Current Startup Market Emotional Biases

Bill Gurley wrote an incredible post yesterday titled On the Road to Recap: Why the unicorn financing market just became dangerous … for all involvedIt’s long but worth reading every word slowly. I saw it late last night as it bounced around in my Twitter feed and then read it carefully just before I went to bed so the words would be absorbed into my brain. I read it again this morning when I woke up and I expect I’ll read it at least one more time. I just saw Peter Kafka’s summary of at at Re/Code (We read Bill Gurley’s big warning about Silicon Valley’s big money troubles so you don’t have to) and I don’t agree. Go read the original post in its entirety.

Fred Wilson’s daily post referred to the article in Don’t Kick The Can Down The RoadFred focuses his post on a small section of Bill’s post, which is worth calling out to frame what I’m going to write about today.

“Many Unicorn founders and CEOs have never experienced a difficult fundraising environment — they have only known success. Also, they have a strong belief that any sign of weakness (such as a down round) will have a catastrophic impact on their culture, hiring process, and ability to retain employees. Their own ego is also a factor – will a down round signal weakness?  It might be hard to imagine the level of fear and anxiety that can creep into a formerly confident mind in a transitional moment like this.”

Fred and I have had some version of this conversation many times over the past twenty years as we both strongly believe the punch line.

Entrepreneurs and CEOs should make the hard call today and take the poison and move on

But why? Why is this so hard for us a humans, entrepreneurs, investors, and everyone else involved? Early in Bill’s post, he has a section titled Emotional Biases and it’s part of the magic of understanding why humans fall into the same trap over and over again around this issue. The “Many Unicorn founders …” quote is the first of four emotional biases that Bill calls out. If that was it, the system could easily correct for this as investors could help calibrate the situation, use their experience and wisdom to help the founders / CEOs through a tough transitional moment, and help the companies get stronger in the longer term.

Of course, it’s not that simple. Bill’s second point in the Emotional Biases section is pure fucking gold and is the essence of the problem.

“The typical 2016 VC investor is also subject to emotional bias. They are likely sitting on amazing paper-based gains that have already been recorded as a success by their own investors — the LPs. Anything that hints of a down round brings questions about the success metrics that have already been “booked.” Furthermore, an abundance of such write-downs could impede their ability to raise their next fund. So an anxious investor might have multiple incentives to protect appearances — to do anything they can to prevent a down round.”

Early in my first business, a mentor of mine said “It’s not money until you can buy beer with it.” I’ve carried that around with me since I was in my early 20s. Even when I personally had over $100 million of paper value in an company I had co-founded and had gone public (Interliant), I didn’t spend a dime of, or pretend like I had a nickel of, that money. In 2001 and 2002 I learned a brutal set of lessons, including experiencing that $100 million of paper money going to $0 when Interliant went bankrupt. And, as a VC, I experienced a VC fund that was quickly worth over 2x on paper that ultimately resulted in being a money losing fund. I didn’t buy any beer or spend all the money on random shit I didn’t need and fundamentally couldn’t afford.

This specific bias is rampant in the VC world right now. As Bill points out, many funds are sitting on huge paper gains which translate into large TVPI, MOC, gross IRR, or whatever the current trendy way to measure things are. However, the DPI is the interesting number from a real perspective. If you don’t know DPI, it’s “distributed to paid in capital and answers the question “If I gave you a dollar, how much money did you actually give me back?” This is ultimately the number that matters. Structuring things to protect intermediate paper value, rather than focusing on building for long term liquid value, is almost always a mistake.

Let’s go to number three of the emotional biases in Bill’s list:

“Anyone that has already “banked” their return — Whether you are a founder, executive, seed investor, VC, or late stage investor, there is a chance that you have taken the last round valuation and multiplied it by your ownership position and told yourself that you are worth this amount. It is simple human nature that if you have done this mental exercise and convinced yourself of a foregone conclusion, you will have difficulty rationalizing a down round investment.”

This is linked to the previous bias, but is more personal and extends well beyond the investor. It’s the profound challenge between short term and long term thinking. If you are a founder, an employee in a startup, or an investor in a startup, you have to be playing a long term game. Period. Long term is not a year. It’s not two years. It could be a decade. It could be twenty years. While there are opportunities to take money off the table at different points in time, it’s still not money until you can buy beer with it, so the interim calculation based on a private valuation when your stock is illiquid just shifts you into short term thinking and often into a defensive mode where you are trying to protect what you think you have, which you don’t actually have yet.

And then there’s the race for the exit, in which Bill describes the downward cycle well.

A race for the exits — As fear of downward price movement takes hold, some players in the ecosystem will attempt a brisk and desperate grab at immediate liquidity, placing their own interests at the front of the line. This happens in every market transition, and can create quite a bit of tension between the different constituents in each company. We have already seen examples of founders and management obtaining liquidity in front of investors. And there are also modern examples of investors beating the founders and employees out the door. Obviously, simultaneous liquidity is the most appropriate choice, however, fear of price deterioration as well as lengthened liquidity timing can cause parties on both side to take a “me first” perspective.

