1, There is no doubt that in the last couple decades, labelling oneself an “entrepreneur” has become “a thing”.
- Cheap debt and easy funding has indeed made it possible for “entrepreneurs” to create “pre revenue” businesses. Controversially, we have seen businesses with no clear plans for making a profit enjoy billion-dollar valuations.
3.The U.S. start-up rate has been falling for decades. There are many reasons for the decline including demographics.
- The narrative around “entrepreneurship” forgets that valuable companies take decades to build. Funds have been chasing negative-gross-margin businesses that grow really quickly. Think WeWork.
- Post pandemic, will we see the air disappear from this bizarre Ponzi balloon created by the venture capital industry?
There is no doubt that in the last couple decades, labelling oneself an “entrepreneur” has become “a thing”. Indeed as mentioned in one of the previous sections, the myth around entrepreneurship
has been used as a justification for the increasing social, income and wealth inequality
explained in previous sections.
Waves of quantitative easing, cheap debt and easy funding has indeed made it possible for “entrepreneurs” to create “pre revenue” businesses. Controversially, we have seen businesses with no clear plans for making a profit enjoy billion-dollar valuations.
My thesis in writing this book is that the Pandemic did not create anything new in the world of business. It only accelerated pre-existing trends. I want to point out that the U.S. start-up rate has been falling for decades. The Kauffman Foundation, citing its own research and drawing on U.S. Census data, concluded that the number of companies less than a year old had declined as a share of all businesses by nearly 44 percent between 1978 and
2012. And those declines swept across industries, including tech. Meanwhile, the Brookings Institution, also using Census data, established that the number of new businesses is down across the country and that more businesses are dying than are being born.
There are many reasons for the decline including demographics. However, I want to highlight one of the dysfunctions within the entrepreneurship narrative by focusing on the technology sector. “Scale” “Hacks” and “fast growth” has become the name of the game. Part of this is the risk aversion of the financiers, who themselves want to have short-term wins and want to fund things that look like they’re working in the short term.
But the problem with things that work really quickly is that they can stop working equally as quickly. In the narrative around “entrepreneurship”, the ecosystem seems to ignore that valuable companies take decades to build. Funds have been chasing negative-gross-margin businesses that grow really quickly. Think WeWork.
Chamath Palihapitiya has pointed out that tech startups spend almost 40 cents
of every VC dollar on Google, Facebook, and Amazon. I will now quote extensively from the 2018
Annual Letter from Chamath Palihapitiya’s Social Capital.
We don’t necessarily know which channels tech startups will choose or the particularities of how they will spend money on user acquisition, but we do know more or less what’s going to happen. Advertising spend in tech has become an arms race: fresh tactics go stale in months, and customer acquisition costs keep rising. Ad impressions and click-trough’s get bid up to outrageous prices by startups flush with venture money, and prospective users demand more and more subsidized products to gain their initial attention.
Warren Buffett once observed that this kind of arms race is
not unlike a parade where one spectator, determined to get a better view,
stands on their tiptoes. It works well initially until everyone else does the
same. Then, the taxing effort of standing on your toes becomes table stakes to
be able to see anything at all. Now, not only is any advantage squandered, but
we’re all worse off than we were when we first started. Such is the world of
user acquisition in tech today: as growth becomes increasingly expensive,
somebody must be footing the bill for all of this wasteful spending. But whom?
It’s not who you think, and the dynamics we’ve entered is,
in many ways, creating a dangerous, high stakes Ponzi scheme. Over the past decade, a subtle and
sophisticated game has emerged between VCs, LPs, founders, and employees.
