Pando

The death of network effects and the sad return of the VC kingmaker

By Sarah Lacy , written on December 7, 2016

From The Venture Capital Desk

Last week, FirstRound Capital released its annual “State of Startups Survey.”

It confirmed-- sadly-- that most men in tech don’t fully get the diversity problem, care about fixing it, or even see any complicity on their part in perpetuating it. Men blame it on that old “pipeline” of women in the industry, while more women blame it on unconscious bias.

But we knew that.

Travis Kalanick-- despite leading the most highly valued private company in Silicon Valley history and the most anticipated IPO-- doesn’t rank as one of the most admired founders.

But we knew that.

A decent chunk of respondents continue to fear IPOs, despite that being considered the optimal outcome for employees and investors when you raise venture capital. Some 31% simply said they do not “intend” to go public.

But we knew that. Google waited longer than those before; Facebook waited even longer; and Uber has waited even longer still. I guess in the future entrepreneurs will just wait… indefinitely?

The answers around the state of fundraising in 2016 were more interesting, more surprising, and more nuanced. They were also more revealing about deeper changes going on in the startup economy. A shift that has reversed the early 2000s trend towards capital efficiency, that’s once again concentrated power in the hands of VCs.

Witness:

  • Founders were at once bullish, in the face of the fact that the much promised collapse of a bubble never actually happened. Last year 73% feared we were in a bubble, now that’s down to roughly half, despite no real collapse in funding. One-fifth are “certain” their company will exit for north of $1 billion.
  • Founders were also deeply concerned about future fundraising, and founders argued power has only concentrated in the hands of investors. Last year 54% of founders felt this way. This year two-thirds of all founders believe VCs have more power in negotiations.

Well, which is it? Is it a good time to be a founder or bad time to be a founder? Welcome to 2016: Both.

I’ve been talking to investors for much of this fall about this shift in power, and the re-rise of mega-capital as the most important determiner in building the next unicorn or super-unicorn.

Among the concerns I’ve heard expressed: Everything we’ve learned about viral loops and growth hacking no longer works, network effects are in short supply, and that’s threatening a decade-long trend of greater entrepreneurial control and capital efficiency. Pattern matching is in; gut feelings are out. And Facebook, Google, and Apple are just too powerful to go around.

What works now? Cash. Shit loads of cash. Paying to acquire users. If you are like me, you see more ads for meal kit services, startup mattress companies, upstart apparel companies, Pelotons, and the like than anything else on Facebook. That’s because those kinds of ads are one of the only way startups are growing right now.

It’s a playbook people have been terrified to return to after the dot com bust, but it’s one that Uber has -- thus far-- validated. And the rise of corporate venture capital and the unending flow of international cash, is all too happy to keep funding it. Many -- including those on Uber’s own board-- have tried to sound alarm bells. It simply hasn’t worked.

The result? VCs are the kingmakers again in a way they haven’t been for the last decade.

Concern #1: Industry maturation and mega-transparency means no one is thinking for themselves anymore

“Financing is becoming increasingly important to success even as the sources of it are increasing,” says James Currier, an angel investor who also co-founded the NFX Guild, an invite only group of founders who focus on growth and network effects. “Funding is becoming more of a self-fulfilling prophecy. For psychological factors...investors [are] packing together because of familiarity and perceived reduction of risk, you’re getting these monster fundings, and starvation/drought nearly everywhere else.”

Currier doesn’t see this as cyclical, rather it’s the industry’s maturation. What happens when the Valley goes from a bunch of misfits creating a new way to fund and create companies with a few million bucks, to the multi-trillion dollar asset class “venture capital” is today. From counter-culture to culture.

He compares it to the maturation of Hollywood. From small, maverick studios to mega-corps who follow formulas and pander to China to get as close to guaranteed hits as they can. Call it “hacking” or call it “best practices.” Entrepreneurs are following the same tried and true tactics to success, which frequently involve a sack of money. Whoever can talk a good game on those tactics, gets the sack of money, and the sack of money is increasing determining success.

“Successful founders are using the same techniques, same learnings, same success factors for the last 12 years,” Currier says, citing things like iteration, A/B testing, the same growth tactics, and lean development. “For the 12 years prior to that, the successful techniques were being invented, so you couldn’t tell who might be a good founder...you didn’t know what would make someone successful. Now you think you do, because we’re into the second inning...This allows us to identify what we think are top founders… Then money naturally goes to the founders with a perceived lower risk, so top proven people can get piles of capital fast, while regular founders are having a hard time. Just like Hollywood.”

