Performative Investing
Mid-awe, Midjourney
Disclaimer! This post may violate the time-tested maxim of “Don’t bite the hand that feeds.” For the last 3 years, I have worked for venture-backed startups, which means my livelihood has been supported (albeit indirectly) by venture capital dollars. For that reason, I’d like to think of this post as not so much biting the hand that feeds as gently nipping and staring plaintively at said hand. Here goes.
Venture capital seems weird because it’s so performative.
To the uninitiated, the very words “venture” and “capital” (the first word connoting exciting danger and the second naming the thing around which our society is organized) conjure romantic images of swashbuckling money men bankrolling the digital rebels to remake society according to their own bold design. Venture capitalists fund exploration and innovation, disrupting our comfortable lives into the future, unafraid of the risks inherent in rocking the boat. Founders want to woo them, MBAs want to be them, Emily Chang wants to interview them.
To the cynical, the image is less about adventurous money-makers than Twitter self-aggrandizement, less bold visionary than glorified fund manager, their returns less a validation of their vision than a sign of an inefficient system.
How to reconcile the outsized allure and cultural cachet with the derision and the whatever-the-opposite-of-cachet-is? Why does VC garner so much attention?
Why VC captures our attention
For one, venture capital is important as the provider of many of our livelihoods. For those of us who’ve made our careers working in the software industry, especially in the Bay Area, venture capital is a common pathway through which investor money is funneled into our bank accounts. My salary, for example, has been a (vanishingly small) line item on a burn rate spreadsheet for one or more venture funds for several years. I should be curious about the hand that feeds. Hand, what are your plans, and why do you feed me?
A more interesting reason for why VC attracts so much attention is because that’s the way they want it. Their public posturing serves two purposes:
Due to overpopulation in their corner of the finance ecosystem, most venture capitalists need to compete for deals (or deal flow, if you prefer jargon). Money is not enough, because hot startups will have several VCs willing to offer them money, so VCs compete loudly to be first or best in the minds of their audience.
It is meant to signal to founders and investors that they can orchestrate / conduct the hype machine that turns equity into cash and dreams into legacies.
When one performs for an audience, one is bound to earn both plaudits and criticism. Here’s a bit of each from someone in the cheap seats.
Low interest rates have led to VC overpopulation
Since the turn of the millennium, interest rates have been low. A low interest rate means money is cheap — you can “buy” money cheaply by taking out a loan with a low interest rate. If you already have a lot of money though, low interest rates mean you can’t “sell it” (use money to make money) for very much, at least not risk-free. So, people that have a lot of money are more willing to invest in risky assets to achieve returns.
In this environment, venture capital looks relatively attractive — it’s risky but if one has to take a risk to achieve return, VC looks pretty good. Money has poured into the space, creating a surfeit of venture funds for the number of strong companies seeking venture funding, which means…
Venture capitalists compete fiercely to fund scarce hot companies rather than companies competing to access scarce funding.
When money is cheap and easy, investors have to show that they are more than money: they are partners in growth, they are advisors, they are mentors, they are experienced operators, they are business generators, they are connectors, they are… you get it. Convincing the market of founders that they can play those other roles takes effort.
One role in particular that VCs know is hyper valuable to both themselves and to founders is the role of hype generator, because both VCs and (savvy) founders understand that…
Hype is (usually) enough
I enjoy looking up the etymology of words, and the etymology of hype is pretty great. The word came into usage in the US in the late 1920’s as an abbreviation for hypodermic, which means “relating to the region immediately beneath the skin”, or colloquially, “barely skin deep.”
Venture capitalists traffic in hype as much as they do in ventures or in capital, and they do so for a completely rational reason: for most of their investments, hype will be the only thing they ever need to make money.
A quick digression: How do venture capitalists make money?
Two main ways, brilliantly explained in this video in which Chamath asserts that venture capital is a Ponzi scheme. (It’s fun and bizarre to watch someone refer to the way they made their money as a Ponzi scheme).
The first way is through management fees, typically 2% of the fund size, due each year.
Earlier this year, a firm we’ll call Intergalactic Venture Partners raised a $20B fund. (“Raising a fund” just means convincing people to give you money for the purpose of investing). Management fees are not dependent on fund performance, a point Chamath lingers on. Even if they don’t grow the value of the fund by a single dollar, they would still make 400 million dollars in annual revenue over the life of the fund, typically 10 years. If you are a venture capitalist, you want to be doing everything you can to grow your assets under management (AUM), because AUM is automatic cash flow.
The second way is probably the more well-known: they keep a portion of the gains in the value of their investments. In VC, the portion that the firms get to keep is called carried interest, or, in the common parlance, just “carry.” The market rate is typically 20%. (Mr. Palihapitiya asserts that VCs focus on fees to the complete exclusion of carry. I think that’s an exaggeration, and in any case, VCs at least have to convincingly pretend to care about carry, because carry is derived from portfolio performance, and telling your portfolio companies that you don’t care whether they succeed or fail because you’re getting paid anyway is a weak pitch. Remember that venture capital firms have to compete for deals.)
