A couple months ago, I laid out a long-term bear case for investing in the venture capital vs. crypto. It is strange to think of venture, with all its mythology of dropouts and disruptors, as the aging incumbent, but crypto’s advantages for investors are many: liquidity, lack of carry, and openness to anyone at any time who wants to get in. Still, for the moment, many startups are awkwardly pursuing both, and it’s unclear that every project can or should be tokenized. Ultimately, the question for early-stage startups of selling equity or tokens may come to resemble the question for late-stage startups of whether to list directly or through a SPAC: SPACs, like crypto, allow quick-and-easy financing, but as the bursting of the SPAC bubble reveals, another term for that process may just be “wild speculation.”
So as we likely accelerate towards the peak of a crypto bubble, I want to lay out a very different bear case for venture by proposing that its incredible success right now in generating wealth is also what paves the path for its downfall—at least, as an overall investment strategy. (Those good enough to survive will remain amply rewarded.) This piece is meant, in some ways, as a counterpoint to Alex Danco’s wonderful “Debt is Coming,” which proposes that venture’s high valuations and high-powered VCs force companies to have to attain massive scale or die—there is no in-between unless, of course, the companies take out an old-fashioned loan.
Danco’s argument is told from the perspective of a company, for whom debt and equity represent completely opposite propositions. I want to retell this story, keeping Danco’s foppish protagonist—high valuations that represent high costs of capital and require extreme cash flows to justify—while flipping its perspective to that of the investor.
From this perspective, the story turns out to be the story like any debt crisis, except that the role of debt is played by equity. And there isn’t much difference, in this telling, between debt and equity at all.
This is, above all, the story of a bubble. Some exposition:
- Startups raised 41% more money this past quarter than in any other quarter historically (that’s $69 billion dollars… the previous record was $49 billion in the end of 2018)
- The average valuation for startups at all stages is at an all-time high
- The average valuation for late-stage startups is three times what it was a year ago (currently $1.6 billion)
- From 2002 to 2019, the median price-to-sales ratio for tech reached a high of 12. For the past year, it’s been over 20.
These factoids come courtesy of Seeking Alpha’s John M. Mason, whose reaction might sound equally symptomatic of a bubble: “This is the foundation of a strong economic recovery… I would not particularly claim the markets here are “frenzied”... The startups of today are the foundation blocks for future, vibrant public markets.”
Mason’s reasoning is that pandemic policy has spurred us into a virtuous cycle of innovation-spurring-the-economy and the-economy-spurring-innovation: the Cares Act, relief plans, and expansionary Fed policy has injected dollars directly into startup growth. This may sound like a somewhat strange argument to make about venture capital, which takes a few years to raise and deploy funds, and many more years to claim profits that it can reinvest. Did America send its freshly-printed dollars directly to the offices of Sequoia and NEA? How did all that money end up raining down on startups anyway?
In fact, the argument makes a little more sense if we accept that the money flooding private markets comes from retail investors—angels who can set up an account in minutes to dump their stimmies into seed rounds. The explosion of retail investing over the past year, however, is likely still just a piece, dwarfed by massive institutional investment (witness a16z’s $1 billion crypto fund). It might be safer just to say that the year of retail investing has forced all hands to bid higher.
What is the cost of higher valuations? Danco points out the disastrous attitudinal change they engender in startups: go unicorn or go home. But they’re equally disastrous for most investors. Consider what it takes for a VC to be successful in beating index funds and accounting for illiquidity and dilution: a 3x return over the course of 10 years, or about 12% annualized return, according to a TechCrunch article that specifies only 5% of VC funds are actually profitable in surpassing that 3x. Then consider that the article is referring to the boom times of the 2010s and consider, too, that the winners can win by a lot, making average returns seem appealing when median ones are not: “Yale’s venture capital portfolio has returned about 77 percent annually,” writes Scott Kupor in Secrets of Sand Hill Road. In good times, venture capital is a terrible investment strategy for most but an incredible one for a few.
What about really good times? What happens when valuations soar?
TechCrunch gives a “realistic case” for getting to 3x—of ten companies, five fail, three exit at a 40% loss, one exits at a 5x gain, and one unicorn exits at a 25x gain. This gets us to 3x.
But what if the valuations of all the companies had been doubled at each stage when the VC invested? The VC would have gotten half the return: or approximately 1.5x instead of 3x. To get to 3x, the VC would need all these companies to do twice as well or have gotten two unicorns from the ten companies instead of one.