This is one of the most confounding issues that accelerates things. Rather than making long term decisions, individuals optimize for short term dynamics. When a bunch of people start optimizing independently of each other, you get a situation that is often not sustainable, is chaotic and confusing, and inadvertently increases the slope of the curve. In the same way that irrational enthusiasm causes prices to rise faster than value, irrational pessimism causes prices to decline much faster than value, which increases the pessimism, and undermines that notion that building companies is a long term process.

Those are my thoughts on less than a third of Bill’s post. The rest of the post stimulated even more thoughts that are worth reflecting deeply on, whether you are a founder, employee, or investor. Unlike the endless flurry of short term prognostications that resulted from the public market decline and subsequent rise in Q1, the separation of thinking between a short term view (e.g. Q1) and a long term view (the next decade) can generate profoundly different behavior and corresponding success.

  • Sam

    I’ve quite often heard dating and marriage metaphors used to describe the building of a relationship between founders and investors. A few years into it now, we get to see how the relationship navigates through “money troubles.” Does the marriage deepen and emerge stronger, divorce amicably, or descend into acrimony and lawsuit? As in marriage, that will depend a lot on the values and character of the individuals, and whether they are truly compatible.

    • Great analogy.

      • I really don’t like that analogy and here is why. When you are dating or married, hopefully it is a one to one relationship (at least in my world).

        This is not the same as a VC having a portfolio of 20 something companies and a founder having a portfolio of 1.

        I am not saying any of this is wrong, but it just is. I totally respect Fred for saying don’t abandon your losers and I publicly gave a shout out this year to one of your partners: Seth about treating the ones that don’t work out with respect, honor, and dignity.

        But you are not married to your VC. In bad times it is their job to help you move on to your next opportunity, but not to support you no matter what.

        This was really brought home to me last week when I lost another fraternity brother. We buried a very famous Silicon Valley CMO. It was very bittersweet, but we remembered another that we had lost and toasted his girlfriend/wife. She married him two weeks before he died from terminal cancer because she wanted to give him a wedding not a funeral. That is not rational behavior which is what you need to be able to do in a serious relationship.

        • I didn’t understand the first sentence of your third paragraph, which confused me in terms of the overall confusion. It’s “I am not saying any of this is wrong, but it just is.”

          As an analogy, I think it works well. And some VCs will behave in the context of the analogy, understanding that the relationship evolves over time, and that you will have to deal with different behavior and difficult situations. How each party deals with this will determine the ultimate path of the relationship.

          I think this is analogous to a marriage. It’s NOT a marriage, but it has some similar characteristics.

          It feels like you are reacting more to the literal notion, not the analogy. And I strongly agree that the literal notion makes no sense.

          • I grant you I am maybe taking this too literally. But I have heard over and over, a relationship with a VC is a marriage, but there is no divorce.

            My sentence is poorly written. I always say “it is what it is” My two mantras are: “Know what you don’t know” and “Never lie to yourself” those are the two hardest things to deal with.

            You are right it is an analogy and your second paragraph is well written unlike mine. Both parties have to realize that time changes circumstances and how you deal with difficulties defines you as much or more than how you deal with success.

  • Can the balanced behavioral shifts necessary to right this ship coexist with the power-law dynamics motivating venture capital?

    • First, you have to believe that the power-law is absolute truth. If you do, then it’s extremely hard to behave in a different way. If you don’t agree that it’s the absolute truth, then it’s a lot easier.

      • So then, while we are all responsible for our individual behavior, on a meta / market level, the behavior Bill describes can be largely accredited to the environment resulting from the VC power-law based business model.

        I’d love to hear more about your approach, how your model differs. It doesn’t seem like you’re quite as extreme as Nevertheless, if you and Fred W. for instance were to detail a different model sans power-law as absolute truth, it would be transformative for the environment. And I think the behavioral change you’re talking about would follow.

        • If you read the post carefully, Fred just showed that you can have a massively successful fund without a power-law distribution.

          Here’s the magic paragraph:

          “Our first USV fund, our 2004 vintage, has turned out to be the single best VC fund that I have ever been involved in. We made 21 investments. We made money on twelve of those investments. We lost money on nine of them. And we lost our entire investment on most of those nine failed investments. The reason that fund performed so well has pretty much nothing to do with the losses. It was all about five investments in which we made 115x, 82x, 68x, 30x, and 21x.”

          21 companies.
          12+ outcomes
          5 outcomes that drove most of the returns

          Note that there were 5, not 1 or two. Of 21. That’s an awesome fund, and it’s definitely not a power-law curve.

          • Fred is the far end of a power curve all to himself… But yeah, you guys are the best because you have a careful, human approach. Aware of your own biases, etc.

            I just wonder if there’s not a systematic shift that can happen by changing the environment itself. But maybe that’s what’s happening now… and evolution takes time, and I’m impatient.

