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Irrationality, Welcome Back to Silicon Valley

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Predictably irrationalWow, finally people noticed.

All it took was Google to supposedly offer $3.5 million to an engineer to not go to Facebook. Now, that is what rational people would call cutting off the nose to spite the face. But these are not rational times. I have been writing about the escalating irrationality in Silicon Valley, which for some odd reason exists detached from the global economic reality.

In past few months, I wrote about three major and potentially troubling signs.

  • Silicon Valley & the Scent of Money talked about the increased number of startups getting funded and the amount of money being pumped into the startups going up, thanks to hyperactive, always tweeting, angel investors.
  • Silicon Valley’s Talent Crunch talked about how there was a decline in certain kind of engineering talent and other professionals in the valley, thanks to the breathless hiring from giants like Zynga, Google (s GOOG), Apple (s AAPL), Facebook and Twitter.
  • The media’s focus on investors and not the founders.

There are some excerpts from Fred Wilson’s post I think are worth highlighting.

I think the competition for “hot” deals is making people crazy and I am seeing many more unnatural acts from investors happening. If it were just valuations rising quickly, I’d be a bit less concerned. But we are also seeing large deals ($5mm to $15mm) getting done in a few days with little or no due diligence. Investors are showing up at the first meeting with term sheets. I have never seen phases like this end nicely.

Irrationality often doesn’t seem irrational because it is often labeled as conventional or fashionable thinking. Let’s step back for a minute: if you take what Michael Arrington wrote or what Fred Wilson has to say or my own reporting, we are beginning to see signs of hyper-inflation in the web and startup landscape.

Fred doesn’t want to call it a bubble and he is right, mostly because it is not a classic case of mass hysteria, and instead it is a madness that impacts only a certain genus, the professional investor. The implications of this early stage investment hysteria are going to be felt across the ecosystem.

Let me explain.

Google, worried and perhaps tired of losing its great engineers and talented people to other companies including Facebook, decided to fight back with a weapon it knows can be effective in the short term: money. A ten percent across the board pay hike and generous offers to exceptional and standout employees are a good way to stem the flow of talent. Facebook and others, if they do indeed want these people, now have to spend cold-hard cash to lure people out of their cushy Google gig.

Of course, one could argue that what is good for the goose is good for the gander. The more cash big web companies offer as salaries, the more startups and others are pressed to offer higher salaries to their recruits, which in turn means that startups are going to need more money. More money means that tide might turn against the angels in favor of larger Sand Hill Road firms. A million-dollar angel round isn’t enough when you have to pay $100,000 or more in engineer salaries! In other words, the startup economics are going to change.

This is not good for startup founders either. Inflation means they need to raise more money, which will come at a cost: They will be giving up a bigger portion of their business to investors. Of course, higher valuations would make exits –- still few and far between –- tougher.

I think Wilson’s comment about “investors are showing up at the first meeting with term sheets” is particularly telling and indicative of the irrationality in the market. And the sad part –- it is only going to get worse.

Image courtesy of Flickr user joelogon

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39 Responses to “Irrationality, Welcome Back to Silicon Valley”

  1. money is not worth anymore, as pointed by low interest rates.
    and meanwhile, the pressure is huge to invest where it actually gets created.

    and you guy are at the confluence of that tornado.
    been there, done that, welcome to the japanese dance with an american tempo.

  2. Hi Om,

    I think you know the story. My father was a distinguised engineer at Bell Telephone Labratories. He made about 70K in 1988 before he retired. That was 4 years after AT&T divestiture and companies where trying to lure him away for twice his salary, but he felt loyal to a company that employeed him and provided job security for 35 years. I know is a foriegn concept in todays world.

    Also, yes there are superstars in companies, but are they really worth 3.5 million dollars? It takes a whole team to get something out the door….maybe the other engineers are not as talented but they still do contribute what they are capable. If you are relying on these 3.5 million dollar engineers for your success than you really have a problem with not developing a solid engineering organization

  3. Before clicking through, I just assumed this post was going to be about Kno, which has something resembling a zero percent chance of success despite having raised north of $50 million.

    Then I learned it was about Google keeping its engineers and what it might mean for startups.

    I think the problem here is too much money chasing an endless array of opportunities in what is legitimately the move to “Web 3.0” — the social, ever-connected, interconnected internet.

