Pando

Get ready: We’re going to see more GigaOms, Quirkys, and Zirtuals. Here’s why...

The ugly downside side of the VC’s new “social game.”

By Sarah Lacy , written on August 12, 2015

From The Venture Capital Desk

There’s a shocking new phenomenon in Silicon Valley -- one we’ve seen occur three times recently…

A company backed by big names -- and in one case raising big money -- going bust and seemingly surprising everyone.

Over much of the last decade, it was taken for granted that well-funded Silicon Valley startups didn’t just die. Rather they faded away like Old Generals, whittling down their burn rates as they went to find a nice soft landing somewhere. Saving face has been elevated to an art form thanks to big tech companies always needing talent, capital efficiency, and connected investors. Many investors believed there was no reason that would change.

I’ve even complained about it before, arguing that failure has its place in a startup ecosystem. Oh boy. Careful what you wish for, I guess.

There’s one big reason this is happening-- and I think we’ll see more--  and it’s not necessarily escalating burn rates or plummeting capital efficiency, although clearly in some cases that plays a role. Rather, it’s a change in how boards of directors act in Silicon Valley. The sad truth is that in practice they don’t provide much of the corporate oversight they did in past cycles when investors owned bigger stakes, controlled multiple board seats, founders had less power, and it was very clear who worked for who.  

In March there was Gigaom’s surprising implosion. Some $30 million in capital just evaporated. No layoffs. No rumors this was gonna happen. No restructuring. In fact, they’d been hiring. The senior team had told us things had been going well, and that the research business was a huge success. Then: Poof! A roomful of (mostly now Fortune) journalists didn’t even spot it coming.

Last month there was Quirky-- the 12th most highly funded company from the New York ecosystem. While Quirky’s implosion looked a bit more like Fab’s than Gigaom’s-- the company still has some money in the bank -- it was more surprising and sudden to those on the outside in its severity. Dan Raile detailed the profligate spending and misapplication of the typical Valley playbook that brought the company to its knees.

But this was a company that had raised enough money it should have been able to see some warning signs, pivot, cut, or, at a minimum, downshift to a zombie company with a low burn even if it had low growth. As is, it was burning some $10 million per month.

Most recently, there was Zirtual, whose story we’ve been following this week and which has now been rescued, apparently for chump change if any change at all, by Startups.co. But that deal didn’t even happen before the company was forced to shut down over the weekend. It was more like GigaOm’s assets getting sold after the fact than it was any white knight coming to the rescue.

Think of other recent examples of hyped companies that failed: Rockmelt. Beachmint. ShoeDazzle. Path. Digg. Foursquare. We didn’t just wake up one day and they were gone. Some are still fighting it out. They batten the hatches. They change strategy. They raise a down round or flat round or inside round. They do interviews about why they are still bullish. It can go on for years.

More bedeviling: The three startups that have gone up in smoke all showed external signs that would lead any reasonably savvy investor, reporter, potential employee, or customer to believe-- surely-- they had more time. It’s very different than the cases above where the handwriting seemed to be on the wall for a long time.

In the case of GigaOm, they’d just raised $8 million a year before imploding, and GigaOm founder Om Malik was a partner at the company’s largest investor, True Ventures. The idea that the firm would simply let it go belly up was unthinkable… until that’s precisely what happened.

In the case of Quirky, the amount raised was even greater, and the investors who put the cash in had even greater pedigrees. They were the kinds of traditional VCs who take board seats. It should have had the most oversight of the three.

Zirtual certainly had more warning signs in hindsight. After its Series Seed the only cash infusions it got were debt, and clearly the company hadn’t been successful graduating to the normal Series A round. No big Valley firm had that much skin in the game.

