Venture Capital: When Creative Disruption Becomes Destructive Creation

It was only when I read chapter 24 of Bruce Schneier’s highly recommended “A Hacker’s Mind” that an idea that I’d been mulling over for some time suddenly took shape: venture capital as a way of hacking a market.

The idea is simple: when an idea is presented to venture capitalists in search of an investment round, what they see is not simply an idea whose potential they have to analyze, but the potential it may actually be able to achieve if they, with their investment, are able to control until it has attained sufficient market dominance to allow it walk on its own two feet.

Let me explain: an idea can seem good or even disruptive, but be unprofitable. There are any number of examples of setups that have to be artificially sustained for years, during which time they grind down competitors working along traditional lines, and then take over their market. When that happens, venture capitalists take the company public, bring in other shareholders with generally lower profitability expectations dazzled by the company’s “success” from a competitive point of view — not its intrinsic profitability — and laugh all the way to the bank. The “portfolio effect”, which allows diversification of risk, can be a goer, provided that common sense is used in the choice of investments. Funded companies can, from the moment venture capital withdraws, aspire to reasonable returns — not, of course, by raising prices sharply, as this would open the door to new players — and possibly come up with innovations that will make them the new standard in their industry.

The venture capitalism model is hundreds of years old, but it was not until the mid-1980s that it became particularly well known, due to its role in the first Internet bubble and the rise of what are now some of the world’s largest companies. In 2010 it amounted to $50 billion, rising to more than €295 billion in 2019, measured as nominal investment, not as additional profits earned from other sources, let alone returns earned.

It does not take much digging to find many, many examples of companies that have been able to compete only because of huge amounts of venture capital steroids being pumped into them: Uber was never about making a profit. It was perfectly clear that with the prices it offered, it was losing money on every ride. But after knocking on every road on Sand Hill Road, it raised enough money to finance its losses for years, allowing it to take a significant chunk of an industry characterized by its huge inefficiency and poor structure. Since its founding in 2009, Uber has attracted more than $25.5 billion in investment, with no intention of ever breaking even. In 2019, the company lost $8.5 billion worldwide, or 58 cents on every dollar, on each of 5.2 billion rides. But there are numerous investors willing to continue investing in that bottomless pit, all waiting for the moment when autonomous driving allows the company to lay off all its drivers and dispense with the most significant cost item in its structure.

The same can be said of many other cases: WeWork, Theranos, home delivery companies for all kinds of things, or OpenAI itself, which would never have been able to afford the very significant expenses involved in training models with billions of parameters on the cloud if it had not been for the significant capital injections it received when it was still a long way from earning any revenue at all. If you extend the model to infinity and beyond, you distort competition and you can, after a certain time, aim to redefine the market — or completely wreck it — and possibly, profit from it.

I’m aware that this characterization of venture capitalism could dent my popularity at a university whose raison d’etre is to create entrepreneurs and whose classrooms are regularly graced by representatives of that industry. That said, the availability of capital willing to take a risk and finance an idea that may need, in some cases, some time to mature and become profitable is essential for driving innovation.

It all comes down to nuance: it is one thing to finance an idea that requires a long maturation period or a high investment to become profitable, and another to deliberately distort the competitive landscape of an industry so that an unprofitable idea can elbow its way into the market and reorganize, manu militari, entire sectors through a form of competition that is basically subsidized by third parties. It shouldn’t be difficult to distinguish a model that funds innovation from one that simply aims to subsidize an unprofitable model, but as more venture capital firms reach scales capable of that level of distortion, doing so becomes harder.

Opinions?

(En español, aquí)

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This post was previously published on MEDIUM.COM.

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