Startups Are Shutting Down!

Big startups are shutting down. More than 3000 private venture backed startups failed in the last year.  Of the startups raising money, 19% were funded at a lower valuation than in prior funding rounds. 38% of VCs disappeared from dealmaking last year and more than a quarter of a million workers at tech companies lost their jobs over the same period. US corporate bankruptcy filings closed out 2023 with the most filings since 2010. The year has been described as a mass extinction event for startups in the press.

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Transcript

Startups Are Shutting Down.

Big startups are shutting down. According to Pitch Book more than 3000 private venture backed startups failed in the last year.  Of the startups raising money, 19% were funded at a lower valuation than in prior funding rounds. 38% of VCs disappeared from dealmaking last year and more than a quarter of a million workers at tech companies were laid off over the same period. US corporate bankruptcy filings closed out 2023 with the most filings since 2010. The year has been described as a mass extinction event for startups in the press.

Hyperloop One – which was supposed to reinvent transportation was shut down after wasting $450 million dollars. [Clip - Elon Musk] “It’s like a tube with an air hockey table – I swear, it’s not that hard.” 

Bird the electric scooter rental company – which was also supposed to reinvent public transportation filed for chapter 11 bankruptcy protection.  It was the fastest startup to ever land a billion-dollar valuation, and at its peak was worth two and a half billion dollars.  It was delisted from the New York Stock Exchange in September after failing to maintain a market cap of above $15 million dollars for 30 consecutive days.  Who would have thought that renting scooters to drunk people for a dollar (who would then throw them in a canal on their way home) would be a money losing business. Bird ran up more than $1.6bn in net losses since 2018 before finally running out of money.

Smile Direct Club – which was supposed to revolutionize the oral-care industry by selling 3D-printed clear aligners direct to customer – was valued at 8.9 billion dollars when it went public in 2019 but the stock fell in value over time as the company proved to be unprofitable year after year. The company shut down last month $900 million dollars in debt.

The health tech startup Olive AI which reached a peak valuation of $4 billion dollars in 2020 driven by the need for automation in healthcare during the pandemic.  The company raised over 900 million dollars from investors.  In 2022 the company began laying off staff citing “tough economic conditions.”  The company was allegedly trying to raise money when it abruptly shut down in November.  Going out of business in 2023 was particularly surprising for a company with AI in its name.

Zume – the robot pizza delivery company which had raised $445 million dollars in VC funding, the majority of which came from SoftBank in 2018 at a two and a quarter billion-dollar valuation, shut down this summer.  The writing was on the wall for quite some time with Zume.  In 2020 they announced that they were shutting down their robot pizza delivery business and were shifting their focus to food packaging, production and delivery systems.  Who did they think would invest in that – investors want robots making and delivering pizza – that should be obvious to everyone. [Clip] “Yo! I haven’t got all day, what kinda pizza youse guys want?”

WeWork – who set out to revolutionize office real estate – by having an app – which I’m told didn’t work very well, and free beer on tap filed for bankruptcy in November.  

WeWork and its founder Adam Neumann were the poster boys of how a blitzscaled business model led by a charismatic founder could apply a veneer of technology to an old business idea and attract venture capital funding to achieve a multibillion dollar valuation. At its peak, WeWork was valued in private markets at $47 billion dollars.  Softbank alone invested 16 billion dollars into the company. Masayoshi Son, SoftBank’s founder, allegedly invested his first $4.4 billion dollars in the shared office space company after Neumann gave him a 12-minute tour of a WeWork in 2016. With such a short tour, it’s unlikely that the free beer even had an impact.

Softbank – run by Masayoshi Son (Japan’s Cathie Wood) was one of the biggest startup investors in the last decade.  They invested in all sorts of non tech companies that were made to look like tech in order to attain a sky-high valuation. According to Bloomberg, the SoftBank Vision Fund alone lost $53 billion dollars over the last two years on startup investments.