Let’s say over the next 10 years, Intergalactic Venture Partners doubles their investment capital of $20B (this would be considered successful but not record-setting). Of the $20B in profit, Intergalactic gets to keep 20% — $4B.
Raising a $20B fund at market rates guarantees cash flow of $400M/year in management fees. Depending on the performance of those assets, there’s about $4B (averaged to another $400M/year) in carried interest to play for.
Continuing the digression with an example from the founder perspective
Let’s say you’ve founded a hot company. Congratulations! I hope all your dreams come true, as long as their coming true doesn’t negatively affect the probability of my dreams coming true.
You need money to pay for engineers and cloud storage and maybe office space, if you’re big into vibes and the in-person culture. Because society tells you that you should raise venture capital money to grow your business, you decide to do so. Except there are so many to choose from, and geez, it seems like a lot of them want to fund your startup. Again, congrats. But how to choose?
How much you raise, and who from, is an opportunity to signal to potential customers, employees, and future investors what you’re about. Are you going to take money from an investor that no one’s ever heard of, or are you going to take it from big brand firm that’s built a media company to disseminate their philosophy (and their investments) through the ecosystem? The VC with no Twitter presence or the VC who tweets to the adoration / ridicule of hundreds of thousands?
Maybe you’re tired of the self-aggrandizement. You just want to hire some engineers or rent a warehouse or build a vertical farm. You got into this game to build a real business that you believe in. Hey, good on you.
But as VCs know and most founders come to realize, building a real business is really hard. It’s easier to build hypodermic and ride hype to your liquidity event. And VCs, especially the ones with big brands or audiences, can help with that.
Running the machine: how does hype help?
Recall the two ways that VCs make money: guaranteed management fees and performance-dependent carried interest. Hype helps with both.
First, in order to collect management fees from a fund, VC firms need to actually invest that money into startups. If a startup has a lot of hype or operates in a hype-blessed space, funding that startup is easy to justify back to LPs, the wealthy people who put up the money in the first place. An AI company with a TAM of $1TR? Yes, please.
More importantly, and Chamath makes this point well, if you invest in a company at a $100M valuation in their Series A, and then based on their user growth, they raise another round next year at $200M, you get to show a 100% return in a year, which, on paper, makes you a genius. You can then use your genius status to raise another fund, which increases your AUM, the basis upon which you collect your guaranteed management fees.
Hype is also really useful for carried interest, the amount that VC firms get to keep from the gains in the value of their portfolio. The better their portfolio companies do, the more valuable they become, and the greater the value of the VC’s equity. But to do well, the portfolio companies don’t need to be making money or taking steps to generating cash flow (hard!); they just need to be generating more hype than they did at the time of investment (easier).
When choosing between future theoretical free cash flow (hype) and near-term actual free cash flow, VCs will, quite rationally, push founders toward the easier, sexier former at the expense the harder, plainer latter.
The operative question that VCs, particularly early-stage ones, want to understand is not “Are you running a real business?” The operative question is “Can you tell a story plausible to a relatively uninformed public about how you’ll run a real business one day?” The bigger the numbers (users, TAM, revenue), the more hand-wavy the story can be.
Let’s now look at how these dynamics played out at two companies, one that played the game quite poorly and one that played the game quite well.
Hand-waviness to the max
The pursuit of hype and growth at the expense of running a business was taken to its logical end by a company called Moviepass. Under CEO J. Mitchell Lowe and parent company CEO Ted Farnsworth, the company rolled out an eponymous pass that allowed moviegoers to see unlimited movies in theaters for $9.95/month. For those keeping score at home, that’s unlimited movies per month, for less than the price of a single movie ticket. Unsurprisingly, this service was popular, and also unsurprisingly, it bankrupted the company less than 2 years after launch after they failed to raise an emergency $1.2B to stay solvent.
The 2022 epilogue, written by the United States Department of Justice, is excerpted below, emphasis mine:
An indictment was unsealed today in Miami charging two Florida men for their roles in a scheme to defraud investors of Helios & Matheson Analytics Inc. (HMNY), a publicly traded Florida- and New York-based company that was the parent of MoviePass Inc. (MoviePass).
The indictment alleges Farnsworth and Lowe falsely claimed that MoviePass’s $9.95 “unlimited” plan – in which new subscribers could see “unlimited” movies in theaters with no blackout dates for a flat monthly fee of $9.95 – was tested, sustainable, and would be profitable or break even on subscription fees alone. Farnsworth and Lowe allegedly knew that the $9.95 “unlimited” plan was a temporary marketing gimmick to grow new subscribers and, in turn, artificially inflate HMNY’s stock price and attract new investors. As a result, MoviePass lost money from the $9.95 “unlimited” plan.
