The High Cost of Cheap Money

Sunday, February 5, 2017

Everyone knows that products and services can be priced too cheaply.

Many people don't realize, however, that money can be priced too cheaply as well.

For the past decade, standards for investments and loans have been quite low and venture capitalists (VCs) have been desperate to find investments. If you have dot com dreams, and you want to sell a bit of equity to a wealthy corporate investor, it's pretty easy to do so.

As a result, startups that would be considered questionable (or even ridiculed) in normal times are now being snapped up with great and irrational exuberance.

These huge sums of investor money have a tendency to paper over terrible inefficiencies, broken business models and ineffective management practices. As these startups become larger, their problems tend to grow rapidly, requiring ever increasing sums of cash to mitigate.

I've visited the offices of many startups - big ones with many tens of millions of dollars of investment - and I've been absolutely terrified by what I've seen. There's the unqualified staff, the complete lack of process, and business models that are guaranteed never to result in positive income statements. Most frightening of all is a refusal to acknowledge that any problems might exist. Those who dare to question what they see are told they lack team vision and are quickly shown the door. Many might dismiss my views as the rantings of a person who doesn't understand that creating new products can be a messy endeavor. The fact is that I specialized in software R&D for the first ten years of my working career.

Many observers simply ignore or laugh at these doomed firms. After all, well-funded, but poorly managed, companies will simply putter along and die out. VCs will learn a valuable lesson about the importance of investing more wisely, and traditional companies will continue doing what they've always done. That's the textbook definition of how capitalism is supposed to work.

Unfortunately, these venture capital funded monstrosities don't exist in a vacuum, and their pending death spirals bode poorly for the economy as a whole.

Firms with highly skilled staff, proven business models, and even superior product offerings can be crowded out of the marketplace by their VC-funded counterparts. Regular businesses can't spend as much on offices, salaries and marketing as their VC-funded competitors, because they have an additional constraint that the VC-funded firms lack: they need to be profitable (or, at the very least, have a well-defined path to profitability).

Even firms that have solid business models can be hurt. Imagine a city is home to the next Amazon-killer. Its business model is as follows: sell name brand laptops for $5 each. As the saying goes, "sure they'll lose money on every sale, but they'll make it up in volume!" In any case, the VC backers secretly hope that they'll be able to flip the firm onto unsuspecting investors before anyone looks too closely at the firm's financials.

The startup is so successful, and its staff so well paid, that suddenly restaurants see an opportunity for new income. They pop up around the startup's headquarters offer dinner specials, and sell lunchtime catering to the startup. Each is soon well in the black and manages its financials well. Shipping companies see the large numbers of sales by the startup and decide to set up distribution centers nearby to keep the founders happy. The shipping fees more than make up for the cost of the expansion. Construction firms see all of the staff that are being hired by the startup, the restaurants, and distribution center and predict a huge demand for housing, so they invest in the creation of new apartment buildings. The startup looks like a success and the local economy appears booming... until the firm runs out of VC money, and the world realizes that the emperor has no clothes. Now even well run businesses, such as the restaurants, shipping firms, and apartment construction companies, find themselves in trouble, as few funds are available to trickle down from the startup.

The disaster does not end there. Like a horde of undead zombies, the startup continues its rampage in the world of the living.

Having started my career just after the first dot com bubble, I realized that people who had held important positions in failed startups didn't simply disappear. They moved to other companies, having risen in stature and title, not due to any particular skill or success, but solely due to being hired by organizations that later expanded rapidly thanks to cheap money. Once these folks left their failed startups, they were free to infect other organizations.

It can be exceptionally difficult to judge qualifications for many jobs. It's far easier for human resources departments to simply screen for lofty titles that had been "earned" elsewhere. So the VP at "Tinder for Puppies" is hired as a Sr. VP for a traditional business without ever having demonstrated any particular competence or having created anything of actual value. At the same time, those who had toiled away and had been held accountable for their work at traditional firms remain at the bottom of the totem pole. Not only does this practice lead to mismanagement by incompetence, but it creates a serious and lingering feeling of resentment among those working below (and even alongside) the former startup employees.

I often joke that my book Strategic Pricing: The Novel has earned more in profit than many Wall Street and venture capital darlings. But really I shouldn't, because it's not a joke. Every time I sell a copy, I make more in profit than Salesforce did last year (it lost nearly $40,000,000) and Uber (it lost more than 1.2 billion dollars in the first half of 2016 alone). I can only imagine what happened to media favorite Theranos after reports surfaced that its tests might not be as accurate as once thought and its founder's net worth dropped from nearly $4.5 billion dollars to nothing, the approximate per copy cost of my book. Nevertheless, I can guarantee with certainty that many of the strategic thinkers at these companies would be far more highly regarded than I would be in many corporate boardrooms. Why? Because they have more experience leading big (albeit fruitless) initiatives at scale.

The longer that money remains cheap, the more strongly we'll train a generation of workers to believe that cheap money is a requirement for running a successful businesses. We'll forget how to start small and stay scrappy. We'll forget how to focus on customer needs, and how to manage budgets. We'll train our next generation of leaders in a way of thinking that will lead to absolute ruin, once interest rates begin to rise and VCs begin to pull back from questionable investments. Even more importantly, we'll train our next generation of managers not to hire, not to promote, and not to listen to anyone who voices an opinion contrary to the cheap money narrative.

So when will all of the dominoes fall? I wish I knew, but the feeling of anticipation is killing me. Maybe I'll be able to write another profitable book about it.

Need some help with your strategy? My door is always open, and I've never taken a dime in investment.

P.S. The recent S-1 filing for Snap Inc. (parent company of industry heavyweight SnapChat) is worth a read. The firm admits in its filing that it has "incurred operating losses in the past, expects to incur operating losses in the future, and may never achieve or maintain profitability." Somehow the IPO is expected to bring in $3 billion for shares that have no voting rights. I can't wait to see what happens.