"The Crisis of Venture Capital: Fixing America’s Broken Start-Up System"

Although the author takes some time to get going—our readers know most of the introductory material, and on a level more useful than "losses as a percent of revenue"—a close reading is rewarded with facts, insights and a matrix to hang it all on. 

And he does get to declining gross margins before the halfway point of the essay.

Plus enough footnotes to make even Matt Levine happy.

From American Affairs Journal, volume V, number 1, Spring 2021:

About the Author

Jeffrey Funk is a consultant on business models and the economics of new technologies. Previously, he was a professor at the National University of Singapore, Hitotsubashi University, Kobe University, and Pennsylvania State University.

Despite all the attention and investment that Silicon Valley’s re­cent start-ups have received, they have done little but lose mon­ey: Uber, Lyft, WeWork, Pinterest, and Snapchat have consistently failed to turn profits, with Uber’s cumulative losses exceeding $25 billion. Perhaps even more notorious are bankrupt and discredited start-ups such as Theranos, Luckin Coffee, and Wirecard, which were plagued with management failures, technical problems, or even out­right fraud that auditors failed to notice.¹

What’s going on? There is no immediately obvious reason why this generation of start-ups should be so financially disastrous. After all, Amazon incurred losses for many years, but eventually grew to become one of the most profitable companies in the world, even as Enron and WorldCom were mired in accounting scandals. So why can’t today’s start-ups also succeed? Are they exceptions, or part of a larger, more systemic problem?

Today’s big losses are not what Silicon Valley founders and futur­ists predicted. Artificial intelligence, driverless vehicles, ride sharing, blockchain, virtual reality, augmented reality, and the Internet of Things were supposed to change the world, enabling a dramatic in­crease in productivity growth. The resulting wealth was expected to be so huge that we would be able to support the unemployed with a universal basic income (UBI). Indeed, Andrew Yang, a successful entrepreneur, ran for president in 2020 on a platform whose most notable feature was a UBI pledge.

Furthermore, all these developments were supposed to be part of a larger technological revolution: accord­ing to many leading commentators and entrepreneurs, we are pur­portedly living in the most inno­vative time ever. And venture capital­ists seem to agree: their funding set a five-year record between 2015 and 2019, with investments in a wide variety of industries, and 2020 set a new single-year record.²

My analysis of start-ups, however, shows that the big losses suf­fered by Uber, Lyft, WeWork, Pinterest, and Snapchat—greater than 50 percent of revenues annually—are just the tip of the iceberg. More than 90 percent of America’s “unicorns”—start-ups valued at $1 bil­lion or more while privately held (before IPOs)—lost money in 2019 or 2020, even though more than half of them were founded over ten years ago. And a similar trend of losses holds for European, Indian, and Chinese start-ups. Of similar importance, recent analyses of venture capital (VC) firms show that returns on investments in VCs have barely exceeded those of public stock markets over the past twenty-five years, and their current losses suggest that returns will fall even further. Indeed, the low profitability of start-ups is a reflection of broader trends in the economy: the slowing productivity growth documented by Robert Gordon; stagnating innovation ob­served by Tyler Cowen; falling research productivity discussed by Anne Marie Knott, Nicholas Bloom, and others; and the declining impact of Nobel Prize research recently noted by Patrick Collinson and Michael Nielsen.³

In this article, I first discuss the abundant evidence for low returns on VC investments in the contemporary market. Second, I summarize the performance of start-ups founded twenty to fifty years ago, in an era when most start-ups quickly became profitable, and the most successful ones rapidly achieved top-100 market capitalization. Third, I contrast these earlier, more successful start-ups with Silicon Valley’s current set of “unicorns,” the most successful of today’s start-ups. Fourth, I discuss why today’s start-ups are doing worse than those of previous generations and explore the reasons why technological inno­vation has slowed in recent years. Fifth, I offer some brief proposals about what can be done to fix our broken start-up system. Systemic problems will require systemic solutions, and thus major changes are needed not just on the part of venture capitalists but also in our universities and business schools.

