California is hard to beat. There are richer places with worse weather, there are (a few) nicer climates with worse economies, but it’s really hard to find any place on planet earth that’s nicer to live in and to work in. There’s a consensus among smart people that the Bay Area is the place to be, and they relocate accordingly.

Smart people are generally right on average. But whenever the consensus among smart people is that you can make a given decision without thinking too hard, beware: the flip side of intelligence is the ability to rationalize bad decisions rather than admit your mistakes. It took a lot of intellectual horsepower to rationalize Superbowl ads and free shipping for cat litter in 2000; it took a similar amount of braininess to believe that subprime mortgages could be aggregated into securities that were as safe as treasuries.

There are three related problems that make California economically tenuous, and a fourth that makes the situation worse:

It’s no longer the best place in the world to start a startup. The gains from the existing tech industry increasingly accrue to a) passive investors, and b) lucky landlords. The state government is a levered bet on tech compensation. These three problems, which are interrelated, won’t show visible symptoms until well after they’re terminally un-fixable.

Here in New York we prize elegant design and high production values.

The good news, such as it is: part of my bear case on the Bear Republic is that its most valuable assets can just pick up and leave, so it’s not a bad place to be right now. If you get a nice offer from a big tech company, by all means, go to Mountain View or Los Gatos or even San Francisco. (If you can afford Pacific Heights rents and ride-sharing everywhere, you can pretend you don’t live in SF at all.)

But if you’re considering starting a company, maybe take a look at Austin, Brooklyn, Denver, or Seattle.[1] All of these places have some of the same problems as California, but at a smaller scale.

The California Cycle

Since the late 1970s, California has benefited from a virtuous cycle that goes like this:

A group of smart people decide to solve a challenging technical and business problem. They raise some money, form a company, and dole out stock options to early employees. The company grows, and either sells or goes public. The founders retire, get bored after a couple days, and return to step two, except this time they’re the ones writing checks.

Every generation of technology has been disproportionately funded by the founders of companies in the previous generation. Kleiner and Perkins of Kleiner Perkins were early employees at Fairchild and Hewlett-Packard. Fairchild and Intel begot Mike Markkula, who retired from his options at 32 and then un-retired after he met Jobs and Wozniak. Sun Microsystems begat Khosla Ventures and Andy Bechtolsheim, an angel investor so aggressive he once wrote a check to a company that didn’t exist yet. (It worked out.)

For this cycle to work, your ecosystem needs three things: big companies that can buy out small companies and produce a cash windfall; rich people who are still hungry to get richer but don’t want to be CEOs any more; and new companies that can survive long enough to raise funding in order to join the other two categories. The cycle further benefits from the Alchian-Allen effect: agglomerating industries have higher productivity, which raises the cost of living and prices out other industries, raising concentration over time.

New, small companies are the most fragile and least visible part of this ecosystem. They’re hard to see because the best companies keep a low profile (a CEO with time to cultivate an image is not a CEO busy writing code or talking to customers), and because reporters are always willing to talk about a company filling the role of Hot New Startup. When Genentech is a startup, they’ll write about Genentech; when there aren’t any new Genentechs, they’ll write about Theranos instead.

New companies are essential because whenever there’s a new technology or a new way of organizing a business, it’s unclear whether the result will be a bigger industry or a smaller one. When Uber first came out, you could debate whether it would 10x the size of the car-hire market, or just reduce ROI to below the cost of capital by creating an unlimited supply of drivers. (You can still have this debate, but it’s harder to deny the upside opportunity.)

Since startups raise the variance within whatever industry they’re started in, the natural constituency for them is someone who doesn’t have capital deployed in the industry. If you’re an asset owner, you want low volatility. Since a startup is a call option on whatever business it will turn into, it benefits from higher volatility.

Historically, startups have created a constant supply of volatility for tech companies; the next generation is always cannibalizing the previous one. So chip companies in the 1970s created the PC companies of the 80s, but PC companies sourced cheaper and cheaper chips, commoditizing the product until Intel managed to fight back. Meanwhile, the OS turned PCs into a commodity, then search engines and social media turned the OS into a commodity, and presumably this process will continue indefinitely.

What that looks like from a financial markets perspective is that tech companies go through a golden age where they’re growing fast and trading at a sky-high multiple, then suddenly they’re trading at a below-market multiple because their revenue growth is flat at best and unstable at worst. What’s worrisome is that, if we have fewer startups, this valuation compression will start to happen later, or not at all. If you’re just looking at public markets, all you’ll see is that the numbers have never been better, and if you’re looking at private markets, you’ll see that the bubble you were worried about has gotten less frothy.