But unlike the other two, investors in Zirtual had recently made wildly bullish statements on the company. Tony Hsieh highlighted it as one of three winners in the Vegas Tech Fund portfolio. And last Friday, by referring to the company as “we” as he tried to drum up new investment on his podcast, Jason Calacanis came perilously close to general solicitation…

"I think that we're set up for... like... what are we calling this? Is this a B? An A?  We have to get somebody who has a little bit of vision…"

It’s one thing to look at a company that seems like a fixture of the Web-- like GigaOm-- or a New York media darling that has raised more than $100 million -- like Quirky-- and be shocked that it’s suddenly gone. It’s another thing to hear from investors that a company is one of their “winners” or “sleepers” in a large portfolio just days before they are gone.

There’s plenty of speculation of what’s gone down at all three. Much of it seems to boil down to boring-old-mismanagement. Gigaom was lacking a CEO for months, after mismanagement by the old one and a shocking $500,000 in monthly debt payment and rent costs. Quirky was, as Dan Raile put it, spending fast and selling broken things. And Zirtual seems the most disturbing of the three: Sources we’ve spoken to say investors were misled and even lied to by the founders.

But it’s not enough to pass the buck onto bad, inexperienced management. Where are the professional investors? Most startup founders have never done this before. We’re all-- to one degree or another-- out of our depth. My board has saved me from my own bad judgement many times. So, where was GigaOm’s board? Where was Andreessen Horowitz when Quirky was blowing through a Series A a month? And why on earth would an angel investor who now admits he had no idea what was going on at Zirtual be publicly urging more VCs to invest?

Part of it is a change in capital structure: At the seed level people, syndicates and seed funds invest far and wide with very little skin in the game and almost no regular updates on a company’s health. At the late stage, hedge funds, sovereign wealth funds, and mutual funds are investing at huge valuations with no board seats or oversight in exchange. These are more like investing in public stocks that simply haven’t gone public yet.

That leaves VCs in a rapidly shrinking middle. Many VCs have started doing smaller more passive investments, rather at the seed round as in the case with Mayfield and Zirtual or later on as was the case with Accel and Beachmint. But many VCs are still taking 20% stakes and board seats.

So what’s changed there? The social game of being a VC. In an age where the cult of the founder is the highest I’ve ever seen it, Valley VCs are obsessed with what reality TV calls “the social game.” As Bill Gurley says, every time a VC’s lips are moving, he’s marketing. Given a failing company is going to be written off anyway, it does little good for a VC to look “anti-entrepreneur” by applying any tough love at all trying to salvage it.

Witness Sean Parker’s disastrous Airtime. One of the old school investors in the round advocated that the capital be returned and it be closed down. Not a crazy request: It clearly wasn’t working. But other investors were happy to play “the good cop,” saying they still believed in Parker and were happy to let the bet ride. And those good cops are making a savvy move. They’d already written that money off, and don’t get any blood on their hands. If it goes under quickly? So much the better. They can focus more time on the winners.

What a board does has just changed and there’s no one to blame because everyone in the Valley has been complicit in it.

But as burn rates climb and business is getting more competitive, we’re now starting to wake up to the hangover of a bad cocktail of marketing, spin, and cheerleading by “brand name” angels to prove some sort of “value add,” party angel rounds which means no one really knows anything happening at a company, waived board rights at nearly all levels of fundraising, and a sense that you can just write off the losers if you throw enough money around the Valley.  

The sad truth is many investors are no longer doing much more than writing a check, writing a blog post, and writing a Tweet that a team is “crushing it.” That’s not a bad thing necessarily. Most people in the Valley think founders should have more say in a company than investors who aren’t in the trenches every day. And some may argue these mismanaged companies would fail anyway. Better that they just explode. But investors would do well to remember, when they do, they take jobs with them.

Those justifications only work if everyone involved-- customers, partners, employees, the press, AngelList syndicate members-- all get how the game has changed.

Employees, reporters, and other investors beware: When someone tells you a company in their portfolio is doing great and you should totally invest, they may not be lying, but odds are they also don’t have the information to back that up. They aren’t making a statement as an informed investor. They are cheerleading to look good to the next potential deal.