In addition, Farnsworth and Lowe allegedly made false claims that HMNY possessed and used technologies – like “big data” and “artificial intelligence” platforms – to generate revenue by analyzing and monetizing the data MoviePass collected from subscribers. However, the indictment alleges that Farnsworth and Lowe knew HMNY did not possess these technologies or capabilities to monetize MoviePass’s subscriber data or incorporate these technologies into the MoviePass application.
Ethan again:
The “big data” and “artificial intelligence” claims are just *chef’s kiss* levels of modern fraud.
When MoviePass collapsed, business personalities on LinkedIn and Twitter told us that they knew the importance of “unit economics” (revenues and costs measured on a per unit basis), and how silly MoviePass was to have missed that particular Business 101 lecture.
Good points, except that poor unit economics is basically a requirement to be a venture-backed company. The thinking goes that the pursuit of positive unit economics (profit) will come at the expense of the ultimate hype-generating metric: all-out balls-out growth. The venture-backed company playbook is: grow first, as fast and ferociously as you can, and then eventually use your size and economies of scale to transform into a real business and make a profit. This IS possible: Amazon is the canonical example, but Salesforce, Square (Block Inc.), and Tesla all made the leap. But the last step is difficult and often requires discipline and core competencies that aren’t naturally built aren’t encouraged by venture capitalists in the growth period.
Let’s leave aside the obvious fraud cases and use as a final example a titan of the consumer internet age, Uber Technologies, Inc.
One more example: Uber Technologies, Inc.
Let’s also leave aside the long list of their well-documented malfeasances, from a corporate culture of sexual harassment and retaliation to willfully breaking US and international laws on its path to ubiquity, and focus on the financial story.
Uber has always bad famously bad unit economics, i.e. losing money on every ride, but the story (the hype) around how they’d eventually run a real business has changed a few times. In the beginning, it was “We’ll wait for Lyft to die, and then we can raise prices above our breakeven and make profit.” As of July 2023, Lyft is still alive, although struggling. Then, for many years it was “We’ll make autonomous vehicles, and our biggest cost (driver payments) will just fall off our income statement.” Uber sold off its autonomous vehicle unit in 2021.
Now it’s… Uber Eats?
I don’t know from personal experience because I’ve never done it, but I imagine it’s difficult to pivot an organization from maximizing hype potential to maximizing profit potential, especially when that business has 22,000 employees and operates in over 60 countries (as Uber had and did at the time of its IPO).
Today, Uber’s cumulative losses are approaching $25 billion, more than 8 times Amazon’s peak cumulative losses during its celebrated unprofitable period. It will be some time before Uber is paying out any of its cash flows to its equity-holders.
Will they turn it around and find a path to profitability? Maybe! I know that a lot of smart people are working on just that. (Sept. ‘23 update: they did it! They made a profit in Q2!)
Do the venture capitalists care whether Uber ever becomes a real business? They do not. For them, Uber has already done its job and played its societal role: grow fast, grow loud, and keep it up long enough for the professional investors to cash out, i.e., sell their Uber shares to the public market.
And how have Uber’s public share-holders fared? Since its 2019 IPO, Uber’s stock is up 2.65% (as of ~12:12pm PT, July 10, 2023). Over the same period, the S&P 500 is up by about 65%.
The venture capitalists who backed Uber early had better returns, ranging between 100x and 1000x.
For Uber’s founders and for their venture capital investors, hype was enough.
Epilogue: Pivot to Profitability
The conditions that allowed VC to grow as an asset class and as a cultural force are shifting. Change may be afoot.
The Federal Funds rate, also called the target interest rate, the rate at which banks can lend money to each other, is up (to fight inflation!). This rate trickles down through the rest of the economy, effectively making money more expensive. Cheap money helped bolster venture capital’s popularity as an asset class; expensive money may dampen it. IPOs and large acquisitions are down. How long they’ll remain so is unclear, but many VCs are now advising their startups to “pivot to profitability.” In other words, “you actually have to try to build a real business now rather than a non-profitable hype engine dependent on future funding.”
In yet other words, hype may no longer be enough. And that might be a good thing! For a long time, the incentives that VC firms operate under have differed from those of the companies they fund and those of a society that wants its businesses to provide sustainable growth and employment. (Whether or not our society wants those things depends on whom you interview). To the extent societal, corporate, and capital incentives align themselves, the system through which innovative companies create broad economic value may improve — and may redefine which types of performance are rewarded.
If these changes persist long enough, the role of venture capital in finance and society will change, and maybe, just maybe, they’ll be less annoying on Twitter (or Threads or Mastadon or however we’re intravenously consuming the internet).