  • “It’s not money until you can buy beer with it” is a powerful construct for a mentor to have passed on to you. You must be glad to have crossed paths with this fellow, as it could have been painful otherwise. It’s terrible enough to see $100 M go up in f****ing smoke — I can only assume — but to have to cough back millions you no longer have on top of it would be truly devastating.

    The construct that has kept me grounded the most is to not take *anything* for granted; but I’ll always remember the beer one now.

  • It’s interesting that many of us who have been through the 1999-2001 period see more clarity about what’s happening, and those that haven’t are not seeing the warnings of the reality.
    That was an epic post by Bill Gurley. Every word of it.

  • Brad you make a great number of points in your post. I want to focus on the poison. I have taken the poison a number of times-more than many that will read this post. It’s never good going down. It’s never good going up.

    Key though for startups. I can’t stress how key this is. At a certain point, the startup CEO is a warrior. Sometimes they have to eat the poison.. Like Odysseus, they absorb, and take on the demons that can kill them.

    My fear is the venture capital industry has canted to operators-when in fact it needs to find Odysseus type people that can help entrepreneurs pass through the Amazons, and find themselves-and their companies

    Just because you lead this or that at some successful firm doesn’t automatically make you a good VC. Our industry is lost on that point.

  • “The pressures of lofty paper valuations, massive burn rates (and the
    subsequent need for more cash), and unprecedented low levels of IPOs and
    M&A, have created a complex and unique circumstance”

    Physics in the VC world.

  • Thanks for focussing a light on DPI that really is the ONE TRUE kpi in this area.

  • Jacob

    Any thoughts on the systems or mechanisms which allow “lofty paper valuations, massive burn rates” to exist? To the extent that unicorns are Icarus, who approved the flight plan? Or does this just reduce to ‘why do bubbles happen’?

    • It’s a natural dynamic that is part of every economic cycle.

      • Jacob

        I guess that makes sense. While I lived through 2008 — but not 2000 — as an adult, this is the first economic shift where I have “qualitative” paper wealth in play.

        Juggling diversification with long term thinking and avoiding a race for the exits when the (potential) downpayment for your (future) first house is in play adds a lot of complexity and emotion into the mix.

        A very lucky & first world problem to be having, but also a challenging one.

        • The only advice I’d have is, if you have a tax burden from a paper gain, pay it now.

          • Jacob

            Appreciate the advice. Luckily, those logistics work out for me and I’m fairly tax-advantaged!

  • I have saved Gurley’s piece as a pdf and in my Evernote account.
    I want to make sure I can always find it.

    It should be a must read for many entrepreneurs, because this is “seed/A/B to down round at C” period is not the same as the dot com bust with private companies and public companies vanishing.

    Reading about LP biases relative to VC biases relative to Special Vehicles was really unique.

    The only piece he missed was exhaustion.
    Downrounds are mentally and physically exhausting even before the survival path starts.

    For VC’s being on a new 2016 -2017 glidepath of good/ great / and disastrous BOD’s is going to be exhausting if they are on the 8 to 12 board common scenario.

    Just saying ‘well, thank god it’s not the summer of 2000’ is not enough.
    At least JIm Beam and Xanax sales should be up . (grin)

    Thanks Brad, for posting your take.


  • Your Interliant experience reminds me of the founder of Safeguard Scientifics. He was already very successful with their model, but then they got caught up in the B2B gold rush and their valuation went through the roof. So he built a $20 million house using money he borrowed *on margin*. Eventually the stock market came back to earth and his holdings had to be liquidated to pay off margin call. Ouch.

  • “It’s not money until you can buy beer with it.” How true Brad. Smart mentor. Human nature is to endow wealth before it’s realized. We all do it. The founders that can balance enthusiasm for valuations with the practical reality of liquidity are the ones who are best suited to weather the impeding storm when markets cool. They’re also more likely to be the ones who are best prepared mentally to ‘stretch’ resources further.

  • Josh Tabin

    It’s the classic buy high and sell low mantra that most people stupidly follow. Everyone on the team is high fiving each other during the 20 game win streak but lose 10 games in a row and the trade/firing talks come out. This entire unicorn dynamic is predictable and recurs in almost every market since the beginning of markets; it’s in the nature of markets to have bubbles and irrational exuberance: Tulip mania baby!

    What board members and investors need to assess is whether these companies have a reason to exist. If they do then they need to find a way to keep it alive at any cost. Many probably don’t.

  • Jeff Osborn

    Without liquidity, the collapse in prices can become invisible. It’s easy to know the stock market is going down; Kai Ryssdal tells us every afternoon. Not so with private company stocks. It’s like a real estate crash- the posted prices don’t change. It’s just that increasingly there are distress sales whose final price (quietly) shows a collapse. The price in the MLS won’t go down, but smart buyers know reality is half of the sticker. It’s worse in public equity markets, in that stocks, unlike houses, frequently go to zero. (And BTW, I sold my share of Interliant for a million or so gain before the bankruptcy, so thanks for that.)