Monday, November 19, 2018

Social Capital's CEO on Silicon Valley: Startup Boom a “Dangerous, High-Stakes Ponzi Scheme”

An interesting look at the Valley via Wolf Street, November 7: 

“Startups spend almost 40 cents of every VC dollar on Google, Facebook, and Amazon.”
Chamath Palihapitiya, CEO of Palo Alto-based Social Capital – a “technology holding company” – and an early Facebook executive responsible for increasing its userbase (he left in 2011 to found Social Capital), has been accused of being outspoken before. And after his excellent but, well, outspoken commentary in his firm’s 15-page first annual letter, he will surely be so accused again.
As he lays bare how the startup and venture-capital ecosystem works – who ends up as “bag holders” is “not who you think,” he says – he steps on toes and says out loud what everyone is trying to keep quiet. Of course, these dynamics cannot last, and he says “It’s time to wait patiently as the air is slowly let out of this bizarre Ponzi balloon created by the venture capital industry.”

Below are the most salient excerpts on this topic from Social Capital’s first annual letter:
“Big Tech [‘the Googles and Amazons of the world’] will get bigger and will leave less room for obvious companies doing obvious things. The demands of innovation are going up, and the quality of the ideas and teams working on those ideas matter now more than ever in this David v. Goliath landscape.”

“Of course, one would think that investors should become more circumspect about the utility of their capital during times like these. Curiously, the opposite is currently true and is setting up for a massive rude awakening.”

“Since the great financial crisis, the quantity of capital that has made its way into the tech ecosystem seeking to fund the next generation of successful businesses has steadily increased. We don’t just have big companies anymore. We also have big funds [such as the Softbank Vision Fund, ‘which has a minimum check size of $100 million and a target of $50 billion per year of investment.’]”

“However, these mega-funds only tell half the story: there has also been a continuous surge of seed capital flowing into the industry as successful founders, builders, and fund managers reinvest their own money into the earliest stages of technology startups. They invest not only in pursuit of future returns, but also for the social cachet associated with claiming, ‘I’ve backed the next big thing.’”
“Whether small or big, everyone wants into the party.”

“The collective returns reflect the new reality that venture capital does not deliver a premium for its investors. In fact, the VC industry reliably trails the S&P.”

Today in VC investing, “The hardest thing for most startups today is the path to market: first finding product-market fit and a way to reach customers, and then building a ruthless machine to acquire, monetize, and retain them. Because of this, when the VC industry invests capital into fast-growing startups today, the plurality, if not the majority, of invested capital will go into user acquisition and ad spending, for better or worse (usually worse).”

“Startups spend almost 40 cents of every VC dollar on Google, Facebook, and Amazon. We don’t necessarily know which channels they 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.”

“Unfortunately, today’s massive venture-backed advertising, sales, and user acquisition playbook has morphed into one that champions growth at any cost.”
“And it is creating a big bill that will soon come due.”

“One important reason why ‘growth for its own sake’ has come to dominate the tech industry is because of the powerful network effects that come from size (again, the byproduct of living in a world dominated by Big Tech).”

“In an internet-connected world, several kinds of businesses – platforms, marketplaces, aggregators, and social networks, to name a few – stand to become enormously valuable and profitable should they reach a certain critical mass. There’s a reflexivity to these network-based businesses. They reason, ‘as we become large, our product will become better and our business more valuable. Therefore, we should spend money to become large. We’ll obtain that money by raising equity at a high valuation, which is justified by how large and valuable we will become once we spend the money.’”

“In a world where only one company thinks this way, or where one business is executing at a level above everyone else – like Facebook in its time – this tactic is extremely effective. However, when everyone is acting this way, the industry collectively becomes an accelerating treadmill.”
“Ad impressions and click-throughs 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.”

“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 who?”
“It’s not who you think, and the dynamics we’ve entered is, in many ways, creating a dangerous, high stakes Ponzi scheme.”...MUCH MORE
Earlier  today:
Unicorns Backing Their Own VCs? Welcome to Peak Tech