Bubbles are the nature of venture capital, says US researcher

Venture capital—or venture capital—financed companies that are in the palms of hundreds of millions of people today. The cost of success was years of loss, until profits began to show up and paid investors for the failures of other companies.

The path can be repeated today with the companies of the time: Uber, Nubank, WeWork. Or not.

University of California professor Martin Kenney says the model, created in the years after World War II, expanded after the .com bubble, the financial collapse of the late 1990s.

The low costs of a technology company combined with the large investments of venture capital funds make companies that will never be profitable to prosper for a long period, the researcher maintains.

“In a sense, it changes the economy,” he says.

In 2018, he published with fellow university student John Zysman the article “Unicorns, Cheshire Cats and the New Dilemmas of Corporate Finance,” a reference to the smirking cat in Lewis Caroll’s classic “Alice in Wonderland.”

“All that’s left is the smile. Many of these companies will go bankrupt, but the investors will already have the money, so it doesn’t matter,” he tells sheet when asked about the title.

You argue that the current investment model for venture capital funds is allowing companies to sustain losses for very long periods, which has consequences for the economy. Can you explain how you came to this conclusion? The United States is a stock market-based society, like Europe. Right after World War II, the idea arose to finance small firms that offered new technologies to create the companies of the future.

This was a model of success in places like Silicon Valley. If we look today at the most valuable companies in the United States, almost all of them were financed by venture capital. It became the American model of innovation. Funding new firms hoping that some of them will be very successful and reorganize the economy. Cisco, Intel, Oracle, all these names are the result of venture capital. The old industry is abandoned and money is moved to the new companies.

There have always been unequal competitions and entrepreneurs who could lose money for a long time to defeat their competitors. Does venture capital change the rules of capitalism or only accentuate them? Today, in the United States, we’ve built a society and an economy to drive the industries of the future, and venture capital is part of that model. In a sense, this changes the economy, because almost all entrepreneurs want to start a company like this. That’s how you get big earnings.

This means that manufacturing is no longer interesting. Manufacturing is capital intensive, it takes a lot of money. It’s slow, you don’t profit so quickly. A new economy has been created where you only look at gains in the stock market rather than gains in the industry.

In other words, maintaining startups requires little capital, and funds have a lot of money to invest, right? It depends on how much money you think is. We need to understand that today, as in 1999, we are in a bubble. Venture capitalists today have plenty of money to spend hundreds of millions of dollars building Uber or Lyft. Companies that will never be profitable.

We are in an ecosystem of extreme speculation. You don’t make that much money on bonds. If you want to make big gains, the way is to invest in a new company and wait for it to be bought. Then you get ten or a hundred times what you invested. Whoever put equity in Google got $1,000 for every dollar they invested. It’s very attractive.

In a stock market bubble, even companies that lose money can be listed on the stock exchange. When that happens, you, as a venture capitalist, have completed your work. You sell your shares and presto, you have made your profit. What happens to the company afterwards is none of your business.

Isn’t loss of money inherent in technological development? When a technology is born, we don’t know how it will be received, whether people will adapt. Losses are inherent in any new business at its inception. But venture capitalists are investing big losses in the beginning—we call this stage the valley of death—and then making massive gains.

You have to be the search engine in the world, like Google, make the semiconductor of all computers, like Intel. The idea is to use those losses to build your business — and build it too fast, so your competitors can’t catch you — and start making promises. And the big promise is: at the end of all the loss, the profit will be huge.

This is related to the “winner takes all” model [vencedor leva tudo], which you talk about in your article. Yes. There is so much capital on the market that funds can lose money for a long time. In 1999, 2000, there was a large venture capital bubble. [a bolha.com]. And she collapsed. Hundreds of thousands of companies went bankrupt. In the stock market, venture capitalists lost billions.

The nature of venture capital is an industry driven by bubbles. It is necessary to invest in a company and sell it to the stock market. And when is the best time to sell a company to the stock market? When there is a bubble. When everything looks fine, like today.

