Whatever the next ‘unicorn’ turns out to be, you can be sure of a few things: It will be a company led by a CEO who seems ever so slightly more than human, it will present itself as a tech-disruptor of a legacy-dominated industry, and it will be backed by billions of dollars of venture capital. It will be propelled by the fanciful and the inane in equal measure, though, under the surface, may even be a fairly unremarkable business, e.g., in office-space rental. But the venture capitalists (VCs) backing it won’t let that get in the way of what they think is a good story, for reasons that will become clear.
Aside from the potential reputational damage done to venture-capital firms investing heavily in hollow businesses, and to the Wall Street banks stewarding their sketchy IPOs, the folly of unicorn hunting raises questions about the utility of venture capital in society. Shouldn’t it disrupt the status quo with positive consequences for all of us? Shouldn’t it be a meritocratic exercise where funds are given to new CEOs with great ideas, but who lack the financial clout to get things moving? Given that many start-ups view venture-capital funding as a significant seal of approval on their way to business success, these questions are serious.
The skewed incentives of venture-capital investment
As long as its incentives remain skewed, venture capital is, however, unlikely to achieve anything like that. Today, VCs are obsessed with finding the next big, duo-syllabic thing, whether Face-book, Goo-gle, or U-ber – take your pick. These businesses do not even need to be profitable in a real, concrete sense; they just need to have a bewitching enough image. WeWork, for example, approached its now-infamous IPO with close to 13 billion dollars in funding, even though it was actually losing two hundred and nineteen thousand dollars an hour.
If you’re thinking that the apparent lack of correlation between investment generated and profitability seems suspicious, you’re not the only one. In a recent talk about venture capital, founder and CEO of the Social Capital fund, Chamath Palihapitiya, likened such patterns of investment to “Ponzi schemes.” “How many of you have had this conversation: ‘Hey! How fast are you growing? … Well, grow faster,’” he says, to a room full of laughing start-up founders. The question was meant to mimic those that typically come from VCs backing new start-ups. The response Palihapitiya got suggests that the question was all too familiar to those in the room. He explains the skewed incentives in venture capital in the following way:
- Once a VC representing a fund identifies a company they want to turn into the next unicorn, they invest a huge amount of money and compel it to grow at a greater rate than it is ready for.
- Forty cents of every venture-capital dollar goes straight into the hands of Google, Amazon and Facebook. This money purchases ads that fuel the superficial, unprofitable growth of the company.
- These ads help to increase the “presence” of the company, and make it look as though it is growing astronomically.
- The resultant “growth” is then used to pull in more investment to the original fund, and to form the basis of subsequent rounds of investment from other funds that want to get in on the action.
- With each new round of investment, the cycle begins anew: The company continues to “grow,” the earlier funds increase the capital they have under management, more ads are purchased, and the new funds enticed by that superficial growth establish a basis for further rounds of investment.
- When the capital of a fund increases, so do the earnings of the VC charged with its management. That’s because a VC’s typical management fee is 2 percent of the total worth of the fund. Therefore the above dynamic continuously increases the fees that VCs can charge, surpassing even the conventional returns from the strong performance of the company receiving all the investment in the first place.
- In other words, simulated growth begets simulated growth, so long as there is always money to be pulled in. The consequences of its running out do not need to be stated.
Why are monopolies bad for consumers?
You might say, “Okay, so what? They’re getting richer, why should I care?” Aside from the fact this dynamic strengthens the hand of the global tech giants in our society, there is another reason to care: These practices actively lead to the creation of monopolies, which always hurt consumers. The venture-capital funding WeWork had at its disposal allowed it to grow at such an explosive rate because it could then buy its customers: It allowed WeWork to sell its own service for less than what it cost them to offer it in the first place. Meanwhile, its competitors without that kind of funding were trying to grow at a rate that would allow them to profitably service their existing customer base. But when faced with ever lower prices from WeWork, sooner or later they went bust. WeWork did nothing more than use the tactics of men like Carnegie and Rockefeller, becoming a monopoly.
Once a company that sells under costs has forced all its competitors out of business, it usually sends its own prices through the roof, because, eventually, someone needs to start making money. They need to transfer the costs of their own growth onto the backs of their now enormous customer base. Those customers suddenly realize there is nowhere else to turn and that the company that once provided them with an impossibly cheap service is now extorting them. What is even worse for the consumer is that the quality of the product or service offered is poor. Some might say that WeWork’s offering is innovative, others would say that it is nothing more than a managed office-space, with no great new technology, couched in new-age language. The real point is that, without any competition, there is no variety in the market and you don’t have to bother adding any value. There is no real choice for the consumer: Not only do they now have only one, uninspiring option, they have to pay through the nose for the privilege of using it. The self-serving practices of VCs are directly responsible for this state of affairs.
What we really need is a world where concrete growth is facilitated for a multitude of players, rather than superficial growth for the elect few. Start-ups can increase the diversity of products and services on offer with their innovative new ideas, but they need long-term partnerships, guidance and financial support. Instead, they are being turned into monopolies or becoming collateral damage in the high-stakes games of roulette played by an insular overclass of venture capitalists who can never lose. For the benefit of start-ups and customers alike, this needs to change.