The Bear’s Lair: Unicorn is a sub-species of Dinosaur

The failure of the WeWork IPO and the poor post-issue performance of Uber and Lyft have called into question the current Silicon Valley fashion for multi-billion-dollar capitalizations of “Unicorns” that make heavy losses and remain privately owned. Maybe throwing endless pools of money at unproven intellectually shaky concepts doesn’t work. When Unicorns go the way of the dinosaur, a healthier, more innovative start-up economy will emerge.

There have been two drivers of the immense flows of venture capital money into early stage Silicon Valley ventures since 2010. First, the decade of ultra-low interest rates, almost always below the rate of inflation, has caused soaring leverage and a wild search for investment alternatives that promise a return above the meagre pickings from bond yields and stock dividends. Low interest rates have also caused a huge increase in asset prices that has generated a tsunami of capital gains which has been leveraged against and monetized.

This is a world-wide phenomenon. SoftBank, for example, the major funder of WeWork with over $10 billion invested in it indirectly, is a leveraged telecoms and technology group founded by Masayoshi Son in 1981, which has invested in a leveraged $100 billion Vision Fund, which invested in the leveraged WeWork. At each stage, cheap debt has been used to leverage the operation’s activities, in the hope of maximizing the returns to Softback and Son himself.

Those of us with a knowledge of financial history (I won’t claim personally quite this length of experience in financial markets) have seen this structure before at the top of a previous bubble; in the 1929 multiply leveraged vehicle Goldman Sachs Investment Trust. That did not end well, though the trust’s sponsor Goldman Sachs is still with us. Of course, Son himself may not be fully aware of this history; in 1929 Japan was not a major market participant, being focused on its forthcoming invasion of Manchuria.

The other major driver of Silicon Valley’s venture capital tsunami has been the immense success of Google and Facebook (Amazon’s success has been similar but not identical). This has caused venture capitalists to discern a “Network Effect” by which those companies, by building user bases of 1 billion or more, have entrenched themselves in impregnable and extraordinarily valuable positions. (The value of the network increases more than proportionately with each additional member, and networks that achieve global dominance are almost impossible to replicate or match by a competitor — there is now considerable mathematics verifying this Network Effect.)

Venture capital companies have accordingly devoted vast amounts of cash to attempts to scale up “Network Effect” companies to a size so large that no other company can compete with them, creating effective monopolies and reaping supra-normal profits therefrom. By the theory, it does not matter if the company loses billions in the interim, and takes decades to do so, so long as it achieves sufficient scale to dominate its market.

Google and Facebook are currently the subject of antitrust scrutiny, even though their exploitation of the Network Effect is not in itself illegal. From the precedent of Standard Oil, broken up in 1911 because of its monopoly position, without having engaged in any more illegalities than other companies of its era, antitrust prosecutions of Google and Facebook would seem highly viable. For one thing, if successful they would remove the political sensitivity over Google and Facebook censorship; if there were a dozen Googles or Facebooks, the political views of their employees would not matter any more than it does in an automobile company; those with quirky political views would always be able to find a service provider that tolerated them.

In the case of WeWork, Uber (NYSE:UBER) and Lyft (Nasdaq:LYFT) however, the venture capitalists have allowed monstrous losses to occur without being assured of any network effect that would lead to eventual profitability, given sufficient scale. Uber and Lyft are taxi services; there is no Giga-Taxi that could provide them with significant economies of scale against conventional taxi companies, who can now utilize taxi summoning software very similar to that which initially gave Uber and Lyft a significant competitive advantage. Indeed, taxi services are intrinsically local businesses, with important connections to local political power structures. Multi-city outsiders attempting to compete with local taxi companies therefore suffer a competitive disadvantage, not an advantage.

Similarly WeWork benefits from no significant network effects, any more than does any other real estate company, nor does its bundling of other services add protection. In addition, WeWork buys buildings or rents them on long-term leases, then sublets the space on short-term contracts, an obviously dangerous practice in a downturn, as the ghosts of every real estate debacle since the 1930s could tell you – the Empire State Building, iconic and beautifully located and featured in a major motion picture (King Kong) just about covered its costs during the Great Depression, but 40 Wall Street, opened two years earlier, failed to do so.

WeWork has attempted to obscure this time-honored problem by hiring armies of software engineers and seeking to add services to its real estate offering. However, those engineers are underemployed. Allegedly, they designed an artificial intelligence powered sensor array, which tracked WeWork tenants throughout its buildings, to discover that they drank coffee in the morning – so WeWork was able to provide truly superior tech-enhanced service by adding a barista.

Then there’s AirBnB, which had been expected to come to market in 2019 but in March 2019 received $1 billion of further private equity funding on a $31 billion valuation. In its early years (it was founded in 2008) Airbnb provided a useful service, as genuinely private dwelling owners rented out their spare rooms, undercutting hotels. However recently its offerings have been bedeviled by professional owners, who have operated as slumlords, so that its offerings are no longer of reliable quality – it appears unable to exercise effective control on them. As with the other Unicorns described above, there is no network effect here, and a severe conflict with local authorities in the areas where it operates, which benefit from large local revenues from hotel taxes imposed on non-resident visitors.

There is little or no innovation in these behemoth Unicorns, nor is there a significant network effect, yet they have absorbed vast amounts of capital, and in the case of Uber, Lyft and WeWork, continue to do so (Airbnb is close to profitability). They represent a perversion of the entrepreneurship process, absorbing large amounts of venture capital, and, even more important, vast amounts of scarce software engineering talent, almost all of which could be much better employed elsewhere.

Even in today’s environment, it is still possible to do entrepreneurship properly. The trade journal GeekWire tells of a Seattle-based insurance start-up, Assurance IQ, started in 2016 by Michael Paulus and Michael Rowell, which developed a smartphone app that sells life, health, Medicare and auto insurance in its platform, allowing potential customers to calculate the amount and type of insurance that fulfils their needs, then either selling it to them or transferring them to an agent who has their details to pre-qualify them automatically. This appears a genuinely innovative service, which makes the insurance channel more efficient by greatly reducing the role of the very expensive salesperson and allowing the customer to take more control of the insurance buying process.

Assurance IQ took no outside venture capital, being entirely bootstrapped, was profitable within a year of its founding, and has now been sold to the insurance giant Prudential for $2.35 billion, less than four years after its formation. Interestingly, its founders believe they were able to attract superior software talent by operating outside Silicon Valley and focusing on older, more experienced engineers who were relatively less in demand in the tech Mecca.

Real innovation may often require modest amounts of outside venture capital to gain the scale at which it becomes eligible for public funding. However, companies that take a decade to become profitable, while absorbing billion after billion of venture capital money, are mere talent sinks for the scarce and wonderful engineers who should be doing something more useful. Those engineers are the truly valuable resource, that must be re-deployed into truly entrepreneurial ventures that reach profitability quickly and continue to grow thereafter in scope as well as size, thereby adding to long-term human wealth.

Like the dinosaurs, the Unicorns are much larger than they should be, and have stomped primitively around Silicon Valley’s primeval swamp for far too long. Also like the dinosaurs, they tend to trample and consume smaller and nimbler competitors. They should be put out of their misery, so that scarce entrepreneurial and intellectual resources can be redeployed to more creative mammalian ventures, all over the United States and the world, which represent our richer and more intelligent future.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)