The perils of paying more in Silicon Valley

Since its founding in 2009, Andreessen Horowitz has become a top Silicon Valley venture capital firm by adhering to a simple mantra: It’s all about the talent. In some ways, Andreessen Horowitz is a talent agency as much as a tech investor. Marc Andreessen, the Web pioneer who was a founder of Netscape and other companies before trying his hand at venture capital, has made this point explicitly. At a private event in 2010, a video of which The Wall Street Journal made public, he interviewed Michael Ovitz, the onetime Hollywood superagent who started Creative Artists Agency.

“A lot of what we're trying to do at Andreessen Horowitz is based directly on Michael’s experience building CAA,” Andreessen told the Silicon Valley big shots assembled for the occasion. The firm declined to comment for this article.

The partners seem to have realised that the economics of Silicon Valley are uncannily similar to those of Hollywood. And by exploiting that insight, they may have helped inflate a tech bubble.

For all the attention Ovitz lavished on his stars, by far the most important things he procured for them were money and control. In the mid-1970s, when Ovitz founded CAA, the breakdown of the traditional studio system had created a world in which stars had potentially enormous, if little appreciated, leverage.

Andreessen, for his part, exploited a shift in power from venture capitalists to startup founders in Silicon Valley. In the 1970s, venture capitalists fronted entrepreneurs relatively small sums for large equity stakes in their startups. By the 2000s, however, new technologies trimmed the cost of getting a company off the ground. Venture capital used to be about ferreting out the best deals, said Naval Ravikant, a longtime investor who founded the investment syndication site AngelList. Now, he says, “the question is who gets access”.

Andreessen Horowitz’s pro-talent stance has helped win over founders, but as with Creative Artists the key to its recruiting success has been the allure of highly favorable financial terms.

The way the typical venture capital deal works is that the investor will place a “pre-money” valuation on the company he or she is hoping to fund, then add an equity stake on top of it. For example, if the investor deems the company to be worth $40 million before the investment, and invests $10 million, the investor will then own 20 percent of the company, now valued at $50 million. The higher the valuation, the better it is for the entrepreneur, who gives up less equity for a given amount of cash.

Within Silicon Valley, Andreessen Horowitz is famous for bidding valuations to heights that make rivals uncomfortable. To offset the dilution of ownership that comes from such prices, Andreessen Horowitz — which says it manages $4.2 billion in assets — increases the amount of money it invests. The firm often kicks in more than the entrepreneur asks for, according to rival venture capitalists who have been involved in these deals. (Some investors agreed to speak only on the condition of anonymity.)

Venture capitalists who have bid against Andreessen Horowitz say the firm often comes in 50 to 100 percent higher than many other bidders. These prices are flattering to the entrepreneur, who suddenly runs a company worth twice as much on paper as previously thought.

Andreessen and his partners seem to believe they're playing a role analogous to that of Ovitz and his fellow superagents: They do what it takes to lock up talent, which they eventually sell to someone else at a huge markup. This generates profits for themselves and a nice payday for the stars, whether they are Hollywood celebrities or entrepreneurs.

But what if the Andreessen Horowitz partners have the analogy wrong? Rather than profiting like Ovitz and his fellow agents, the venture capitalists may be more like the Hollywood studios — chronically overpaying for projects whose costs they can rarely recoup. Andreessen and his partners have invested so much in so many startups that it would take a remarkable string of successes to make the approach pay off. Already, they’ve suffered a few impressive flameouts, including Fab, on which they are likely to lose tens of millions of dollars.

If prices remain buoyant, the eye-popping valuations of the firm’s top-performing companies will keep it profitable and losses will be containable. But if the market turns, Andreessen Horowitz could have serious trouble. Worse, Andreessen Horowitz isn’t just a beneficiary of behavior that’s driving up valuations. If a bubble is forming, it is ultimately because too much money is chasing too few companies. But the firm’s own aggressive bidding may be partly responsible.