America’s Failing Venture Capital System

A 2020 report by Morgan Stanley⁴ documents several key trends in venture capital, particularly the falling rate of returns over the last forty years (these findings are summarized in figure 1). Investments in VC funds by individuals and institutions have risen over the last twenty years, as have VC investments in start-ups, the latter reaching a record high in recent years. Yet returns on VC investment fell dra­matically in the mid to late 1990s and have stayed low ever since, now barely higher than those of major stock market indices, an aston­ishing change when one considers the far higher risks associated with funding start-ups.

Within this twenty-year period, several major changes oc­curred in our start-up system that have contributed to these low returns.⁵ First, investor exits for most start-ups, at least until 2020, are now largely accomplished by acquisition, rather than by taking companies public through an initial public offering (IPO) on the stock market. The problem here is that the returns on investment from an acquisition are typically much smaller than those from an IPO, and thus the trend towards acquisitions is probably one reason for the falling returns for VC over the last twenty-five years. Second, among those start-ups that do go public, the percent that are unprofitable at the time of their IPO has increased dramatically over the last few decades, exceeding 80 percent in recent years, according to analysis by Jay Ritter of the University of Florida.⁶ This increase has continued despite the falling overall percentage of IPOs versus acquisitions, a change that should have caused the per­centage of unprofitable start-ups at IPO to fall.

These two trends together form a vicious circle. Lower profitability at the time of IPO naturally leads to smaller share price increases and thus to lower returns for start-up IPOs. These lower IPO returns in turn discourage start-ups from going public and thus drive the trend toward acquisition. But without profitability, incumbents will be unwilling to pay high prices for the start-ups that they acquire, and so returns on acquisitions will also fall. Lower acquisition valuations in turn affect IPO valuations. Poor IPO performance and low acqui­sition prices thus reinforce each other, and jointly lead to poor returns for the original investors in VC funds.

This decline in returns for venture capital is a serious problem for the U.S. economy, not only because it suggests that innovation is less profitable than in the past, but also because it significantly affects the investments of major institutions such as pension funds and uni­versity endowments. As shown in the previously cited Mor­gan Stan­ley report,⁷ these institutions have steadily in­creased their investments in VC funds since 1970. These institutions also invest in start-up IPOs, and the data discussed in the next section indicate that pre-pandemic returns for investors in unicorn IPOs were nega­tive.

Venture capitalists will disagree with this analysis. They will emphasize that some VC funds are actually making money be­cause returns are heavily skewed, and thus, overall, the system is working. This objection is partly correct: as shown in the Morgan Stanley report,⁸ a small percentage of investments does provide high returns, and these high returns for top-performing VC funds persist over subsequent quarters. Although this data does not demonstrate that select VCs consistently earn solid profits over decades, it does suggest that these VCs are achieving good returns. Therefore, such funds might still be considered good investments, despite broader trends.

From a public policy standpoint, however, market averages are more important than the individual returns of a few successful VCs, because most investors cannot reliably distinguish between high- and low-return funds. After all, the notion that high risk requires higher returns is an old one, taught in every introductory finance course, yet the VC system, on average, is not providing this risk premium. Thus, the VC system bears a closer resemblance to another form of risk-taking: gambling. Gambling also consistently offers low average returns but occasionally produces large payouts that are heavily skewed to a few big winners. And gamblers, like VC funds, tend to place their bets in the expectation that they will win one of these rare jackpots. But policymakers and the public should realize that average returns ought to be higher for risky investments than less risky ones. If they are not, it is time to rethink the value of VC.

