The Intelligent VC

If you read this blog, you’re either well-versed in consumer technology, or you accidentally stumbled into it, in which case please stay. This post was spurred as I was reading a classical investing book, the very same that taught Warren Buffet how to make his $58 billion. I’m referring to The Intelligent Investor. As history has taught us, we’re not very good at remembering history. What this book does is point out, in retrospect, poor investment decisions made during the last century, and how to avoid, or at least mitigate, further bad decisions. As the title of the book suggests, it’s aimed at investors (even unintelligent ones). This post is aimed at VC’s and technology stock speculators. 

Below is a direct quote from the book (emphasis mine):

Air-transport stocks, of course, generated as much excitement in the late 1940s and early 1950s as Internet stocks did a half century later. Among the hottest mutual funds of that era were Aeronautical Securities and the Missiles-Rockets-Jets & Automation Fund. They, like the stocks they owned, turned out to be an investing disaster. It is commonly accepted today that the cumulative earnings of the airline industry over its entire history have been negative. The lesson Graham is driving at is not that you should avoid buying airline stocks, but that you should never succumb to the “certainty” that any industry will outperform all others in the future. 

The pitfalls have proved particularly dangerous in the industry we mentioned. It was, of course, easy to forecast that the volume of air traffic would grow spectacularly over the years. Because of this factor their shares became a favorite choice of the investment funds. But despite the expansion of revenues—at a pace even greater than in the computer industry—a combination of techno- logical problems and overexpansion of capacity made for fluctuating and even disastrous profit figures. In the year 1970, despite a new high in traffic figures, the airlines sustained a loss of some $200 million for their shareholders. (They had shown losses also in 1945 and 1961.) The stocks of these companies once again showed a greater decline in 1969–70 than did the general market. The record shows that even the highly paid full-time experts of the mutual funds were completely wrong about the fairly short-term future of a major and nonesoteric industry.

Growth, expansion, disruption - these are words that VC’s throw around to describe blossoming companies that will take over the world. Not now, but in the future. Google, Facebook, Twitter, and Yahoo are just some of the largest tech companies that are built upon this growth factor. They need it to thrive, since revenues are predominately built upon advertising.

Another quote, from Maciej Cegłowsk, the creator of Pinboard:

Advertising is like the flu. If it’s not constantly changing, people develop immunity.

Keep the above quotes in your head as you read the things below. 

VC’s invest in tech startups for one reason, and one reason only: to get a return on their investment. They invest a few million into a startup for a certain percentage of the company > if the company is lucky it goes public > VC firm profits and reinvests in a new startup. Rinse and repeat. Guess how most of these companies get paid? That’s right. It’s internet advertising. Sponsored search results, promoted tweets, trending topics, you’ve seen all these things before. 

Companies that are dependent on advertising make revenues and profits only if their user base grows. Their stock price is directly correlated to growth as well. Once growth levels off, reality kicks in, and Wall Street penalizes low performers. Twitter knows this problem all too well. Their growth has halted (with no doubt due to that bewilderingly mystifying homepage). And look what has happened to their stock (spoiler: you wouldn’t want to have your life savings invested in $TWTR). 

Twitter Stock Price

Twitter Stock Price

Google and Facebook are still managing to grow their user base, but believe me, it won’t last forever. Facebook is already trying to diversify its sources of income, first with the comically huge purchase of Whatsapp for $19 billion, and then Oculus Rift for $2 billion. Whatsapp is dependent entirely on advertising. Oculus Rift is an investment for the future, and currently unprofitable. Neither acquisition brings with it tangible resources (equipment, land, inventory, accounts receivable), only potential growth. There’s that word again, growth. 

These companies are doing the only thing that they know how to do, which is to grow their users. More eyeballs, more advertising revenue. From early in the companies life, VC’s have always pushed for growth, and then after becoming public companies, Wall Street urges for the same thing. This investment mentality won’t end well.

Growth isn’t bad, but when the business model is advertising, there is an inherent limit. It might takes years to reach, but it will be reached. VC’s should stop preaching growth and start encouraging profitability early in the startups life. Not that your startup needs a VC to begin with. There are plenty of successful startups that did it all alone without advertising, unnatural growth, and rather, just by a desirable product and hard sweaty work (for example, Basecamp).