Interest rates and the problem of Other People's Money
How venture investments can sometimes be a bit Ponzi-ish
A good friend asks, "What are the VC vibes around a higher for longer rate environment? Good? Bad?"
My response: "I think the general feeling is that the pain already happened (all the hikes), higher for longer doesn’t necessarily make it worse (or at least only makes it marginally worse by comparison). Definitely lots of ‘low rates produced fake companies, normal interest rates produce real businesses’ vibes, though."
He replies: "Do people actually not think they were fake companies before?? Don't rates have nothing to do with any of these businesses??"
No, I don't really think that most VCs thought that their pandemic-era cash-burning no-moat portfolio companies were "fake" businesses. But the truth is that VCs aren't really paid to figure out whether their companies are real, they're only paid to invest in companies that can get very big, very quickly.
Incentives matter
Every high-growth money-losing company exists in the superposition of a future profitable and an unprofitable business, and you won't really know which one you have until the company makes a concerted effort to show profitability, usually after growth slows. You can certainly make some guesstimates of what future profits might look like, using tools like payback period or comps to similar businesses, but it's still only a projection until it actually happens.
(This wasn't the case of the last generation of on-premise software companies — the Microsofts, the BMCs, et cetera — but in the new era of SaaS the vast majority of software companies go public while still GAAP unprofitable.)
The question is always, "At which point does it make sense to actually find out?" There are a few situations where you absolutely might find out immediately, like when there is absolutely no capital available anywhere to continue funding your burn. But in most instances where there's conceivably some capital out there for you (let's call this OPM for "other people's money"), there is a "grow fast or get to breakeven" decision available.
Let's say you've invested in the Series A of a super fast growing company with unclear business quality, like WeWork for example. Let's also say this company is growing at some crazy number, like 1000% per year, and is consuming lots of cash to do this. Do we keep growing and raising/consuming cash? Or do we pause to figure out how profitable we could get if we tried?
Take a look at the incentives of the VC investors. If you grow super fast, here's what happens:
The company raises a large Series B round (of OPM) at a much higher valuation
The deal gets on TechCrunch, and you get a lot of personal and brand prestige for being an early investor in the company
That round counts as a markup, which you get to brag to your LPs about
You can use this prestige and (unrealized) performance to raise a new fund, which means more AUM and more fees for you
The same thing happens, to an even larger degree, after the Series C, the Series D, and so on....
What happens if you instead pivot the company to profitability today? Well, pretty much none of that tasty stuff I just listed. You might build a profitable business that's growing OK, and maybe OPM comes in anyways (except they're coming in at a private equity type multiple, not a venture type multiple). You might get a fist bump from your partners or your LPs, except you're not really executing against the mission that they are paying you to perform, so maybe only a limp handshake or a subtle nod.
But actually something really bad can happen if you do this -- you might discover that your WeWork-style business is actually not capable of yielding attractive and durable profits, that it's actually not a great business after all. Ruh-roh. Maybe you’d be better off leaving that exercise to the Series D lead.
For these reasons, as long as the business is growing very quickly, it's almost always in your best interests to grow the business into higher revenues and a higher valuation, and to leave the question of long term profits for somebody else in the future to figure out.
But this path requires abundant, reliable, and cheap OPM.
Interest rates are the cost of Other People's Money
Interest rates usually have almost nothing to do with the operations of startups (outside of lending / mortgage sourcing / fintech type businesses), but they have everything to do with how abundant OPM is.
When we were in the 2020-2021 ZIRP type environment, cash was effectively free. You could borrow for almost nothing, your savings yield almost nothing, and tens of trillion dollars of global investment capital was on the hunt for yield wherever it could find it. As Ranjan Roy writes,
Money is always swimming towards yield. Millions of investment professionals are taking tens of millions of actions, every day, to help drive capital to its sustenance. The entire global capitalist economy rests on this constant flow.
So what happens when you lower interest rates (especially to zero)? All those millions of little dollar-organisms have to change course. They need to find a new source of life. ...
So all these dollar-organisms all start swimming towards riskier waters. Treasury investors shift to corporate debt. Public equity hedge funds shift to late-stage private equity. Late-stage private equity shifts to mid-stage, mid-stage to early stage. Seed rounds become bigger. Angel investors become a thing. Unicorns, unicorns, and more unicorns. Ashton Kutcher.
So low rates means abundant capital reaching into the riskier ends of the returns curve (early stage venture, crypto, SPACs, etc). More capital in those waters just means more OPM. You don't need to quantify it -- you can feel it every day. Founders stop returning your calls, term sheets get deployed faster, VCs you barely know start inviting you to coffee in the hopes you'll intro them to your best companies. When your VC talks to you about whether the market is “hot” or not, what he/she is really talking about is how much OPM is floating around in the marketplace.
Everybody knows when OPM is plentiful, and plentiful OPM is a "green light" signal to grow, grow, grow. That's how we get Growth at All Costs.
As long as there's lots of OPM (read: low interest rates), venture capital incentives are so tightly tied to portfolio companies growing their revenues that it's almost not in the investor's job description to distinguish between businesses that will command profits at scale and those that won't. No, they're not knowingly unleashing broken businesses into the wild like a pump-and-dump artist; they're fulfilling their job description which is "get money into something that grows revenues 100x after our fund invests."
Is this nefarious? Is this negligent?
I think there is a charitable logic in all of this that can explain why it sorta-kinda makes sense. That rationale is: Almost any product that can grow to $1b+ in revenues is probably valuable and differentiated enough that the company selling it can command meaningful profits at scale. This is what people have in mind when they think of a company like Snowflake, which has a technology that's so enormously difficult to build that only a few vendors (who are all doing awesome) can pull it off.
But of course that logic falls apart in the case of something like WeWork or MoviePass or DoorDash, where the reason the company grew so large was not necessarily because of differentiated value but rather because the cost of the service was subsidized by venture capital. Turns out that making something artificially cheap is not the same as innovating.
(But guess what — the WeWork Series A investors did amazing!)
The job of a venture capitalist is to find something that can grow incredibly quickly, and figure out how to finance it with OPM. The job of a late stage or public market investor is to figure out whether all that growth amounted to anything worthwhile. Everyone in the ecosystem is just fulfilling their assigned role — the role dictated to them by their personal incentives, and by interest rates.
Great calculus as always from P-Math!