A glance at the rest of the developed world suggests that these problems of VC-funded start-ups are not exclusively American. The rest of the world got a late start with venture capital, but by the end of the 2010s other nations were also setting new records in VC invest­ments, particularly China and India. By June 2020, the number of unicorn start-ups in China (227) had nearly equaled the number in America (233). And global unicorns have now reached an enormous $1.9 trillion in total value.⁹ But, as I shall discuss below, the lack of VC profitability is a global problem, with Chinese funds earning only slightly better returns than American ones.¹⁰

The Start-Up Successes of the Late Twentieth Century

There was a time when venture capital generated big returns for investors, employees, and customers alike, both because more start-ups were profitable at an earlier stage and because some start-ups achieved high market capitalization relatively quickly. Profits are an important indicator of economic and technological growth, because they signal that a company is providing more value to its customers than the costs it is incurring.

A number of start-ups founded in the late twentieth century have had an enormous impact on the global economy, quickly reaching both profitability and top-100 market capitalization. Among these are the so-called faamng (Facebook, Amazon, Apple, Microsoft, Net­flix, and Google), which represented more than 25 percent of the S&P’s total market capitalization and more than 80 percent of the 2020 increase in the S&P’s total value at one point—in other words, the most valuable and fastest-growing compa­nies in America in recent years.

Rapidly growing start-ups of this type merit attention both because they are arguably the main factor driving returns to venture capital—rather than the average profitability of all start-ups—and because they are the principal cause of the “creative destruction” celebrated by Joseph Schumpeter¹¹ and other economists. As can be seen in figure 2, these giants reached profitability and top-100 market capitalization relatively quickly: Thirteen were profita­ble by year five, and another nine by year ten. Ten achieved top-100 market capitalization by year ten, and sixteen by year fifteen. Only one took longer than ten years to become profitable. Amazon and Qualcomm became profitable in year ten, a relatively long time within this group but far outpacing contemporary unicorns such as Uber, WeWork, Snapchat, and Pinterest, which still suffer losses greater than 50 percent of reve­nues at year ten or later.

Many of the successful start-ups of the late twentieth century created value for workers as well as investors. In addition to high-paying jobs for semiconductor engineers, software engineers, labor­atory scientists, and other white-collar workers, many of them also created well-paying blue-collar jobs—particularly the semiconductor manufacturers and other hardware companies that once employed thousands of workers in their production facilities. In this respect, also, they outshine the unicorns of more recent years, none of which employs production workers, and few—if any—pay adequate wages to their blue-collar employees. Uber, Lyft, and other gig-work start-ups are major contributors to income inequality and thus have drawn significant political backlash—a reaction resulting in regulations that could bring about their ultimate collapse.

A Cornibus Unicornium

In the contemporary start-up economy, “unicorns” are purportedly “disrupting” almost every industry from transportation to real estate, with new business software, mobile apps, consumer hardware, inter­net services, biotech, and AI products and services.¹² But the actual performance of these unicorns both before and after the VC exit stage contrasts sharply with the financial successes of the previous generation of start-ups, and suggests that they are dramatically overvalued.

Figure 3 shows the profitability distribution of seventy-three uni­corns and ex-unicorns that were founded after 2013 and have released net income and revenue figures for 2019 and/or 2020.¹³ In 2019, only six of the seventy-three unicorns included in figure 3 were profitable, while for 2020, seven of seventy were. The six profitable start-ups in 2019 included three financial technology (fintech) firms (GreenSky, Oportun, and Square) and one company each in e-commerce (Etsy), video communications (Zoom), and solar energy services (Sunrun). In 2020, three of these firms became unprofitable (Oportun, Square, and Sunrun), and four others became profitable: three e-commerce com­panies (Peloton, Purple Innovation, and Way­fair) and one cloud storage service (Dropbox). Thus, a remarkably small fraction of start-up unicorns has achieved profitability, despite the fact that forty-five of the seventy-three analyzed here were found­ed over ten years ago. By contrast, twenty-two of the twenty-four start-ups listed above in figure 2—including Amazon and Qualcomm, which lagged in achiev­ing profitability—were earning profits already by year ten....

....MUCH MORE