The game has changed.
In April, venture capitalist Bill Gurley wrote an essay crystallizing what many VCs had been talking about for months.
Essentially, too many companies have taken too much money at unsupportable valuations. A lot of the money they raised came with huge caveats that would protect late-stage investors.
A lot of these businesses now have limited options, Gurley wrote. They can't raise more money from the private markets because their last rounds came with such strict conditions. They can't go public because their numbers aren't good enough.
Keith Rabois, a partner at Khosla Ventures, says:
In the steroid era of baseball, a lot of people were hitting 30 home runs and the perception was that wasn't that difficult. Well the reality is almost no one ever hits 30 home runs without using special supplements and the same thing is true [for startups]. And as you deprive companies or take away the steroids, it turns out that very few people can build transformative and disruptive companies that are worth billions of dollars.
So what happens next?
Business Insider spoke to eight leading venture capitalists about what the tech landscape looks like from their point of view --and where startups go from here.
The answer involves a lot of pain for founders, employees, and investors in the years to come.
Some founders will find that their VCs aren't so supportive anymore.
For the last few years, money has been easy to come by in Silicon Valley. Venture capitalists have been raising huge funds and have the capital to deploy. But now that startups are staying private longer, investors are faced with a choice: Do you put in more money to get a company off life support, or do you invest the same amount in a new company?
A lot will choose to pass the next time around:
I wouldn't say the easy money's gone, but the price of oxygen has increased. --Keith Rabois, Khosla Ventures
For a really really long time the VCs have been saying, "Oh, we're super founder-friendly, we're always going to support you." You've seen a lot of different funds tell the entrepreneur, "Hey the next round of financing we'll do a pro rata, but you've got to go get it." --Semil Shah, Haystack
Maybe we felt like the consumer pain point was so huge, and the potential for it to grow explosively high, so we might have overlooked unit economics ... Where today, we are focused on the unit economics/gross margin question. -;Nikhil Basu Trivedi, Shasta Ventures
The venture community has realized that a number of companies were funded at valuations that were far ahead of their fundamental progress as businesses, and that some of those companies are not actually that great fundamental businesses. --Alfred Lin, Sequoia
The success of companies like Facebook and Uber has created an obsession with fast growth in the Valley, and investors are largely to blame. Overfeeding a startup leads to poor decision making, because too much capital means startups don't need to prioritize. --Mamoon Hamid, Social Capital
Expenses will be slashed -- including head count.
Startups have been told to curb their burn, or how much money they spend each month. While some companies have cut visible perks, like house cleaning or free food, much of the reduction will come from laying off employees.
I know for a fact that -- I think this is a good behavior -- many, many companies in January, February, and March, basically got the s--- beat out of them by their investors. And reduced burn. I heard from a few CEOs that they almost reduced their burn by 60 to 70%. --Semil Shah, Haystack
I was talking to this exec from a company I won't name, it's one we're not in, she came from out of the area and had been at a big company somewhere else and was brought in to run human resources. And they had an Omelette station in the morning. The revenue model wasn't working, and there's 350 people. --a major Silicon Valley investor who requested anonymity for this article
The more impactful decisions if you look at burn are not food every day, they're people. So you start thinking about where do we trim? Where do we have fat in our organization? And the first to go is the trimming of the fat. Then in some cases, to make the business work, you have to go deeper into the muscle, and all the way close to the bone. --Nikhil Basu Trivedi, Shasta Ventures
One of the bigger costs with most of these businesses is people. Compensation of employees. That's a very hard lever to change. At some point perhaps salaries and comp-cash competition go down, but right now that's almost difficult to fathom. The second big cost is often real estate, office space for all these people. That's subject to a little more short-term market winds, and there's some corrections going on right now in commercial real estate in the Bay Area. But it would have to go down by another 30, 40, 50% to have a meaningful effect on many companies' burns. --Keith Rabois, Khosla Ventures
Some companies will fold.
As the pendulum swings from growth at all costs to building a sustainable business, some companies will get caught and die. If they can't show that their business can make money and are burning through much cash to not give a company time to correct it, then they won't survive the industry shift.
A number of companies will fail because they won't be able to raise a next round, they're just not great businesses, they're being outcompeted, they're losing money on every order. --Nikhil Basu Trivedi, Shasta Ventures
You haven't seen an avalanche of failures, but I think the percentage will be increasing. If you say there are 100, 150 companies, private, high valuation, a lot of capital, at least half I would say will end in unhappy outcomes. The other half may be spectacular successes ... One truly spectacular success does trump a lot of failures. I don't know that it's bad for venture investors, as long as you have a few of those big successes in your portfolio. That said, most investors don't, and can't. --Keith Rabois, Khosla Ventures
Startups that mostly sell to other startups will run into problems.
This is the time period when businesses really need to know who their customers are. There may be some companies where the unit economics work well for a certain customer base -- maybe the monthly subscribers or those who live in only dense urban environments. Those companies need to evaluate whether there is enough of a customer base for them to build a sustainable business, even if it means taking a down round to support it.
Others, though, may find that the economics of the business don't work regardless of how many ways you try to slice the customer base.
If startups identify that most of their customers are just other startups, then that could be a big problem if their revenue goes poof alongside the startup's collapse.