What do you think of the pricing we see today? They are something out of this world, right? Of course, there are companies like Google. Google is a winner, but there are companies that are not profitable. The question is, how long will they survive? As long as stocks are rising, they can continue to sell papers and pay off their trades.

And there’s another issue: you never know who will be the winner. Who knew Zoom would be the winner we saw? It was ok company, nothing special. And then the pandemic came and Zoom took off. Many of these startups will go under. When the venture capitalist invests in normal times—not now—he hopes that five or six of them don’t come out, so that with one or two he can get his money back. But if one of them is Google, all the rest of the damage doesn’t matter. You will make a thousand times the capital you put there.

But that matters to the company, doesn’t it? For employees. Employees enter the company expecting the big win, so they can retire and never work again. Maybe if I gave you the chance to spend a year or two in a company with the chance of earning a hundred times your salary, you’d be willing to give it a try. You would work hard, but if you were the winning company, it’s over. If not, well, you’ve wasted money and time and are going to try to find another job.

Not everyone would make that choice. But in Silicon Valley and elsewhere like this, lots and lots of people are willing to take that risk. Not only is venture capital willing, very smart people are too, because they can make a fortune that would change their lives. An entire society is created, an entire economy, an entire way of thinking around this idea.

It goes something like this: there are children in Brazil who want to be the next Ronaldinho. Most of them try, try and get nothing. But one or two do. They don’t think of everyone else who hasn’t reached their goal. They think, “I could be like him. I have to work harder than anyone else.” It’s kind of a superstar economy, like football. There are some good players, but the money is really in Peles. It’s a star mentality. You don’t have to be great. It doesn’t have to be fast. All you have to do is be in the right company and work hard.

You named a 2018 article from “Unicorns, Cheshire Cats and the New Dilemmas of Corporate Finance.” Can you explain? Do you know the Cheshire Cat?

Yes, from “Alice in Wonderland”. All that’s left is the smile. Many of these companies will go bankrupt, but investors will already have the money, so it doesn’t matter.

What about the traditional industry? It depends on the industry. We can talk about retail, journalism, car rental. I could speak from several sectors. Restaurants, for example. They have to pay for advertising on Google, or nobody will find them. That’s a kind of tax on every restaurant in the world. Where does this money go? Is he in Brazil? No, go to Silicon Valley.

With everything you said, what can we do? Do you think governments have a role in this scenario? Should risky investment be more regulated? In a world where we want innovation, venture capital is important, it is a means of achieving innovation. The question is: what are venture capitalists funding? Should we allow a company like Uber in Brazil? Well, there are positives and negatives. Perhaps a Brazilian Uber correspondent would be a solution. And how to ensure that workers have a reasonable wage?

In Brazil you have your own venture investors creating companies. Is it better to ban foreign companies and only have Brazilian startups to keep the money generated within the country? China made that decision. Countries like Brazil have been very open with these companies. I’m not saying it was a good or a bad decision, but as a country you have to think about it.

Another question is: how to tax venture investors’ profits? They create new technologies, and a lot of them we want, right? They can improve our lives. But who should get a piece of that pie? We increase profits with new technologies, who should share them?

We live in a time of a lot of investment in Latin America, especially in Brazil. At the same time, we have an unstable scenario, very uncertain, with elections next year. What should we expect? Venture capitalists are investing like mad in China. It’s very stable, but it’s a kind of communism. Why? Because there is opportunity. Brazil is by far the largest economy in Latin America. There may be chaos, but there is still plenty of opportunity. 200 million people is a huge market.

No matter how crazy the president is, or whether a Lula, someone more socialist, is elected, the opportunity is there. I believe investors will be looking to the market unless things get very shaky. Of course, the more your economy grows, the more attractive it is. But the general characteristics of Brazil are, in my opinion, very attractive. Investors will continue to invest in Brazil as long as there are opportunities for big profits.

X-ray

Martin Kenney, 70

Professor at the University of California, he is co-director of the institution’s international economics research group, founded in 1982. He became interested in risk investment studies in the 1980s, during his doctorate.