Disruption!

You absolutely saw this in the aggregation of top investors around DoorDash, versus Postmates. As we wrote months ago:

Postmates is clearly not the company that the Valley’s most elite forces-- TechCrunch, Uber, Benchmark, Kleiner, Sequoia, Y Combinator-- expected to win at on demand delivery. And if it does, it’ll be a sweet victory for every entrepreneur who didn’t focus on playing the game in the Valley, manipulating the tech press, or happen to conform to the young, Stanford grad, YC engineering centric ideal.

DoorDash-- not Postmates-- was the delivery company picked to be the winner by most of the Valley gatekeepers…

...Postmates didn’t conform to the norm; DoorDash did. DoorDash came out of Stanford and was engineering centric. Postmates was started by a German whose LinkedIn account paints describes him as more of a sales guy, founder, and project manager. DoorDash got the YC seal of approval, followed by the Sequoia seal of approval....And much of the tech press simply assumed YC and Sequoia picked right. 

After writing that story, I got several emails from a few prominent VCs who admitted-- anonymously-- that that over-reliance on “pattern matching” was exactly what they fell into in that case.

Currier also cites the instant transparency of things like AngelList, Crunchbase, blogging, and social media which makes everyone in the industry’s moves known around the world instantly. “So fewer people are thinking for themselves,” Currier says. “Because they don’t need to anymore. There’s more data, more signal available.”

In other words, that all important “gut” and “contrarian thinking” Silicon Valley has fetishized for decades is driving far fewer decisions than following, clustering, pattern recognition, and concentrating bets on a few mega-startups.

Concern #2: Winners are anointed by VCs and mega-rounds before a market even gets going. Cash has replaced network effects and economies of scale.

Consider the early Web 2.0 days when there was a revolution of quick and dirty startups, because the cost of company formation had just plummeted. There were dozens and dozens of “me too” companies in every sector that seemed hot. Hundreds of YouTube wanna be’s. There was Plurk and Pownce to take on Twitter and Tumblr in micro-blogging. Social networks for every vertical.

Contrast that to today. Let’s look at the deca-corns. There’s one substantial competitor to Uber. There’s no substantial competitor to Airbnb. Other than Facebook, there’s no substantial competitor to Snapchat. This is even more pronounced in the SAAS market. Is anyone other than Google, Microsoft, and Facebook putting big bucks behind a Slack killer?

First Round’s Josh Kopelman agrees that we’re seeing fewer “me too” companies, particularly after any company raises a mega-round. However, he points to the contraction of early stage funding as another driver in founders feeling like they’re losing power. “[The first quarter of 2016] was the hardest quarter to raise a seed round in the past five years,” he says. “And the most recent quarter showed a quarter-over-quarter decrease in seed and angel deals of roughly 13%. And it was the first time there have been fewer than 1,000 completed seed deals in a given quarter since [the fourth quarter of 2012]. My sense is that entrepreneurs are intuitively feeling that it is getting harder.”

To me, that goes hand-in-hand with Currier’s observations and his comparison of the Valley to the maturation of Hollywood. It’s all part of the trend of concentrating bets. For more than a year now we have seen the number of deals decreasing, while the dollar amount increases. Whether this feels like a contraction utterly depends on which company you happen to work at.

We’ve long seen a disparity in terms of how well a number one player in a category does, versus the me too’s. Again: Look at YouTube and compare it to MetaCafe or Vimeo. But in the past, that was largely because of the benefit of network effects that happened with companies like eBay and Facebook. Part of the concern is that some of the “real world” and commodity based businesses that are driving the Valley’s valuations today simply don’t seem to have the same network effects.

Consider a recent Naked Capitalism series, that expresses concerns Pando has been citing since last February about Uber: Its business model does not seem to be getting any better with scale.

Published financial data shows that Uber is losing more money than any startup in history and that its ability to capture customers and drivers from incumbent operators is entirely due to $2 billion in annual investor subsidies. The vast majority of media coverage presumes Uber is following the path of prominent digitally-based startups whose large initial losses transformed into strong profits within a few years.

This presumption is contradicted by Uber’s actual financial results, which show no meaningful margin improvement through 2015 while the limited margin improvements achieved in 2016 can be entirely explained by Uber-imposed cutbacks to driver compensation. It is also contradicted by the fact that Uber lacks the major scale and network economies that allowed digitally-based startups to achieve rapid margin improvement.

