Highly respected venture capitalist Bill Gurley sounded the alarm about a month ago in an interview in the Wall Street Journal about the amount of risk VCs and startup employees are taking on these days. Very specifically he is worried about burn rates. To quote:

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.

Fred Wilson, another uber respected VC piled on. Fred had one of the startup money quotes of all time in his article.

At some point you have to build a real business, generate real profits, sustain the company without the largess of investor’s capital, and start producing value the old fashioned way. 

We are going to get to that point again. There has been a bit of talk about today’s entrepreneurs not having any muscle memory from the first internet boom or the Great Recession. I happen to have some. This is how this is going to play out.

Companies are going to continue to raise a lot of money at very high valuations and people are going to continue to debate if we are in a tech bubble or not. We are. The good news is that it is still a great environment to go out and raise as much money as you reasonably can at a not out of this world valuation. While there are exceptions if you do not pay heed to the reasonable valuation part of the last sentence it will come back to bite you as this unfolds.

At some point in the future, it could happen tomorrow, it could happen two years from now, there is going to be a macro event that changes everything.  I can’t tell you what it is but something is going to happen. We get in a war with Russia. Ebola spreads. Something that we never even dreamed of like a plane hitting a skyscraper or a major institution going bankrupt. Something is going to happen to shake confidence and when that something happens the money is going to dry up throughout the economy including funding for startups. The cash burn fire will be dampened. And once the flame of the burn goes away it is going to get very dark.

After the event investors are going to tell their portfolio companies to batten down the hatches. The mode is going to change from growth at all cost to survival. Survival means getting to cash flow positive. Getting to cash flow positive will require swift and decisive action. Hordes of people that that are currently working for money losing companies will get laid off. The huge sales and marketing spend will need to be turned off. I know this sounds crazy but effectively spending a lot of money is incredibly difficult. The only thing more difficult is to stop spending a lot of money. It takes time to turn it off. Regardless, frugal management creating a real business will become vogue.

There will be a large percentage of entrepreneurs that think none of this applies to them. That they can go out and raise more money. Most of them will be wrong. And even if they are right it will be a painful down round that pretty much kills them or their company anyway. The entrepreneurs that do not heed the advice of their investors will step off a cliff in the dark. Their startups never to be seen when the light returns.

I have seen this play out twice. I am confident that some version of it will happen again. So what’s a startup to do?

1. Have a moderate financial strategy. Don’t take on too much money. Don’t spend what you have like there is more. When the badness happens you do not want a high burn rate.
2. Hire thoughtfully. You don’t want to someday fire all those people that put their trust in you. Doing so will remain with you forever.
3. Listen to your investors. Or don’t. If they are telling you to spend at all costs now either ask them to pony up or resist the temptation. When they tell you the good times are dead take immediate action. The same day.
4. Build a real business now. The old fashioned way. Through paying customers that generate profits.

Startup companies that do these four things have a much better chance of making it through the valley of a downturn. Work on building a real business now. When it gets cold and dark you will be glad to have that as security.