Unconventional Strategy – Applied to Startup Economics
Cost is killing Silicon Valley. If you have been reading some of the news over the past year coming out of the valley, then your probably aware of the brain drain happening at a rapid pace. Protests on housing, insane talent costs and equity offerings just to compete with the Googles and Facebooks is having a huge impact. It’s becoming impossible to get a startup through A round without raising $2M-$4M in seed, which means you start from day 1 with a lot of dilution. Doesn’t matter if you raised it on a note or a set valuation, you cannot escape the basic math. Good luck building a cyber security startup on a $1M seed round in the Valley. Can it be done? Sure, but your eating Raman Noodles and all 8 of you are sharing the same 1 bedroom apartment.
New York city is no peach either as once you evaluate the total costs and hidden costs (New York City income tax, rent, salaries, cost of living, etc.) your funding doesn’t go very far.
Human psychology plays a big role in strategic thinking. It elicits emotion. It just “feels” successful to our ego to say, “We are a Silicon Valley startup”. From movies to books to hit shows, our human consciousness has adopted the dopamine of associating stature, success, wealth and smarts with the term Silicon Valley. This is the “sheep herd” mentality at play. Its powerful stuff. The downside of this human trait is we make our decisions based upon what will feed the ego, collective thinking and not based upon strategic thinking. Its “feel good emotions” vs practical decision-making theory. Data and unconventional thinking always wins. Fads and sheep herd mentality is a normal default in today’s tech society at large. We want to belong. We want and desire to be accepted. Skinny jeans, yoga pants, popular phrases, hairstyles, Apps, car choices and other movements we normally call “the latest craze”. Its part of what makes us human. Nothing wrong with it.
Building a startup today means you have to look beyond Seed funding to A, B and C round strategy and costs. I see founders so pumped and excited about getting offers of funding in the Valley with requirements to move there, that they forget to unemotionally think through the economics. Startups are opting to go elsewhere for a reason. Global venture funding was down 23% in 2016, but dropped 28% in the valley alone last year according to CB Insights. In addition, Unicorns outside of the U.S – companies valued at $1 billion or more, has gone from 30% in 2013 to 58% in 2016.
The cost to build a startup, hire talent and grow it to any substantial size in San Francisco, NYC and the Valley has reached fire-drill proportions. It’s no longer whispered in hushed conversation, it’s talked about by everyone. Its bad. Which is good for us at DataTribe. We hire key talent for our startups from the Valley and San Francisco and move them here to the DC/MD/VA corridor. Places like Ottawa, Austin and MD/VA have become perfect environments to build startups. Low cost of living, huge talent pools, cheap office space, large customer bases and more family friendly environments. The ability to scale beyond your first 10 employees is incredibly more viable outside of the valley. You have to think longer term, not just about the first $1M check written to prove out your idea.
Don’t get me wrong; the ecosystem in the valley is second to none. You can walk into a coffee shop and find your new co-founder, CTO, 5 people willing to throw money at your idea and at least two good mentors. No one has the supporting ecosystem like the Valley, no one. But the costs to live, hire and build a startup has gotten so insane that startups are bailing, investors are throwing money at Atlanta, DC/VA/MD, Utah, Colorado and Ottawa. Smart founders are thinking more long-term today. Cost and available talent pools become the priority. Remember, it’s about winning – not about feeding your ego or feel-good emotion.
As a founder, your main job is to raise money, hit milestones and make sure you stretch every investment penny as far as it will go. As your company gets beyond 10 people, the task of scaling becomes a CEO’s top focus. The cost to attract and retain top talent becomes your #1 cost center. People are always your top expense. Have you ever tried to hire a top engineer when the max you can offer him is $130K and 1% equity and Twitter offers him a $800K per year compensation package? Yeah, it sucks. So lets take a look at cost. There are nuances to consider as well. One experienced Product Manager in Silicon Valley is worth 2 inexperienced PM’s on the East Coast. Here we have tons of Project Managers, but scant resources for true commercial product managers. Enterprise sales experience in the Valley has no peer either.
