The Ponzi Schemes Right Before Our EyesBy Pablo Ricaud Arriola | Mon, 09/27/2021 - 15:43
We long ago arrived at a point where a lot of people are wondering if the right incentives are being rewarded in the entrepreneurial scene. According to data released by Pitchbook, early-stage valuations hit all-time records in 2Q21of $50 million (median) and $105.4 million (average), as did late-stage valuations, with the trendline suggesting that average late-stage valuations could top $1 billion by year-end. One can’t help but feel like the fever is running rampant, with valuation now viewed more systematically rather than the reality-driven discipline it should be. The post-COVID excess of money supply and the cry for yield in a zero-rate environment has sent this trend into hyperdrive, with investors flooding the equity markets and forcing an economic effect of “grab whatever you can” that the world has seen many times before, where past home runs and returns are automatically expected to be repeated into infinity. Is it fair to say that numbers are just ceasing to add up despite the praise around them?
Whether you look at Deep Water Horizon, mortgage-backed securities, or any other example of a fever running higher than it should be, bypassing common sense, they all result in a circle of validation among very smart people that creates a leading effect where none of these very smart people has the incentive of calling bananas on the other, resulting on a lot of patting on the back and few dissenting opinions.
Investors’ returns used to come from companies’ profits, and yes, exits, produced from profitable businesses but, when looking at the early- and even late-stage investing at this point, the relationship between investments and returns is in some cases resembling a Ponzi scheme. This might seem like an exaggeration but let’s look at it in simple terms: A Bernie Madoff, produced investor “A” returns with investor “B” money, not with profit, but with capital infusions, an obviously not profitable enterprise where if new money in larger quantities ceased to ingress, the whole machine would blow up – because the “machine” does not make money by itself, it creates return only by injecting more money. Let’s now switch players, and call the investor “A” and “B” Fund Seed and fund Series X. The latter produces the former’s return, and so on and so on. This would obviously not pose a problem if not for a massive distinction – the underlying vehicle, like with Bernie Madoff’s scheme, is not profitable, and never will be.
One would think the chief thing investors would be looking for are viable unit economics and a clear path to profitability, apart from operational excellence and good technology, and most do, but there is a latent trend, where exaggerating the role of technology within a business, and to forcibly fabricate a social impact mission around it, is way more important. Moreover, when did the ability to burn through cash at staggering rates become a desirable thing? Somewhere along the way, the line between raising money for growth and raising money to survive the cash burn got blurred, and not just blurred, but the ability to burn cash at accelerated rates became sought after, coveted.
The amazing way this has become possible is through a remarkable alignment of incentives. Founders, employees, and investors at every stage all want and need the same thing: for the company to be worth more and for it to raise more money, so they can get out and have a return. No one is incentivized to check on the other one because they all need the same thing. Valuations are paid and expected to be paid later at an inflated rate. And they are being paid. Not because of a reasonable valuation, but because that is the price to get in, expecting to be paid back with the same currency. This is the reason we see more and more examples of fancy accounting practices (see: Adjusted EBIDTAs), fancy pivot stories, and marvelous explanations for losing tremendous amounts of money with the promise of stopping once the planets align perfectly. It does not matter at all if a company is equipped to make money. Not now, not ever. The only thing that matters is that the investor can dump its equity to another one along the chain, usually by propelling the story, condoning said accounting practices, and “playing along” so the valuation keeps getting higher and like the games of musical chairs or hot potato, when the music stops, the last one in line, or the one holding the potato, gets capitulated. Game over.
The last link of this Ponzi scheme? The mystical IPO, where all things go full circle, where the hyperbolic, pumped “bag” is dropped to the unsuspecting retail investor that will materialize the last link’s return and carry the equity of the huge, money-losing machine. By this point, the investment is so validated by so many extremely educated people, that few retail investors can resist, or have the technical tools to lift the veil.
How many Ponzi schemes are we seeing where the return depends on a new investor picking up the increasingly large tab and not on the underlying investment at all? The underlying investment is, like Mark Hanna would put it, a fugazi - fairy dust.
Mostly companies that end in the public markets are good examples of great companies that have traversed the cycle and provided actual long-lasting value to investors and equity holders along the way. The problem is with the ones where the profitability case makes no sense, yet they keep thriving — aka raising cash — despite it.
Often, the ever-losing money startups, with a business model full of promises (where a thousand happy assumptions need to be realized) and an amazing, flawless product, do not resemble what they end up being. The original business models were impossible to make profitable from the get-go, but nobody cared. If the story is cool enough and there is money to fuel the forest fire’s rage and get this company to the final link, everyone makes money. Except, the one who ends up holding the bag. After that, what we can see is just a mirage of the original version, where the product/service is deteriorated in a desperate effort for profitability, predating suppliers, partners, and employees via a too-big-to fail entity that might hold for several years, but one that not a single equity researcher would touch with a stick, less the investors that called it a revolution at stage 1. When chickens come home to roost, the profitable version of the once “rockstar” company ends up being a speck of what it was, which means the company was never so great to begin with.
How many industries do we see right now where the exact same products are only differentiated by who gives the end customer more money? Across industries, the billions burned have often little to show for it – traffic congestion made worse (source: WIRED), restaurants’ bottom line getting squeezed, credit card penetration in Mexico actually going down in recent years (source: Bank of Mexico) - to name a few. Dozens of new entrants have arrived and several have been coined as mighty “unicorns.” But what is a unicorn, really? It looks like the billion-dollar mark has ceased to be sustained by real numbers and more by the desire of a group of people to call it so.
Like a Ponzi scheme, the snowball keeps growing with new money, absolutely. Even if you call it a customer base — try giving away $100 dollar bills on the street and see if an “exponential” queue is not inevitable. A great entrepreneur used to be the one able to solve problems creatively and who faced the music if the endeavor failed to produce returns. More and more, it looks like having a perfect existence with unlimited cash burn to throw money at every problem or bury it underneath is what an entrepreneur really needs, if only it were actually sustainable.
Sometimes, we see entrepreneurs and investors get punished for being reckless and unethical, for lying about what a company is or will do, or just for being too over the top with their assumptions. There used to be checks in place and still are, like with the Adam Neumanns or the Elizabeth Holmes of our time, but the reality is that if you provide enough margin and oxygen to keep the machine alive, you’re in the clear. It is also very difficult to call something an actual lie when talking about the future and what “will happen,” which can be pushed around forever. The pivot schemes never run out; the thing is, money does run out. Maybe if Theranos wouldn’t have messed with people’s health, by this point the company would be long gone in the public market’s listings.
The good news is that I know most entrepreneurs are trying to scale viable businesses, with solid unit economics. They are trying to make the world better. What is worrying is that it seems to be getting increasingly difficult not to get trapped into playing “the game.” Like it was difficult not to buy a Tulip bulb in 1637.
No matter how much we talk, numbers don’t lie and are right there in black and white for us to see. Crises have taught us that when too many smart people oversell something too much, someone is getting burned