And at that point, how many VCs are still profitable? 1%? The high valuations of bubbles will be highly rewarding as long as they continue—as long as these companies can also go public with twice the valuation and find investors willing to pay the price. But the fact that VCs have to wait 5-10 years for that opportunity makes that expectation a dangerous one, particularly when even a slight fall in valuations could wipe out all hopes of profitability.
It’s no wonder, as Danco says, that VCs push their companies to make billions. They’re not really in a position to be profitable otherwise.
“After two years the Jazz Age seems as far away as the days before the war. It was borrowed time anyhow—the whole upper tenth of the nation living with the insouciance of grand docs and the casualness of chorus girls. But… even when you were broke you didn’t worry about money because it was in such profusion around you.” — F. Scott Fitzgerald
Because corporations are now people, we might recast the Gatsby of our age as one Tiger Global, famed Venture Capital firm and a true embodiment of our raffish zeitgeist. Everett Randle has laid out the Tiger playbook: deploy capital quickly, offer huge valuations, do little diligence, and get out of the founders’ way. The quick math is that when you deploy capital quickly, you have longer to let it compound, so you can get a lower annualized return while still ending with greater profit. Effectively, Tiger is able to invest in slightly worse companies for slightly higher prices. Better yet, its strategy lets it invest in better companies too.
It’s possible that Tiger could actually win this game: because it offers more attractive valuations, it can have its pick of companies, especially by promising founders that they won’t have to report to a VC as boss. And if it wins, it will undoubtedly be because it knows this is not a sustainable model for the industry as a whole when sky-rocketing valuations will wipe out VCs who can’t have their pick of the next Stripe or Plaid (or aren’t as good at picking). But this game that Tiger is playing with the rest of the industry is a fun and dangerous one. Either everyone lets Tiger get its choice of companies with its tactics, or everyone tries to replicate it—and all go down in the bubble.
As it stands, Tiger looks increasingly symptomatic of venture as a whole in overinflating valuations in order to grab deals. The catch is that there is no such thing as being simply “symptomatic” in finance because each action affects markets directly. The more that Tiger offers high valuations to get deals, the higher the bar is set for deal-making, and the higher Tiger will have to offer in turn. Higher valuations lead to higher valuations as well as worse results—this is how bubbles beget bubbles at the exact same time they beget their own demise. In finance, the symptom is the disease.
Or if you prefer, financing is tautological: we need more money pouring in to fuel growth that could justify the amount of money pouring in.
That lesson comes to us from the economist Hyman Minsky, who repeatedly suggested that there is no such thing as a proper valuation of a company’s expected profits since any valuation will affect those profits in turn. Valuations masquerade as descriptive metrics of historical growth projected into the future, but they’re actually actions that can fund (or defund) the same future growth they’re supposed to anticipate. For a time, that can make valuations something like self-fulfilling prophecies, marshaling huge amounts of capital into industries to make them successes that justify the valuation in turn. But as valuations burst upwards, lenders expect greater and greater returns on their capital to keep pace with the explosive recent growth of their industries—and so they set terms that not only create an industry but break it when their debts can no longer be serviced.
The mistake, then, is a simple one: financiers think they’re setting terms descriptively based on great historical growth, but they’re actually setting terms performatively that guarantee short-term growth while all but ensuring long-term growth will never meet their terms. The bubble begets the bubble at the same time that it begets its own demise.
As Minsky writes in “The Financial Instability Hypothesis:
“Stability is destabilizing, not initially to a recession but first to an expansion of investment. The determination of today’s financing structure by the past behavior of the economy means that the financial structure becomes more susceptible to a financial crisis… In a capitalist system the terms on which bankers finance positions in capital assets and the production of investment output are critical determinants of system behavior.”
In fact, we might recognize Minsky’s story as one that’s already been twice-told here.
The first is Ray Dalio and Karl Marx’s comparable visions of debt crises, which I wrote about last week. Minsky’s version is much the same. The first mistake is lenders believing that the same historical growth they’ve personally propelled is a sound basis for future projections. As Dalio puts it, “These debt-financed purchases emerge because investors, business leaders, financial intermediaries, individuals, and policy makers tend to assume that the future will be like the past so they bet heavily on the trends continuing.”
Minsky is blunt. Not only is this what he calls “Ponzi Finance,” in which the economy as a whole has to keep borrowing money at higher and higher terms in order to fuel enough growth to service its previous loans, but “Ponzi Finance” is “an essential and not a peripheral characteristic of the financial structure of capitalism.”