    Of course most of these deals will go south; it’s venture capital after all. And of course this is a “bubble” of sorts, but one that lacks a moronic IPO window encouraging ever more stupid, ever increasing investments. Without that, this bubble will doubtless be much smaller and probably deflate itself now and again followed by periods of reinflation.

    And, again, Kno. I mean really. People are going to buy iPads not “some other tablet”.

  4. My Iomega Zip drive is around here somewhere.

    Ahhhh the Utopians. The “offer $3.5 million to an engineer to not go to Facebook” is “finally” a good thing. Okay.

    I guess now that Cap-N-Trade is DOA Goldman Sachs is readying a new tech bubble.

    Fill the water balloons with NY Fed FRNs and let the bidding begin. I’m not old. But this is getting very old. I don’t think this country will survive another tech bubble.

  5. Interesting post Om. Perhaps now that the justice dept steped in and asked various tech companies to not use anti-poaching agreements, we are seeing the free market principles in action. Though this is not something new and has happened in storage and security industries in the recent past – perhaps not at this scale. The fact is companies have laid off large pools of talent and without anti-poaching agreements, which signalled ‘my talent is important to me, don’t touch them’, we are seeing this movement, not to mention an improving economy. A proactive talent management strategy at these firms, can certainly help. That said startup economics may change from an equity perspective, not cash. And a VC/CEO can always tie milestones to equity vesting, though that gets complicated and is a new direction. Thoughts?

    • Shail

      That is exactly what I said. The startup economics are changing and rapidly — aways from the lean-startup mantra people espouse so often. I think this is going to get progressively worse in next week months, before being right-sized.

  6. Its the same story being repeated. Happens every 5-7 yrs. We must remember that not even 5% of the VCs actually understand the details of technology i.e. how to implement/execute it.This is because none of them have ever implemented it ( i.e. done some coding or design). It is natural for them to rely on blogs, news, or fellow VCs( equally dumb).

    Other thing is that none of them have their own money at stake. It is all the money raised from others. People who do have their own money at stake and are in game for last 15-20 yrs( i.e. have learned from 2-3 crashes) will know the valuation game.

    I agree that startup economies are going to change but not rapidly. Overall, good for the whole ecosystem of startups.

    • Well put Amit. But I disagree on the rapidity with which the startup economics are going to change.

      I think many of the companies which have raised $1.5M or less in their seed/series A rounds are going to find going tough, and when it comes for Series B, things will be even tougher.

  7. Tony Healy

    Om, the relevant question is why wasn’t that $3.5 million engineer being paid properly before the offer from Facebook? If his value to the company is so high, how could Google get away with not rewarding him properly previously?

    I think what we’re seeing is a terrific and long overdue market correction where value creators are attracting the rewards they’re worth. There’s nothing wrong with that at all.

    If similar dynamics had existed during the boom, it would have prevented funding flowing to pointless companies, and instead directed it to those who could execute.

    • Tony

      I think that is a good and valid point. My suspicion is that the person in question was pretty well compensated and from a monetary standpoint, was full vested or something.

      I do agree that market should value the “value creators” correctly but what is the correct value, is something that is debatable. Or rather in the eye of beholder.

      PS: The funding isn’t flowing to those can execute, but instead it is flowing everywhere :-)

      • John Hutchins

        The reason Google wasn’t paying more is that, previously, it was able to offer stock options with the expectation that the value of the option would rise over time. Unfortunately to get the same kind of returns for currently offered stock options Google would have to control most of the worlds economic output and have a stock valuation such that most of the money in the stock market would be in Google. Facebook, on the other hand, can still offer stock options with the knowledge that once they go public those options will be worth many multiples of what they are being offered at. It is really just Google moving from a quick growing start-up to a more mature company, similar to IBM, HP, or Microsoft.

        What this really means is that Google has lost its ability to hire and keep top-level developers. They will be lucky if they are treated as though they were a post-doc experience. What they should have done is created a stock option alternative structure where if you worked on say, Android then you get certificates worth a fraction of the value of the Android project so that when it took off your certificate is worth millions and you can cash it in to Google. That may seem expensive but the alternative would be for you to have been working for Facebook, Twitter, Groupon, etc and made millions when the company got bought out or had an IPO.

