Decoding Gurley’s Post On Bubbles

Bill Gurley wrote an interesting post today on “bubbles.” While many of his posts are widely shared, for whatever reason, this one didn’t fly off the shelf, but after reading it twice this morning, I think it’s very important, so important for people to read that I’ve reproduced it here with my own six (6) annotations, which I try to unpack below. If you work at or invest in early stage startups in the Bay Area, it’s worth giving this a few minutes of thought:

——

January 24, 2014: Over the past few months, many journalists have begun to ask the question that no one really wants to hear; “Is Silicon Valley in another technology bubble?” It’s a dangerous question to ponder – especially out loud and especially here at ground zero. Silicon Valley thrives on optimism, and anyone waving the bubble flag is auditioning for the title of nonbeliever or party pooper.

There is another reason it is dangerous to predict the arrival of a bubble. It was 1996 when Federal Reserve Board Chairman Alan Greenspan first uttered the now historic phrase “irrational exuberance.” Even though things were frothy enough that the head of the federal reserve felt the need to talk down the market, the top was in fact many, many years away. And the venture capital firms that pulled back in 1996 missed the best three years of return in the history of venture capital industry. All of which makes predicting market tops a delicately tricky business. [1]

Warren Buffet has a famous quote, “Be fearful when others are greedy and greedy when others are fearful.” Using this traditionally contrarian investment mindset, one would certainly tread with trepidation in today’s market. Although we may have not reached the level of observing obvious greediness, there is most certainly an absence of fear. [2] Those that managed companies in 2008 or thirteen years ago in 2001 know exactly how fear feels. And this is not it.

There is another way to think about identifying bubbles. [3] Occasionally you will hear sophisticated investors talk about the notion of “discounting risk.”  They might suggest that certain investors in a certain sector are discounting risk. The implication is that they are not properly accounting for the risk of the given situation. [4] Investors are not the only ones that can discount risk; executives and employees can discount risk as well. This happens anytime someone is operating in a situation where their assessment of risk is far lower than the actual risk to which they may be exposed.

All of which leads to my “discounted risk of employer profitability” theory. Ask yourself this question. What is the percentage of employees in Silicon Valley that are working at profitless companies (i.e. companies that are losing money or have negative cash flow)? And how has that trended over time? What was that percentage in 1999? What was it in 2003? And what is it today? An employee’s decision to work for a company that is losing money is an implicit decision to discount risk. If the macro environment changes, that company is under much greater stress than one that is profitable. Yet many individuals are making just such a decision today. [5]

Through this lens you can also see why markets are cyclical, precisely because the willingness for people to take on such risks happens gradually over time. Like the boiled frog, the employee base as a whole does not perceive that anything is changing. Yet, at a micro level, one person’s decision to get comfortable with this risk is based on the fact that someone else did it earlier, which was based on someone else even before him or her. And as more and more people make that decision, the risk is constantly increasing. [6] No one makes the implicit decision, “I am going to go to work for a money losing company!” However, slowly over time, a large portion of the employees in the area inherently are. And then, when the bubble bursts, the consequences are far greater.

Its not just employees that take on this incremental risk. I am just highlighting that looking at this particular detail is one way of measuring the discounting of risk. Obviously, venture capitalists, investment bankers, public market investors, founders, and executives are all part of the game, and they all play a role in the acceptance of more and more risk over time. There is value to knowing where you are, even if you play the game on the field.

—–

Disclaimers: I do not know Gurley, but like many of you, follow his tweets and blogs closely given his experience and ways with words. Therefore, I don’t mean to imply this is what he was getting at, but rather, this is my interpretation, my reading between the lines. I also don’t mean to sound an alarm bell, but rather capture the sentiments I see and hear around me.

[1] Gurley’s post hit the web on the morning of the biggest little market corrections of late. Today, the DJIA dropped a bit over 300 points, and the tech sector was not spared. What I believe Gurley is saying is that those private investors who pull back now may, in fact, miss out on tremendous venture scale opportunities over the next few years.

[2] There is, indeed, an absence of fear in and around the Valley, though you can see some parts of it creeping up. The first signs of this are related to the delta between salaries and rents. Disciplined “value” investors are also concerned about the delta between what they perceive to be fair prices and the intense competition among big, established firms to offer higher prices.

[3] Yes, people often forget that there are bubbles with a big “B” and then ones with a small “b.” Even if a small “b” bubble occurs, it can affect startups and the folks who invest in them.

[4] The notion of “discounting risk” takes many forms. I’ll give you one example, based on deals I’ve looked at in a specific sector — the number of companies which offer an offline service based on online demand, who think they can grow geographically in the same manner Uber has. Here, the “execution risk” can, at times, be discounted, and with enough money going around, founders can sometimes take what the market bears.

[5] OK, this is the money shot of the post. There are TONS of people who are now in the Bay Area living month-to-month off a salary that entirely driven by venture capital investment into nonprofitable companies. Some of these companies are early, or some of them never get to the point where they can figure out how to earn money. Because I help a lot of people move in/out of many jobs, I hear the concerns, and of the biggest concerns I hear, after working at a startup that never makes money, is: “I am looking to join a company which is more stable, which has product-market fit.” That is code for, “Hell, no, never again.”

[6] I hear stories of people bunking up to 4 in a 2BR cramped apartment in SF (and the like), eeking out a salary and hoping to keep riding the wave. Many of these hyper-growth companies, truth be told, probably employ too many people, and at the first sign of any trouble, you can bet either hiring will slow, freeze, or worst, slight downsizing will occur. Age is a factor here. Folks can do anything when they’re 22, they don’t really care about what they have and where/how they sleep; folks who are 32 sure, do, and with so many jobs wiped off the dockets in the last five years, it’s a scary thought to think where those folks who want to get into a more stable company go. Maybe it will all work out because people will go work at the unicorns, and there is an entire stable of unicorns in the Bay Area’s barn right now.

 

Haystack is written by Semil Shah, and is published under a Creative Commons BY-NC-SA license. Copyright © 2018 Semil Shah.

“I write this not for the many, but for you; each of us is enough of an audience for the other.”— Epicurus