What results is a cognitive dissonance of the markets: the same loans that fuel a bubble upwards force terms that the economy will collapse trying to repay. The better things get, the worse they are. For a time, as Dalio says, bubbles are self-reinforcing since investors “mistakenly believe that investments that have gone up a lot are good rather than expensive so they borrow money to buy them, which drives up their prices.” This is finance as a performative art, willing its own returns into existence. But Minsky, Dalio, and Marx all agree that interest rates will rise, as, for that matter, does the borrowing capacity of companies. The combination, in Dalio’s words, “supports the leveraging-up process, and so the spiral goes until the bubbles burst.”
Or as Minsky puts it:
“The upper turning point is completely endogenous once it is accepted that interest rates rise in an investment boom and that the successful functioning of the economy induces profit-seeking bankers and their customers to engage in speculative financial arrangements and to economize on holdings of money and protected financial assets.”
When the bill comes due, writes Marx, “a crisis must obviously occur – a tremendous rush for means of payment – when credit suddenly ceases and only cash payments have validity.” Minsky gives two criteria for that top of a bubble: 1) “increasing weight of speculative finance,” and 2) the growth of debt rather than money or assets to fuel continued growth.
The first point might seem clear enough while the second seems more debatable: when we talk about venture capital and Tiger Global, we’re talking about equity financing, not debt financing, right?
But this is where we get to the second telling of Minsky’s story. And it is very much the story of Tiger Global.
Marx, Minsky, and Dalio all write of debt crises, begotten by over-leveraging, high interest rates, and expansive lines of credit that can never be repaid. There is no great history of an equity crisis because, after all, nobody ends up in debt: if companies go down, it is not because they couldn’t afford to pay back their previous investors (who in theory demand nothing) but because they couldn’t continue raising money from future investors. The growth wasn’t good enough to justify higher valuations or, if you prefer, a higher valuation wouldn’t be good enough to justify growth.
For a financier, however, there isn’t necessarily a great difference between these forms of investing in a company: terms are set to fuel growth that should justify some annualized rate of return (in the case of equity, 12%), the investor receives an IOU or a “share” of a company in return, and the investor can ultimately sell that IOU/share as its own currency or sit back for cash flows and dividends from cash flows. The equity financier—the venture capitalist—has the major disadvantage of having to wait years before being able to trade that share or receive dividends in what will hopefully be a successful exit to public markets; in the meantime, they are unable to unload an investment at subpar terms and forced to let it go to 0. That means the equity financier will demand much higher annualized returns as well to justify an investment (Danco’s argument for debt), but ultimately both debt and equity financiers will remain invested in their companies doing well enough to service their investment—until the point it’s clear they can’t.
This is part of Danco and Randle’s suggestion that VCs are forced to be frienemies to their portfolio: the math means that they should help companies do well because they also require companies do well to justify their investment. Part of Tiger’s competitive advantage here is that it’s a deadbeat dad of investors.
At the same time, however, Tiger represents a kind of 21st century, VC-version of the kind of high-interest debt financier that fueled bubbles in previous times. For as we’ve seen, the flip side of offering higher and higher valuations is requiring a higher and higher effective interest rate—or annualized return—that can justify the investment. The higher valuation may be attractive for companies that have to give up less equity to receive the same amount of money, but it sounds a lot like the kind of Ponzi debt financing that Marx, Minsky, and Dalio write about: not only does it require explosive growth to justify higher and higher valuations in the future, but it effectively increases companies’ “borrowing capacity” to pull in more capital. As always in bubbles, more and more capital is deployed to juice growth in the hopes it will justify that capital’s incredible expense.
Consider Marx’s note about the creditors of the late 1850s:
“A high rate of interest can also indicate, as it did in 1857, that the country is undermined by the roving cavaliers of credit who can afford a high interest because they pay it out of other people's pockets (whereby, however, they help to determine the rate of interest for all), and meanwhile they live in grand style on anticipated profits.”
It is not hard to imagine a 2021 update with certain venture capital firms as the roving cavaliers, setting an effective high rate of interest through high valuations that demand high returns, paying out their loans with others’ money, determining the going rates for all, and living in grand style on anticipated profits.
Whether those profits ever will appear seems a minor question in venture these days, and perhaps that betrays a deeper understanding of the economy and bubbles. Bubbles are, after all, the best times to make money—as well as lose it, sure, but there’s no need to be negative here. After all, they can go on for years.
With special thanks to Annika Lewis and Li Jin for inspiration.