Land and Burn Rates

The key reason that startups are getting harder to start in California is that the incremental cost of existing and growing has gotten higher. There are two monopolists to blame: landlords, and platform companies.

Landlords are the most annoying. A California landlord is generally not much more skilled or talented than other landlords; they just happened to own property in a place with a high concentration of engineers (thanks to good schools) and hippies (thanks to those schools’ liberal arts programs, as well as the fact that you can sleep outdoors in SF year-round). The engineers ensure that there’s growing demand for property; the hippies conspire with landlords to limit supply. Perhaps the funniest case study was that it took four months for San Francisco to determine that a laundromat was not an historic site that the city could not allow to be demolished.[2]

I’ve lived in the Midwest, on the Texas/Mexico border, and in New York, and when I moved to San Francisco I was surprised to see that anti-immigrant sentiment was quite socially-acceptable there. Literally, on my way to work, I’d see propaganda posters about how people like me who’d moved to San Francisco had better pack up and leave — or else. I can understand some level of discomfort with changes in one’s community brought about by immigration, whether it’s smart people from foreign countries or just people from other cities. But the policies SF has chosen are just plain pathological: the city reduces the supply of housing to discourage gentrifiers from moving in, so gentrifiers bid against natives. The rising cost-of-living prices more industries out, making tech companies more dominant, and the rising share of tech company residents means that tech comp increasingly sets the market price for housing. If San Francisco wants to eliminate gentrification, they’re going to have to accept becoming very poor. If they want to mitigate the impact of gentrification, they should start building some big Stuy Town-style high-density apartment blocks.

Real estate supply restrictions have a perverse effect. Per the law of supply and demand, they mean that demand is immediately and indefinitely reflected in price. Since demand is set by the incomes of people who think they’ll be earning that amount of money for the next year, the cash flow characteristics of a city’s businesses determine what effect high real estate prices have. In New York, finance and law start paying you well right away. It’s rare for a startup financial company to produce negative cash flow for owners after the first year. Other industries in New York have worse immediate cash flow prospects — media, fashion, and music, for example.

For a city to have a thriving arts scene, you need some combination of:

Families or nightlife, both of which produce demand for reasonably educated workers who work non-traditional or variable-schedule jobs, either as babysitters or bartenders. Cheap neighborhoods that aren’t unsafe. My current neighborhood, Williamsburg, fit this role ten years ago. Upside, either in the form of selling out or marrying someone with a boring but lucrative job.

New York manages to combine all of these in clever ways. For example, the New York restaurant industry benefits from two dinner shifts, because finance and media/fashion are basically in two different time zones. Traders leave work at 5 and have expense-account dinners at 5:30; by the time the table’s cleared at 8 it’s time for the ad agency and fashion people to show up for their expense-account dinner. New York’s nightlife feeds into family formation, maintaining a balance between demand for babysitters and bartenders, while also keeping wages up by reducing the supply.[3] And in a broader sense, status in New York is a progressive tax on wealth because the city is full of opportunities for conspicuous consumption. You can earn below the poverty line and save money, at least if you’re healthy and able-bodied; but as Tom Wolfe pointed out back in the 80s, you can also slowly go broke earning a million dollars a year.

Startups are not like New York’s low-paying jobs; there is a “marriage” market, in the sense that one exit opportunity is to meet a Corp Dev matchmaker and decide where you want to settle down. But that takes a while, and unlike in New York, the economically disadvantaged party is the one paying for the dates, at least in terms of opportunity cost.

There’s anecdotal evidence of this. When Airbnb was just starting out, the founders spent years being nearly broke. It’s hard to imagine someone living in the Bay Area spending a long time “nearly broke” today; they’d spend too much on rent and have to move back home or get a BigCo job. Y Combinator has implicitly acknowledged this. When the program started in 2005, they’d offer founders a maximum of $20,000 to spend the summer running a startup. Now it’s $120,000. That’s a 14% compounded growth rate in the minimum amount of cash on hand needed to start a company. YC has also grown, but it’s hard to count on one organization to hold back the tide here. As long as higher rents raise the cost of starting a pre-revenue company, fewer people will join them, so more people will join established companies, where they’ll earn market salaries and continue to push up rents.

And one of the things they’ll do there is optimize ad loads, which places another tax on startups. More dangerously, this is an incremental tax on growth rather than a fixed tax on headcount, so it puts pressure on out-year valuations, not just upfront cash flow. According to Social Capital’s 2018 letter, almost 40% of VC money goes to advertising on the largest search, social, and e-commerce channels. Those channels have adapted to a world where they’re the best place to scale because they have the biggest audience, which means there’s more money for them in optimizing their revenue capture. Thus, ads get better-targeted, ad loads rise over time, more content moves into the walled garden, and it becomes progressively harder not to pay an economically efficient (read: very high) ad price.