  8. David Lifson

    While I completely agree there is irrational funding going on (and not just early stage – I hear Series B rounds are inflating too), I disagree with your last bit. It may be true that founders need to raise more cash to pay for talent, but it is not true that valuations will stay flat in the face of that. As you know from your experience at True Ventures, early stage valuations are more about owning 20% and market comparables than data and traction. So if seed rounds creep up to $1.5-2M, valuations will adjust accordingly. Remember, it’s in everyone’s best interests to make sure startups are both 1) not underfunded with respect to costs and desired milestones, and 2) maintain enough founder equity so that in later rounds, founders stay engaged and motivated.

  9. It is a bubble! VC’s wouldn’t be so care free with the money if the interest rates weren’t so low. If interactive brokers is lending $1 million at 1.3% for every $200k you have, just imagine what VC’s with 100’s of millions are getting. When you say inflation it’s a bubble being inflated, so hyper inflation is a bubble inflating fast… When rates start rising all this will come to an end.. quickly.

  10. Just making sure I’ve got this right: tech companies making billions of dollars in profit, giving some of that money back to their employees = scary, irrational bubble and we are all doomed, especially the poor investors.

    Millionaire investors making even more millions of dollars from investing in companies on the backs of 80 hour weeks from underpaid coders = totally ok, nothing to worry about, thank god we’re back to normal.

  11. Good companies usually have few super star developers doing work equivalent of 20-30 engrs and not recognized since there is no straight forward metric like sales. May be google is being smart about it. I doubt they will offer it to average performer.

  12. R Paul singh

    Thanks for bringing this issue to light. Some of us who have seen Internet bust 1.0 worry if we are heading towards bust 2.0 2000s telecom = 2010 cloud while 2000 Internet and web = 2010 social web.

    Would love to do a guest blog on this if you like. Let me know

    R Paul Singh

  13. Are the days of skilled founders building something cool in their garages and living off Ramen over?

    Is today’s “startup” simply a group of suits hiring programmers to build whatever ponsai is being hyped today?

    Will the media ever get over their love affair with investors? “…The media’s focus on investors and not the founders.”

  14. Knowledge economy…. It’s great to see that companies are having to spread the wealth. The way the technology evolves what r the odds that what you know today will be worth so much tomorrow. Besides… If you subscribe to the thesis that in general tech has oversubscribed consumer needs… I.e. The startups will make money via mktg innovation not technological. And that’s where I’d expect the mkt to go. Nothing is bad for startups except lack of social fabric such as food, healthcare and accomodation that prevents any risk taking.

  15. Clearly a VC bubble. Arrington crashes that VC “collusion” party a while back with all those guys crying in their beer about not getting good deals. That screams, “too much $ chasing” to me. If that’s not a bubble, then what is?

  16. If Companies want to pay their employees that way then one of 2 things ultimately happens; they remain on top and it was a good choice or the money should have been spent elsewhere.

    I suppose another, perhaps positive angle, might be that it’s nice to see that people are willing to spend money at a time when the economy is keeping many people from doing the same thing…

  17. Do people really believe that there is too much money chasing not enough start ups? It is more the “French Laundry Syndrome.” Investors are looking at the same sources (e.g. Y Combinator). So they end up paying top dollar, and complaining about the price. But they keep making reservations.

    • Rob, I completely agree. Maybe I’m not mingling with the elite class of entrepreneurs, but I haven’t witnessed the phenomenon Fred Wilson describes of investors showing up at first meetings with term sheets. If they’re really doing that, my guess is it’s with serial entrepreneurs with proven track records of exits at hefty valuations — the “celebrity chefs” who open a new restaurant, to follow your French Laundry analogy.

  18. Hi, Om. Sounds bad. It’s not like that here in the Twin Cities. Nor is it, I suspect, in other tech centers between the two coasts. (Except maybe Groupon’s Chicago, an aberration.) But then, people on the coasts think we’re a bunch of rubes here, standing in the middle of a cornfield. (That would be a snowy cornfield right now, btw.)

    • Actually not at all. I think the whole cost structure today is getting irrational. If folks can get more money for their engineering skills, more power to them. I am just pointing out that the whole economics of a startup is going to change.