deal is increasing. Seed funds like SoftTech and First Round Capital are encouraging entrepreneurs to raise larger seed rounds to clear all the hurdles for a Series A, and they’ve raised larger funds to make sure they can write them.

So what does this mean for entrepreneurs? Raise more while you can, $1 million may have been enough for your last startup but it won’t be this time. The crunch will come if funding ever dries up or valuations start to fall. Right now you can raise more at seed, and you can likely get a higher valuation commensurate with that.

Make the decision early on to be in the East Bay if you don’t want to raise enough to support the prices of San Francisco real estate. (Which will only increase as long as mega rounds and unicorns continue and thrive.) It’s much easier to set that expectation from the start, rather than tell employees they have to commute later on.