So, why are startups failing now, how much money has been lost, why did people ever invest in some of these crazy business models and how might this affect the broader economy?  Before I get to that let me tell you about today’s video sponsor…

OK, so we have seen a very difficult period for startups over the last year or two, but it comes in the wake of probably the best period for VC backed startups in decades.  During the decade from 2011 to 2021 VC investment in private start-ups grew more than sevenfold from 46 billion dollars in 2011 to $345 billion dollars in 2021.  In 2022 when the federal reserve began hiking interest rates, this money began drying up as investors lost their taste for unprofitable – but high growth investments.

The flood of money into Venture Capital over that ten-year boom period was driven by two main factors: Firstly - low interest rates – which meant that a dollar of earnings that was expected to come in ten years’ time - was worth almost as much as a dollar of earnings due to arrive the next day.  This meant that that you could focus more on growth than near term cashflows. Secondly; A recent history of profitable exits from VC funded startups like Facebook, Google, Whatsapp and Snap meant that investors were suddenly paying a lot of attention to tech startups – hoping to repeat those successes. Venture capital went from being a small asset class run out of offices on Sand Hill Road that had burned investors in the dot com bubble to a massive global asset class like hedge funds or private equity.  The big names in VC became household names.

During the lockdown period of the pandemic – people around the world began adopting new technologies at a faster rate than ever before, and there was a feeling amongst investors that a sea change had occurred, and the future belonged to “working from home” companies like Zoom and Peloton. People were using apps like Uber and door dash for food delivery and booking rentals on Airbnb to get out of big cities now that they no longer had to turn up in the office.

While the prior wave of profitable high growth tech stocks had been (one way or another) in the advertising space, or in businesses like cloud computing the new wave of startups had untested business models – gig economy businesses which attracted a lot of competition and might never flip to profitability – or robot made pizza which would be cooked en route to a customer’s home. As it turned out, a lot of these new business models didn't really work – especially when interest rates started going up and investors wanted to see positive cashflows.

Investors over the period of the tech stock bull market had started taking a lot of risk, a lot of new investors were young and had never seen a rising interest rate environment and they expected that a lot of the new business ideas that they saw - including during the pandemic, would continue on forever. There was a lot of optimism around technology and high growth startups back then amongst retail investors who didn’t really worry about valuation.

Startups do fail all the time, so what makes these bankruptcies any different?  Well, many of these firms were worth billions of dollars in the private market until very recently.  The investors in private markets are supposed to be more sophisticated than retail investors, but the qualification to invest in private investments like these is just that you have more money to lose.  A lot of the VC’s possibly believed in many of the questionable investments that have since gone bust, but a venture capital fund isn’t really there to hold on to these investments until the underlying business flips to profitability.  They invest at the idea stage with the goal of selling these businesses on to the public when the hype is at its peak.  They did manage to unload a number of the biggest flops like WeWork – but not at the valuations they were hoping for, and have found themselves holding the bag on a lot of investments that they bought in to at peak valuation.

Historically, by the time a company had reached a billion-dollar market cap (having raised hundreds of million dollars in funding) it had mostly sorted out its business model. If not already profitable, it was firmly on the road to profitability.  This was not necessarily the case for many of the companies now failing. The huge valuations many of these companies were attaining in the private market may have been more of a function of how much money had flowed into the private tech startup market since 2011 rather than necessarily reflecting the quality of these companies and their business models.

So, how much money has been lost in these startups?  Well, according to Erin Griffith at The New York Times, $27.2 billion dollars in VC funding had gone into the 3,200 venture-backed companies that went out of business in the first 11 months of 2023. That number was based on data from PitchBook which they put together for The New York Times and they said that the data was not comprehensive and probably undercounts the total because an awful lot of companies go out of business quietly – without any big announcement. That 27.2 billion dollar number excluded many of the largest startup failures that went public, like WeWork, or that found buyers at much lower prices than VC investors had invested at.  Erin gives the example in her article of Hopin (I’m Hopin I pronounced that correctly) a start-up that raised more than $1.6 billion dollars in VC funding, was once valued at $7.6 billion dollars and recently sold its main business for just $15 million dollars.  That is a big loss and a lot of money burned.