Within our portfolio, we've had discussions with all of our founders and CEOs about what percentage of your revenue is coming from companies that are venture-backed. If that's a high number what are you doing to change that? That may even be an issue for Facebook. There was a lot of discussion in Q4 that their top advertiser was Wish. --anonymous
There are good businesses that have SMBs [small and medium-size businesses], startups as customers, that are recurring revenue businesses that are must-haves for those companies. You can't just get rid of payroll system or your HR function to cut costs. We very much prioritize companies, if they are selling into startups, whether they're core, they're must-haves, they're daily habits and behaviors, versus things that might be just nice-to-haves. --Nikhil Basu Trivedi, Shasta Ventures
Large companies may swoop in, but only if it's strategic and at a discount.
Don't look for big companies to swoop in and save failing startups unless there's a really strong strategic fit and they can get a bargain.
Microsoft acquires where it's strategic. Google has retrenched a LOT on acquisitions in the new Alphabet structure, Facebook where something is particularly strategic on Mark's agenda and fits into Mark's vision ... Apple's always been a fairly reluctant acquirer. --Keith Rabois, Khosla Ventures
Billionaire businessman Mark Cuban argues that companies not going public only damage the ecosystem because they are looking for these sales.
When companies don't go public, the VCs still need their exits. So they sell their company to their bigger, already public competition. This reduces jobs and worse, it kills competition. Instead of having and up and coming public competitor, they use their stock to take out the competition. See Instagram, Oculus, WhatsApp and many many others. --Mark Cuban, billionaire investor
Some startups will suffer the "brain damage" of a down round.
For a lot of companies, Gurley wrote, the only way out other than bankruptcy is to take a down round.
Down rounds happen when a startup takes a financing round at lower than its last valuation. If you include down exits, like Gilt Groupe's sale for $250 million when it had raised more than $284 million, down rounds have outpaced creation of unicorn companies since the last quarter of 2015, according to CB Insights.
Many founders hate them because it's a big hit to the ego -- suddenly they don't run a billion-dollar company anymore -- and employee morale.
I've heard of companies already without naming names that have gone from valuations in the 10s or 100s millions of dollars at the last round, to being in the single-digit millions. --Nikhil Basu Trivedi, Shasta Ventures
If you can't face a down round with your employees then you have pretty big problems because hopefully they're there not just for the money, but they're on a mission. If they're not there on a mission and they can't take a slight down round that's a big deal. It gets rid of what we call "the tourist," they're around and they're not in it for the long term. --Alfred Lin, Sequoia
Some will entirely recapitalize their stock, wiping out early investors and employees.
Some down rounds come with dramatic revaluations, which wipes out most of the paper value of these companies.
Recaps are messy. In the worst cases, they wipe out the value of existing shares -- everybody who was sitting on options or early series shares sees the value of those shares go to zero.
Early investors hate them because they often get washed out of the roundwhen it happens. Employees who quit before a liquidity event and spent their own cash to buy their stock options -- and then pay the taxes on those options -- get screwed.
And remaining employees who just saw the value of their shares go to zero will need extra incentives to stick around.
You want to make sure their economic opportunity remains just as interesting as the day when they joined. If the economic opportunity is not going to be there, then those later employees will start questioning why they are there. --Hemant Taneja, General Catalyst
Companies have and are doing certain things like repricing options if they feel like the valuation has come down significantly. During recaps you take care of employees that are sticking around, so I think that there are tools in people's tool kits to be able to do those kinds of things. --Alfred Lin, Sequoia
Employees will learn a hard lesson.
One difference between this bubble and that of 2000 is that most of the liquidity is still tied up in the private markets. Companies, investors, and employees have made big gains on paper, but that doesn't mean anything unless an employee can actually spend it on anything.
For employees and investors they are SOL [s--- out of luck]. That is, unless these companies wise up and start going public ... The VC attitude of not going public is crushing the dreams of tens of thousands of employees with options. --Mark Cuban, billionaire investor
In '01/'02 most of these companies were public, so it played out in the public market. You had companies that went public and then lost 90% of their value or went bankrupt. But in the interim, the employees got something out in the public markets. ... Here, there's no liquidity. --Alfred Lin, Sequoia
What does all of this mean for employees? I think going forward they'll be more skeptical of valuations, and instead look for companies that are building sustainable businesses that solve problems they care about. And while this period will be painful for many, I'm hopeful that a disenchantment with fast growth at any cost will breed better businesses in the long run. --Mamoon Hamid, Social Capital
Remember: All of this is just a return to normal.
Lest we forget: Failure is the norm for startups, and while the next few years might be painful, technology is more pervasive than ever.
For every on-demand company that fails, there could be a $10 billion acquisition of a company that's trying to cure cancer.
"Investors like us that are raising funds, we're not going to sit idle. We certainly want to be active if there's good opportunities out there," General Catalyst's Taneja said. "If anything, you can say that as values get more rational, things will get better from the economic perspective."
Sequoia's Lin said:
In aggregate I don't think if they're gonna be worse off, I think more companies will survive this because they raised a lot more money. I think their expectations will have to be limited. ... I think the number of people who end up with zero will be about the same [compared to 2001]. And I think the number of people who will be disappointed will be about the same.
Much of this is the natural fluctuation that Silicon Valley goes through.
"It resets the landscape back to normal. There's a natural Silicon Valley ebb and flow, some small percentage of startups succeed, they're transformative, they do change the world," Rabois from Khosla Ventures said. "A lot of startups fail. That's part of the business, it's very difficult."