As Lyft’s investors have said-- and we’ve echoed-- that’s why Lyft is still in this race. That’s why Lyft isn’t MetaCafe. It’s why Lyft isn’t MySpace. It’s why Lyft is Pepsi. It’s why Uber’s number two executive, isn’t a technologist or an eagle-eyed operator, he’s a marketer. Lyft’s market share goes up and down based solely on how much it spends. Uber controls so much of the market, because Uber has raised and spent so much more.

“There are some economies of scale in transportation, but we know that once pickup times are under a certain time limit, consumers are indifferent on services and there is no ongoing economy of scale or network effect,” says CRV’s Saar Gur. “So one of [Uber’s] major advantages came from having a lower cost of capital.”

In other words: The reason Uber has so maximized its valuation, despite creating so much pressure on its eventual IPO and sending traditional VCs like Bill Gurley into fits. For Gur, this doesn’t speak to Travis Kalanick’s weakness as a CEO. It speaks to possibly his greatest strength: He got how much this game changed before almost anyone. That there was no network effect here. It was all cash.

And that game keeps escalating. This morning, I saw this Tweet observing that Uber is running ads against Lyft searches in the app store in an effort to purchase users at any price, in any place:

What stands out more are the categories where you still see a lot of “me too” investing, predominantly meal kit companies. While Postmates and DoorDash have consumed most of the money for general delivery, the “solving dinner” market has been the most overfunded segment in terms of number of deals in the mobile age.

Why? Part of it is a lot of the major VCs sat this category out early on, and the companies didn’t raise mega rounds at first.

“CEOs were either not interested in raising more money until they got certain proof points and/or they were not able to raise the money and so the space ended up with no clear mega-winner,” Gur says.

To wit: $135 million of BlueApron’s $193 million raised to date came in its Series D. The lesson is clear: If you want to avoid wasteful spending, raise a shit load early. That comes with the trade off of control and ownership that entrepreneurs have enjoyed since capital efficiency plummeted in the early 2000s, which puts VCs in the driver’s seat once again. Whoever gets that first mega round, will only get more capital while the rest of the entrants starve.

“In the fitness space, Classpass smartly purchased FitMob so that it would not have to compete on the supply side or compete with marketing dollars on customer acquisition,” says Gur, who is an investor in Classpass.

This is new to consumer. But Gur notes that this wave is what’s been going on in enterprise software for decades: Serial entrepreneurs have much more of an edge in enterprise, because the playbook is so similar from wave to wave, company to company. There aren’t weird fads, that drive success, nor is it driven by network effects or economies of scale. Startups make software that other companies want, and they buy it. You find product/market fit and block and tackle until you grow large enough to get public.

For all the talk in the early 2000s that SAAS was a cheaper, more democratic way to build software companies, that mostly didn’t prove the case. Out of thousands of entrants in those early days, Salesforce and Netsuite were two of the only ones that built major multi-billion dollar companies. And it took a lot of time and a lot of money.

“In these markets, the category leaders often accrue a huge premium in valuation relative to the number two, which lets them hire more salespeople and market more, which lets them raise more money at a higher price,” Gur says.

Sound familiar? Swap “hiring salespeople” and “marketing” for paying driver bonuses and subsidizing rides, and that’s Uber. Years after the “consumerization of enterprise” was tossed around to talk about better user interfaces and more grassroots user adoption, the industry is seeing an “enterprise-ation of consumer” in terms of how these companies are funded and grow.

Concern #3: Apple, Facebook, and Google control consumers. Pay up or lose. Raise a mega-round or die. Either way, entrepreneurs make less; VCs control more.

This gets us back to dominance of growing through cash these days. One reason for that is just how dominant Google and Facebook have become-- and stayed. “There aren’t 1,000 ways to acquire customers in a scalable manner,” Gur says. “Head-to-head competitors often end up bidding up media.”

We’ve written before about the uncommon dominance of Facebook, Google, Apple, and Amazon -- years after they went public. These companies’ largest problems are how to spend their cash, and they are jockeying to become the first trillion dollar market cap companies one day, as they vie for every industry in the realms of atoms and bits.

There’s precious little white space for startups between Google dominating data, Facebook dominating people, Apple (and Netflix) dominating entertainment, and Amazon dominating logistics and things.

But the stranglehold on customers through the app store, on Google or on Facebook-owned channels is a double-fuck you to would be spoilers. In a world where the new used to continually disrupt the old, the dominance of Google and Facebook are destroying the capitalization, ownership, and playbook of the young.

Whenever these companies finally have to go public, will that show up in the results?

[Disclosures: Josh Kopelman and James Currier are both investors in Pando.]