Someone has to pay for the outrageous costs of the growth described above. Will
it be VCs? Likely not. They get paid to allocate other people’s (LPs) money,
and they are smart enough to transfer the risk. For example, VCs habitually
invest in one another’s companies during later rounds, bidding up rounds to
valuations that allow for generous markups on their funds’ performance. These
markups, and the paper returns that they suggest, allow VCs to raise
subsequent, larger funds, and to enjoy the management fees that those funds
Picture this scenario: if you’re a VC with a $200 million
dollar fund, you’re able to draw $4 million each year in fees. (Typical venture
funds pay out 2 percent per year in management fee plus 20 percent of earned
profit in carried interest, commonly called “two and twenty”). Most funds,
however, never return enough profit for their managers to see a dime of carried
interest. Instead, the management fees are how they get paid. If you’re able to
show marked up paper returns and then parlay those returns into a newer, larger
fund – say, $500 million – you’ll now have a fresh $10 million a year to use as
you see fit. So even if paying or marking up sky-high valuations will make it
less likely that a fund manager will ever see their share of earned profit, it
makes it more likely they’ll get to raise larger funds – and earn enormous
management fees. There’s some deep misalignment here…
There’s an analogy to be made between today’s venture backed
startup ecosystem and the American healthcare industry. Part of the reason why
American healthcare is so expensive is because insurers, who play a key
middleman role in setting prices for medical care, have a fantastic two-sided
business model. High prices, which ought to be a cost of doing business for
them, are actually a key revenue driver. Why is this? High costs allow them to
charge higher premiums, allowing them to pull steadily more and more money out
of patients’ and payers’ pockets. As a result, the cost of medicine steadily
rises, as do the insurers’ take. In the end, both patients and payers are the
ones who end up as bag holders footing the bill. The same thing is happening in
today’s venture world. Highly marked up valuations, which should be a cost for
VCs, have in fact become their key revenue driver. It lets them raise new funds
and keep drawing fees. And just as insurers’ business model translates into
higher costs of patient care, so does the modern venture model translate into
higher costs of, well, just about everything. We have higher salaries, higher
rents, higher customer acquisition costs, Kind bars, and kombucha on tap! So if
it’s not VCs, who ends up holding the bag?
It’s still not who you’d necessarily expect. Later-stage
funds, who invest large follow-on rounds into these marked up companies, do
indeed pay inflated prices – but they also usually get their money out first
upon a liquidity event, and are also happy to exist in “Fee-landia”. In some
cases, high prices may even work to their advantage. They’re able to hold
certain late-stage companies hostage to their high valuations by demanding
aggressive deal structures in return for granting “Unicorn Status” (the
billion-dollar valuation that VCs so crave). Unlike in other pass-the-buck
schemes, the bill is not getting passed from early investors to later
investors. The real bill ends up getting shuffled out of sight to two other
The first, as you might guess, are early stage funds’
limited partners, particularly the future limited partners that invest into the
next fund. Their money, after all, is what pays the VC’s newly trumped up
management fee: marking up Fund IV in order to raise money for more management
fees out of Fund V, and so on, is so effective because fundraising can happen
much faster than the long and difficult job of actually building a business and
creating real enterprise value. It might take seven to ten years to build a
company, but raising the next fund happens in two or three years.
The second group of people left holding the bag is far more
tragic: the employees at startups. The trend in Silicon Valley today is for a
large percentage of employee compensation to be given out in the form of stock
options or restricted stock units. Although originally helpful as a way to
incentivize and reward employees for working hard for an uncertain outcome, in
a world where startup valuations are massively inflated, employees are granted
stock options at similarly inflated strike prices. Overall, you can understand
how this arrangement endures: VCs bid up and mark up each other’s portfolio
company valuations today, justifying high prices by pointing to today’s user
growth and tomorrow’s network effects. Those companies then go spend that money
on even more user growth, often in zero-sum competition with one another.
Today’s limited partners are fine with the exercise in the short run, as it
gives them the markups and projected returns that they need to keep their own
Ultimately, the bill gets handed to current and future LPs
(many years down the road), and startup employees (who lack the means to do
anything about the problem other than leave for a new company, and acquire a
‘portfolio’ of options.) What is the antidote here? The antidote is two-fold.
First, we need to return to the roots of venture investing.
The real expense in a startup shouldn’t be their bill from Big Tech but,
rather, the cost of real innovation and R&D.
The second is to break away from the multilevel marketing
scheme that the VC-LP-user growth game has become. At Social Capital, we did
this by actively shifting away from funds and LPs to rely only on our own
permanent capital moving forward. Are we crazy to reject tens of millions of
dollars a year in fees? We think not, and we believe it’s time to wait
patiently as the air is slowly let out of this bizarre Ponzi balloon created by
the venture capital industry. In the meantime, we find comfort in the teaching
of Andy Grove that only the paranoid survive.
———————–end of extract from the 2018 Annual Letter
from Chamath Palihapitiya’s Social Capital.
It is highly unlikely that entrepreneurship will disappear of course. But it is hoped that post pandemic, a more conservative narrative will be infused into the ecosystem.