The hype around AI that we have seen in the last year has masked a lot of the losses in the tech space. Meta was up 178 percent last year due to a combination of AI hype and cost cutting within their core business. This covers up the 46.5 billion dollars lost on the metaverse – which no one will venture into, for fear that they run into Mark Zuckerberg.

AI was the only bright spot for startups last year, which according to Bloomberg received almost $18 billion dollars in VC funding.

So, should we expect these startup shutdowns to affect the broader economy?  Well, there are job losses associated with these business failures. As I mentioned in the intro, Bloomberg reports that more than a quarter of a million workers at tech companies were laid off last year, but the job losses are happening in an economy that is otherwise doing just fine. The labor market has been very tight, meaning that the people who lose their jobs should find replacement jobs easily enough.  As bad as the stories of these firms shutting down might sound, we have to keep in mind that the Stock market is at all-time highs right now, with the gains driven by megacap tech stocks like Meta, Microsoft and Nvidia all of whom closed at new all-time highs on Friday.

According to The New York Times, some VC’s have been encouraging founders in their portfolio companies to consider walking away from struggling businesses, rather than waste years grinding away.  Some of these companies have been able to wind up and return some money to their investors.

One of the negative economic effects of startup shutdowns is that in such an environment it becomes harder for founders with good business ideas to get funding. According to Pitchbook, the number of active investors in US Venture Capital, which was defined as firms that made two or more deals in the last year, plummeted by 38% in the first three quarters of 2023 compared to the same period the prior year, according to PitchBook data. That translates to 2,725 fewer firms making deals.

According to S&P Global, US corporate bankruptcy filings rose last year hitting the highest level since 2010.  The FT reports that corporate insolvencies in England and Wales climbed to their highest level since the global financial crisis in the six months to September last year as businesses grappled with high borrowing costs and slowing demand.

A new paper by Bruno Albuquerque and Roshan Iyer – The rise of the walking dead: Zombie firms around the world - argues that some of the increase in recent business failures is a catch-up effect, and that many of the companies that failed in the last year were zombie companies that had been propped up by low interest rates and pandemic relief measures.  These were businesses that would likely have collapsed earlier without the support they received, which has now mostly been withdrawn.  The failure of bad business models is just part of the creative destruction of the capitalist system and is necessary for a healthy economy.

The paper defines zombie firms as firms that are risky, unproductive and unviable but that manage to avoid immediate default, often thanks to banks, investors, or government support, in light of misaligned incentives.

Their research shows that the share of zombie firms (both listed and private) has steadily grown over the last 20 years, initially growing in the wake of the Global Financial Crisis. After a downtick from 2016 to 2019, the share of zombie firms resumed its upward trend, likely driven by the unprecedented policy support and easy financing conditions made available to businesses as pandemic relief.

The paper finds an increase in zombification over the last twenty years for both listed and private firms, with zombie firms accounting for over 10 percent of all listed firms in 2021, up from 6 percent in 2000 and for private firms the rise has been from 1 percent in 1997 to over 5 percent in 2020.

The authors find that the presence of zombie firms in an industry dampens investment, productivity, and employment for healthy firms.  They find that healthy firms who find themselves competing with zombie firms are less able to access credit and that nonzombie firms in industries heavily populated with zombie firms tend to exit the market at a faster rate than average, and that new competitor entry rates in those industries are significantly lower.

The paper argues that the policies that led to zombification, while well meaning, might delay an important creative destruction in the global economy, harm healthy firms and have negative consequences for long-term productivity growth.

No one wants to see firms going out of business, especially startups which are often the most exciting and innovative firms, but if a business model makes no sense, or only works in a zero-interest rate environment, then its disappearance means that capital can again flow in the direction of the best businesses. 

Thanks for tuning in to this week’s podcast, and a special thanks to my supporters on Patreon who make all of this happen.  Have a great week and talk to you again soon, bye.