This past Monday (9-15)  the online edition of the Wall Street Journal, contained an interesting interview with noted Tech investor Bill Gurley, a partner at Benchmark, entitled “Venture Capitalist Sounds Alarm on Startup Investing, Silicon Valley Has Taken on Too Much Risk, Gurley Says.”    Bill also writes a blog called Above the Crowd.  This article is part of a series in the Journal called “Tech Under the Hood.”

Mr. Gurley and Benchmark are investors in Uber, Zillow, OpenTable and other Web startups.  He has recently voiced some concerns regarding the money being poured into startups in Silicon Valley. 

The Journal asked the following question:  You quoted Warren Buffett's famous quote, "Be fearful when others are greedy and greedy when others are fearful." And then you wrote: "Although we may have not reached the level of observing obvious greediness, there is most certainly an absence of fear. Those that managed companies in 2008, or 13 years ago in 2001, know exactly how fear feels. And this is not it." What did you mean by that?

Mr. Gurley: Every incremental day that goes past I have this feeling a little bit more. I think that Silicon Valley as a whole or that the venture-capital community or startup community is taking on an excessive amount of risk right now. Unprecedented since '99. In some ways less silly than '99 and in other ways more silly than in '99. I love the Buffett quote because it lays it out. No one's fearful, everyone's greedy, and it will eventually end. And there are reasons, which might take all night to explain, why this business is cyclical over time, and the more chance you have to see different cycles and to see how it slips away, you can see it. There's a phrase that I love: "discounted risk." Do people discount risk? Right now you've got private companies raising $200, $400, $500 million. If you're in a competitive ecosystem and you raise that amount of money, the only way you use it—because these companies are all human-based, they're not like building stores—is to take your burn up.

He goes on to say.  “And I guarantee you two things: One, the average burn rate at the average venture-backed company in Silicon Valley is at an all-time high since '99 and maybe in many industries higher than in '99. And two, more humans in Silicon Valley are working for money-losing companies than have been in 15 years, and that's a form of discounted risk.  In '01 or '09, you just wouldn't go take a job at a company that's burning $4 million a month. Today everyone does it without thinking.” 

WSJ: Because the equity looks so valuable?

Mr. Gurley: Yeah, it's a whole bunch of things. But you just slowly forget, and half of the entrepreneurs today, or maybe more—60% or 70%—weren't around in '99, so they have no muscle memory whatsoever.  So risk just keeps going higher, higher and higher. The problem is that because you get there slowly the correcting is really hard and catastrophic. Right now, the cost of capital is super low here. If the environment were to change dramatically, the types of gymnastics  that it would require companies to readjust their spend is massive. So I worry about it constantly.

Mr. Gurley then responds to other questions citing reasons that it appears that things are getting  excessive.   A summation of his ideas is that burn rates because capital is readily available have gone to very high levels.  Public, SAS companies which he views as potentially among the highest risks are losing tons of money but Wall Street views that as ok for these companies.  There is a vicious cycle.   Money is available from the Street to fund these losses, at very high company valuations and other public company boards see this and decide to up their burn rate because they have money being thrown at them to fund those losses. 

This leads to companies that are less able to weather storms or “to get to cash flow profitability or the ability to generate cash flow” as valuations move higher and along with it operating costs fueled by investment dollars.  Consequently, there will be some failures which in Mr. Gurley’s view will be good in returning reality, or as he says, “sanity”, to the market. 

He also references liquidation preference as a factor that in time makes it more difficult for companies to raise money because, as he states, the “liquidation preference piles up on a startup”.  This fact makes it imperative that companies can show a clear path to cash flow and profitability or the money tap will ultimately be turned off. 

This article is thought provoking because it reminds us that we have seen this in tech sphere in 2001, and in other financial segments like in the mortgage bust that lead to the crash in 2008.  It always happens where too much money starts to chase opportunity.  Credit, investing and underwriting standards decline and there is a market adjustment.  Sometimes it’s painful.  Let’s hope that this time the adjustment will not require widespread and excessive pain in the public market which will, of course, negatively impact angel and early stage venture investing too.  That said, this underlines the need for all startup companies to take the money they can get when they can get it but to guard it and use it wisely in getting to a sustainable market position and a cash flow positive situation as soon as possible.