Friday, February 8, 2019

Are the current unicorns actually only Cheshire Cats?

Innovations backed by venture capital has come to become the touchstone for entrepreneurship. But how credible is this trend? Martin Kenney and John Zysman calls this to question in an excellent paper.

Sample this,
In recent years, the amount of capital available to private firms has grown immeasurably, allowing firms such as Uber, Spotify, and Dropbox to continue to lose money and remain private far longer than previously – in the hopes apparently of going public or being acquired at even greater valuations. As a result, money-losing firms can continue operating and undercutting incumbents for far longer than previously – effectively creating disruption without generating profit. Arguably, these firms are destroying economic value. This new dynamic has social consequences, and in particular, a drive toward disruption without social benefit. Indeed, in some cases, they may be destroying social value while also devaluing labor and work in the enterprise.
And this about the emergent 'proto-monopolies' of winner take all (WTA) markets involving platform companies,
In each case, the dominant firm captured nearly the entire market and had become very difficult to dislodge. The start-up process in such WTA environments assumes that the startup will initially be cash-flow negative as it grows and competes against other startups and incumbents that are also seeking to restructure the new business space that the technology’s progress has made possible. Such startups begin by “bleeding” money: Investors are wagering upon the firm establishing a powerful market position—or what could be termed a “proto-monopoly.” These firms are not expected to win via early and sustained operating profit, but by absorbing operating losses during their growth phase financed by venture investment with the aim of driving incumbents and other new entrants out of the market. Investors are increasingly comfortable with absorbing the exceptional losses, if convinced that it will be possible to lock in a position to generate quasi-monopolistic profits and, by extension, enormous capital gains. The current technological and financial environment has created remarkable dynamics. For any given platform or Internet-related idea, low-entry cost and plentiful capital results in very low entry barriers. As a result, there are an enormous number of entrants. Because of this and because many of these markets will have WTA characteristics, the competition ignites an equity-capital consuming race to establish market leadership. The result is that ever-increasing amounts of capital must be raised. With the WTA opportunity beckoning, these startups have been able to raise ever-larger amounts of money at ever higher private valuations. The result is the “unicorn” phenomenon – private companies valued in excess of $1B in their last funding round. This growth-at-all-costs dynamic is reinforced at each stage of the capital-raising process (post-seed) for venture-backed companies because the metrics used by each investment stage to determine investment potential is growth – growth in users, engagement, and conversion for consumer-focused startups or monthly growth in customer acquisition and revenues. As long as the growth metrics are accepted by investors as proxies for value, then valuations can increase. Paradoxically, a sustainable business may not be the objective and may not matter, if earlier investors, founders, and management can sell their stakes in the business at higher valuation multiples to later-stage investors or through an IPO or trade sale before the actual unit economics and profit-generating potential of a company are clarified through repeated performance. The present entrepreneurial finance logic with low startup costs, emphasizes on disruption that will result in a new WTA industrial organization and abundance of finance, that not just encourages, but demands, a drive to breakneck expansion. In fact, a startup that does not grow as quickly as possible is soon overwhelmed by the startup with more capital and more reckless investment.
Some observations.

1. It has become an entrenched narrative that the success of technology solution companies is attributed to the exceptional genius of geeky entrepreneurs. Then there is also the story from the Silicon Valley folklore of college drop-outs in garages founding remarkable companies (though they were exceptional exceptions than any norm). This overlooks the reality that the present winners were the luckiest among a group of entrepreneurs who were at the right place at the right moment in time to be able to exploit the low-hanging fruits from an emerging technology wave and benefit from the inherent dynamic of network effects which privileges the first-movers. 

In terms of sheer sharpness of intellect required, one could just as well objectively argue that designing a massive civil engineering structure is at least as much challenging, if not much more, as developing a complicated software solution.

2. The facts do not support the conventional wisdom that these start-ups have been leading the innovation-edge in areas like nano-technology, robotics, artificial intelligence, facial and speech recognition, bio-technology, digital IDs, driverless vehicles etc. Of the 290 unicorns which have attracted $980 bn, less than a tenth are working on truly innovative solutions. Most of the cutting edge innovation work is happening in well-funded government-financed laboratories and universities and large and established companies who have the deep-pockets to support such innovations.

3. The most disappointing feature of the tech-entrepreneurship world has been the lack of success with innovations which have made a meaningful impact on persistent development challenges. Despite all its promise, areas like tele-medicine, Edtech, Agtech, and Fintech remain almost completely hype without any substance. Instead the landscape in developing countries is littered with me-too solutions which are straight copies of versions in developed countries.

4. It is not a stretch to argue that the entire unicorn world is like the man riding the tiger who cannot afford to dismount for fear of being eaten up by it. The unicorns have raised vastly inflated expectations as reflected on their valuations, and investors desperately want to at least preserve their mark-to-market share valuations. The only way to do this is to keep growing. And in most cases, since growth is built on bleeding capital to acquire customers, just to grow requires more capital, attracting which makes the story of rising valuations even more important.

5. Finally, this time is no different from previous times. Including the infamous tulip mania, history is replete with examples from previous eras of new arrival and innovation disruptions which led to such irrational exuberance. The paper talks about the bubble in optic fibre cables. Similar bubbles have been associated with every major large scale general purpose technology from railroads to electricity to automobiles to Internet.

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