Digital landlords at least homesteaded their land and made it worth renting on. Unfortunately, they’re a lot better at charging the Laffer optimal tax rate on their tenants’ profits.

Public Pension Funds: A Slow-Motion Run on the Bank

You may notice that my thesis is about “California,” but my comments have been restricted to the Bay Area. There’s a reason for this: the Bay has provided vast income and capital gains tax upside for California in the last few decades, which the state has habitually spent as quickly as it can. Government spending tends to be sticky, especially because one of the easiest ways for governments to give away money is to get higher cash flow today in exchange for taking on higher future liabilities.

The final piece of the California puzzle — after the real estate tax on low-cash flow startups and the platform tax on growth-stage startups — is the literal taxes on everybody.

There are two key points to understand about California’s fiscal situation:

Income taxes, which are volatile, are a large proportion of state revenue. And capital gains taxes are in the high-single digits. Since capital gains are the integral of income over time (they’re a change in the market’s estimation of the net present value of all future income from a company), they’re particularly cyclical. California’s public pensions are massively underfunded (the $769bn in that article is an overestimate, but it’s directionally right).

Now, consider the incentives for someone living in California during a recession. Budgets are getting cut, but state worker headcount and compensation are sticky due to heavy unionization, so the net result is that there’s a reduction in new services offered. At best, this means the state government is stuck solving whatever problems were most pressing back when their budget was growing; at worst, it means that the state is just a jobs program. While there’s pressure to lay off employees, there’s heightened pressure from those employees not to do so — the stability of a government job is particularly desirable when unemployment is high.

So something has to give: taxes have to rise. As taxes go up, people start to consider living elsewhere. (We already see this with people who run mature companies; they like to retire to Florida or something for a year before they close a sale, so they avoid the capital gains tax.) Every time the tax base diminishes, the tax burden on the people who stay behind goes up.

Big companies won’t leave right away. The network effects of the Bay are too strong. They may grow other offices, and employees will transfer, but the Stanford/Berkeley/Caltech-to-Big Tech Company pipeline will persist. However, the current crop of big companies will still be the big tech companies in 2030 and 2040.

Over the long term, California’s future looks like New York excluding New York City, albeit with nicer weather. There will be big companies that slowly decline, the tax base will deplete, and politicians will have to find ways to raise taxes on the remaining citizens while getting them to tolerate the same or diminished levels of government services.[4] Eventually, this will reduce the price of housing, but not in a way that revitalizes startups. Instead, we’ll have a dynamic where a house that used to be 50% too expensive at a million dollars will still be 50% too expensive at $750,000.

Conclusions

Once upon a time, California was cheap. In the 50s and 60s, it was a place where you could work part-time to fund your biker gang. In the 70s, you could work part-time to fund your revolutionary terrorist cell. Such side projects are infeasible today. If you’re going to run a massive bombing campaign out of a house in San Francisco, you’ll need to raise at least a mid-six figure seed round.

You can see the decline over time:

Semiconductor startups, which are capital-intensive once they start manufacturing, were mostly founded by people leaving other hardware companies.

PC companies got founded in garages.

The biggest of the Internet companies got founded in garages and trailers, yes — by procrastinating grad students who had stipends and university-provided computers.

Mid-2000s consumer web companies economized on labor by hiring friends, and raised small seed rounds. When Y Combinator started, funding was explicitly modeled on grad student stipends.

Today, YC thinks it takes $150k to fund a startup through Demo Day and beyond.

As the market for talent gets more efficient and the supply of housing remains constrained, the required burn rate for startups will rise, making them an increasingly expensive indulgence. Rewind the Airbnb story but with higher rents and it’s a story about three guys who ran a novelty website for a while before they all got jobs designing marketing microsites for Oracle.

California’s politicians will always be able to say “We’re so happy to be the home of companies like X, Y, and Z.” It will take them a long, long time to notice that “X, Y, and Z” used to change every five years, then it was every ten, then it was the same companies for a generation. By the time they figure out that the big new companies aren’t being founded nearby, the next big startup cluster will already have had its first round of exits, and Austin or Portland or Raleigh will be full of angel investors and small VC shops itching to perpetuate the local startup cycle.

Californians will end up like the landed gentry in interwar England. Lovely houses, illustrious history, and no conceivable way to pay their bills.

Edited May 3, 2019: there’s a follow-up post with more details and some proposed solutions.

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