The formula behind San Francisco’s startup success

Why has San Francisco’s startup scene generated so many hugely valuable companies over the past decade?

That’s the question we asked over the past few weeks while analyzing San Francisco startup funding, exit, and unicorn creation data. After all, it’s not as if founders of Uber, Airbnb, Lyft, Dropbox and Twitter had to get office space within a couple of miles of each other.

We hadn’t thought our data-centric approach would yield a clear recipe for success. San Francisco private and newly public unicorns are a diverse bunch, numbering more than 30, in areas ranging from ridesharing to online lending. Surely the path to billion-plus valuations would be equally varied.

But surprisingly, many of their secrets to success seem formulaic. The most valuable San Francisco companies to arise in the era of the smartphone have a number of shared traits, including a willingness and ability to post massive, sustained losses; high-powered investors; and a preponderance of easy-to-explain business models.

No, it’s not a recipe that’s likely replicable without talent, drive, connections and timing. But if you’ve got those ingredients, following the principles below might provide a good shot at unicorn status.

First you conquer, then you earn

First, lose money until you’ve left your rivals in the dust. This is the most important rule. It is the collective glue that holds the narratives of San Francisco startup success stories together. And while companies in other places have thrived with the same practice, arguably San Franciscans do it best.

It’s no secret that a majority of the most valuable internet and technology companies citywide lose gobs of money or post tiny profits relative to valuations. Uber, called the world’s most valuable startup, reportedly lost $4.5 billion last year. Dropbox lost more than $100 million after losing more than $200 million the year before and more than $300 million the year before that. Even Airbnb, whose model of taking a share of homestay revenues sounds like an easy recipe for returns, took nine years to post its first annual profit.

Industry stalwarts lose money, too. Salesforce, with a market cap of $88 billion, has posted losses for the vast majority of its operating history. Square, valued at nearly $20 billion, has never been profitable on a GAAP basis. DocuSign, the 15-year-old newly public company that dominates the e-signature space, lost more than $50 million in its last fiscal year (and more than $100 million in each of the two preceding years). Of course, these companies, like their unicorn brethren, invest heavily in growing revenues, attracting investors who value this approach.

We could go on. But the basic takeaway is this: Losing money is not a bug. It’s a feature. One might even argue that entrepreneurs in metro areas with a more fiscally restrained investment culture are missing out.

What’s also noteworthy is the propensity of so many city startups to wreak havoc on existing, profitable industries without generating big profits themselves. Craigslist, a San Francisco nonprofit, may have started the trend in the 1990s by blowing up the newspaper classified business. Today, Uber and Lyft have decimated the value of taxi medallions.

Not making money can be the ultimate competitive advantage, if you can afford it, as it prevents others from entering the space or catching up as your startup gobbles up greater and greater market share. Then, when rivals are out of the picture, it’s possible to raise prices and start focusing on operating in the black.

Raise money from investors who’ve done this before

You can’t lose money on your own. And you can’t lose any old money, either. To succeed as a San Francisco unicorn, it helps to lose money provided by one of a short list of prestigious investors who have previously backed valuable, unprofitable Northern California startups.

It’s not a mysterious list. Most of the names are well-known venture and seed investors who’ve been actively investing in local startups for many years and commonly feature on rankings like the Midas List. We’ve put together a few names here.

You might wonder why it’s so much better to lose money provided by Sequoia Capital than, say, a lower-profile but still wealthy investor. We could speculate that the following factors are at play: a firm’s reputation for selecting winning startups, a willingness of later investors to follow these VCs at higher valuations and these firms’ skill in shepherding portfolio companies through rapid growth cycles to an eventual exit.

Whatever the exact connection, the data speaks for itself. The vast majority of San Francisco’s most valuable private and recently public internet and technology companies have backing from investors on the short list, commonly beginning with early-stage rounds.

Pick a business model that relatives understand

Generally speaking, you don’t need to know a lot about semiconductor technology or networking infrastructure to explain what a high-valuation San Francisco company does. Instead, it’s more along the lines of: “They have an app for getting rides from strangers,” or “They have an app for renting rooms in your house to strangers.” It may sound strange at first, but pretty soon it’s something everyone seems to be doing.

A list of 32 San Francisco-based unicorns and near-unicorns is populated mostly with companies that have widely understood brands, including Pinterest, Instacart and Slack, along with Uber, Lyft and Airbnb. While there are some lesser-known enterprise software names, they’re not among the largest investment recipients.

Part of the consumer-facing, high brand recognition qualities of San Francisco startups may be tied to the decision to locate in an urban center. If you were planning to manufacture semiconductor components, for instance, you would probably set up headquarters in a less space-constrained suburban setting.

Reading between the lines of red ink

While it can be frustrating to watch a company lurch from quarter to quarter without a profit in sight, there is ample evidence the approach can be wildly successful over time.

Seattle’s Amazon is probably the poster child for this strategy. Jeff Bezos, recently declared the world’s richest man, led the company for more than a decade before reporting the first annual profit.

These days, San Francisco seems to be ground central for this company-building technique. While it’s certainly not necessary to locate here, it does seem to be the single urban location most closely associated with massively scalable, money-losing consumer-facing startups.

Perhaps it’s just one of those things that after a while becomes status quo. If you want to be a movie star, you go to Hollywood. And if you want to make it on Wall Street, you go to Wall Street. Likewise, if you want to make it by launching an industry-altering business with a good shot at a multi-billion-dollar valuation, all while losing eye-popping sums of money, then you go to San Francisco.