According to a new study conducted by the data science team at Hired. Based on over 280,000 interviews and job offers from 5,000 companies, the data showed that the average salary for a software engineer in the Bay Area is $134,000. The highest by far in the country. In the DC/VA/MD area, the average software engineer salary was $110-$120K. Now this is where it gets interesting. When you factor in the cost of living in Silicon Valley the results show that these same engineers are now the LOWEST paid engineers in the country. With rent, food, taxes, transportation and other factors included – Silicon Valley engineers made the least! Not good.
According this data analysis, a Silicon Valley engineer would need to make $198,000 to take home the same amount of money that a software engineer in Austin or DC/VA/MD took home on a $110,000 salary when factoring in the cost of living. Holy shit.
Ok, now lets talk about the other cost centers that founders need to consider – office rent, services and contractors. These are fundamental cost areas that are glossed over in studies and reports. Yeah, I get it; the cost of living really sucks in the valley. Yeah, its tough to recruit and keep top talent when Google, Facebook, Twitter, etc. offer over 3 to 5 times the compensation package than you can as an early stage startup. Yeah, that sucks. But it gets worse.
Office rent in San Francisco sits around $60 to $72 per square foot. To put that in context – here in the cyber tech hub of MD, really nice office space runs around $25-$32 per square foot. Your costs are double in the Valley. Yeah, that sucks too. How about contracted services? Most first time founders never calculate they will need to pay ongoing legal, PR, marketing and design/branding services. Yeah you may have 10 people on your team, but you cannot afford to hire a full-time experienced marketing person, in-house counsel or other experienced services you need, no early startup can. In the Seed to A round and often times 12 months after an A round, you must continue to pay a Marketing firm, PR firm, law firm, contracted UI/UX, design, 1099’s, etc. Its part of the deal. No one escapes this reality, but very few ever consider it when fund-raising. In the Valley, you have to take a lot more early stage money get to an A round, plain and simple math.
The costs for these services are the highest in the country – you guessed it, in Silicon Valley. Yeah, that sucks. On average, these services run about 30% cheaper in MD/VA, Austin and Ottawa and are just as effective in my view. So lets put all of this in the context of strategy. Strategic thinking is just as important today as having brilliant product ideas.
At SEAL Team 6, everything we did, everyday was based upon unconventional thinking, game theory and psychology. It was pounded into my head non-stop. Our brains were “re-wired” to look at problems in ways 99% of humans do not. Strategy is really nothing more than a plan of action designed around avoiding certain consequences and maximizing your chances of success. Whatever your criteria for success is. It is also about examining the usual way people are doing things -the norm, and asking “what would happen if I did the exact opposite?” Where are the lemmings headed and why?
Data is king in unconventional strategy thinking. Following the sheep herd mentality because it feeds an emotional response is the normal human default. This doesn’t mean you will automatically be successful because you built your startup in MD or Ottawa, it might mean you just extended your crash and burn 90 days with a smaller burn rate. It does however mean your beginning to think about longer-term strategy and not ego, acceptance or external visuals.
As a founder, you have to make hard, calculated and cold decisions. You have to think about what is in the best long-term interests of my startup and what gives us the best chance to win. Cost, talent pool and scalability are huge factors in success. Ego just makes you feel good, but doesn’t help with your burn rate.
Lets take emotion, hype and conventional thinking out of the equation. Lets focus on data. When we examine the available data, lets focus on:
Cost of living
Cost of Talent
Cost of Customer Acquisition
Competition for Talent
Available Talent Pool
Employee take-home pay
Ancillary Services Cost (PR/Marketing/Finance/Legal/UI/UX, etc.)
From the available 2014-2016 data, we know that Silicon Valley has the highest cost among the technology hubs for all of these categories (although New York is not that far behind in some of these). Lets look at a category that most first-time founders never really consider – State Taxes. It takes a little longer term thinking to bring this topic into the equation, after all who really spends a lot of time worry about Long Term Capital Gains and state taxes when your running around like crazy trying to raise your first Seed Capital.
Everyone wants to believe their startup will be massively successful and it’s important to have that conviction or why start a company? So let’s say you successfully raise Seed, A round and B round money for your California startup. You now own 20% of your company post B round and things are really clicking. A large company comes around and offers you and your board $200M to exit. For the sake of simple math, lets assume your take is $40M as the founder in this scenario. That is a life-changing money. The current Long Term Capital Gains hit is 20%, however the Affordable Care Act adds another 3.8% for a 2017 total of 23.8% long-term capital gains you need to slice off for Uncle Sam. Not horrible compared to most countries, but not as good as it used to be (15%). After that check gets written and sent off, now you owe State Taxes on this windfall. Lets take a look at the check we write to California and NY.
The states with the highest state income tax rates:
New York: 12.68% (8.82% + 3.86% for New York City)
New Jersey: 8.97%
So you stroked a check to the U.S Government for $9.52M. Now you owe the great state of California another $5.32M for a whopping total $14.84M paid in taxes, which leaves you with $25.16M. Nothing to cry over for sure and no one is going to throw a pity-party for that. It’s still a lot of money. New York is just as bad and getting worse. Keep in mind that in both locations you most likely had to raise more money to grow because the cost of living, talent, office rent, equity to attract top talent, etc. is a lot higher than other areas (Austin, MD/VA, Colorado, Ottawa, etc.). So in 8 out of 10 scenarios your dilution to get through B round in CA/NY is most likely higher because you needed more money each round to compete, hire and scale. This is a factor very few ever think about or even discuss.
As a founder sitting down with pencil and paper or standing in front of a whiteboard charting out your startup strategy, if you do not take a moment to apply some long-term strategic thinking or look beyond the excitement and hype of being a “Silicon Valley startup”, you will pay for it in the long run. Maybe that $5.32M check you stroked to the State of California was worth it, along with the greater dilution due to the cost of fueling your CA/NY startup. Maybe not. Just something to think about.
I am not trying to be a “homer” for one state or technology hub over another. I have built startups in CA, Switzerland, VA, MD and Nevada, but now with a little gray in my beard and scars on my back, I think more carefully about Startup Economics than I did when I was younger and eating Ramen Noodles.
Lets take a look at MD/VA/Austin and Nevada. Again, not trying to be a “homer” for either, but its hard not to when you follow the data.
Taking the same scenario above with your $40M windfall:
Nevada: 0% state income tax due (you take home $30.48M)
Austin: 0% state income tax due (you take home $30.48M)
Maryland: 8.15% (5.75% income tax but an additional 1.75%-3.20% depending the county your business is in, lets average this to 2.4%) (you take home $27.22M)
Virginia: 5.75% (you take home $28.18M)
Colorado: 4.6% ( you take home $28.64M)
Although some of these states tax rates are certainly higher than 0%, they are not 13.3% or 12.68% like CA/NY and they have very low-cost of living, deep engineering, business talent pools and concentrated customer bases. Some better than others, but on average – solid venture and fund-raising ecosystems to support a startup. This translates into you and your key hires holding more equity. Why? Well you don’t need to raise as much to get off the ground in your Seed, A and B series rounds because rent, salaries, ancillary services, cost of living and talent retention equity is lower in these states than CA/NY. Not in all cases, but in most. Hard to quantify how much more equity you will retain, but it is somewhere between 1%-5%. Not scientific but an educated guess. I did not factor that into the above data because it depends upon your market, business strategy, customer base, etc., etc.
Lastly, this is not meant to be a poke-in-the-eye to Silicon Valley or New York ecosystems or meant to showcase some “homer” advocacy for one state over another. It’s meant to be an exercise in strategic and unconventional thinking. Nothing more, nothing less. Being a founder or CEO means people are relying on you to lead and think ahead, not just come up with a cool logo or slogan. It is hard enough to survive, scrape, fight and claw your way to an A or B round. To make a lot happen with a little. To challenge more established players and gain some customer traction. In 2017 and beyond, Venture Capitalists have no issue funding a startup in Ottawa, St. Louis or Denver. A startup needs to hit success milestones no matter where they are located to attract further funding, but you’re the CEO, you are the founder and everyone from your employees to the Board is looking to you to spend wisely and get them to the Promised Land. Spend some time on strategic long-term thinking from the get go and evaluate all of your options.