Tech Markets Are Irrational

What To Focus On

Cyrus Yari

Published: 23rd October 2020
Last updated: 29th June 2021

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While this was mostly written in February 2020 pre-Covid, with minor adjustments made since, the argument still holds true. Being more of a podcaster and speaker, this is the first online article I’ve ever published.

I enjoy studying human behaviour. I also eat, sleep and breathe technology: both building and investing.

As a Tech Banker, I worked on a fair share of M&As / LBOs, especially for Enterprise SaaS, FinTech and Consumer Internet companies. I then jumped to the other side of the table and became an operator. I advise a few VC-backed startups on the side and am also a member at Google Campus London.

I try to be as rational as possible, and I like things that make simple sense (hence my fanaticism with Charlie Munger and Nassim Taleb’s philosophies). Prior to becoming an operator, my experience with cash-burning startups or “growth” companies was minimal - other than doing a few Venture Debt deals in banking.

When investing, I love nothing more than a robust, established, cash-generative tech corporate, especially those with strong recurring revenues, low churn, and a mission-critical solution. It wasn’t until I left my role as a tech banker and went into startups that I realised so much of the industry is in disorder.

Today it is madness. Whether you blame SoftBank for the greater fool theory of some of these companies or you blame low interest rates, something is wrong. My favourite non-WeWork example of VC gone awry is the mattress industry.

For example, let’s take a look at Casper.com (flipping mattresses online: wow much innovation). They filed for IPO and went public in early 2020. Unlike a decade ago, it is now becoming a trend to go public if you’re doing $312MM in year-to-date revenue (9m), while losing $65MM bottom-line in the same period. Mind you this isn’t even true bottom-line, and even if it was, as Charlie Munger says: EBITDA = bullshit earnings. Well, thanks Uncle Charlie, good to now know I (along with every other banker) have financed M&A and LBOs based on ratios consisting of bullshit 🙃

A mattress company. Not tech. And they make a loss on every sale they make. “GROWTH STRATEGY”.

Competition is beyond crazy in this category - there are at least two dozen D2C brands in this space in Western Europe alone, and the CPA of c. $345 per sale is only going up. There are so many of these identical products - that in many cases use the same factory - which are sinking pits for marketing dollars / pounds / dough. The product itself does not allow for cross selling or new product additions easily; paid acquisition is the only route to growth (costly and inorganic, not viable long term). What’s concerning is that this is happening across most of the tech world, including software.

It's as if you told me that your lemonade stand had a 100x (1 on day 1 and 100 on let's say, day 7) increase in customer base in a few days because you have decided to pay your customers to drink your lemonade. Any idiot can manage a company if turning around a profit is not a requirement.

Maybe I am completely wrong but growth at any cost seems like an impossibly stupid idea. And that exactly is the problem with VC today. The business models may make more sense when compared to the period before the last tech bubble but no one seems to give a damn about the valuation herd mentality in private markets. Why so much FOMO? Is it the new yacht you want to buy or the Richard Mille?

I see a lot of stupid ideas getting 7 or 8-figure funding, that are foolish at best. I've seen companies with zero revenues and $20MM cash-burn being valued at $300MM+. Are you guys just in for a huge race to win the award for rational vc’s irrational 100 list? Driving up valuations based on nothing? How can you price in the full upside of 20+ years and still set up a model that shows a return for your fund? Is it just hoping for some poor dimwit to pay the bill at the end of the day? Or am I missing something? So many questions.

“From the perspective of an operations guy, there is a lot of riff-raff in venture capital: posers, herd mentality, technology infatuation, too much education, not enough experience to appreciate what grit and focus it takes to grow a business out of nothing.”—Frank Slootman

Your portfolio company managed to double its customer base in a year? Yeah, maybe so, but that's like me telling you that my lemonade stand attracted 4 customers a day instead of 2. Much wow.

Fact 1: Central Banks around the world have held interest rates lower for longer than anyone has reasonably expected coming out of the global financial crisis. Everyone expects rates to remain lower for longer (especially now post-Covid).

Fact 2: Growth rates in nearly all markets, developed or developing, have trended downwards during that timeframe.

Fact 3: In a low growth world, growth becomes priceless for investors.

Practically, lower interest rates (and consequently lower discount rates) have pushed up valuations for all kinds of private assets, from boring old infrastructure assets like utilities and toll roads to sexy start-ups that peddle mattresses with a catchy name and under the guise of a tech company.

Sure, guys like Doug Leone at Sequoia and Marc Andreessen have consistently posted great returns. It's also true that they're massively oversubscribed. You can't get into their funds. They've been closed to new investors for years. This is the rare case it makes sense to invest in a fund-of-funds; if they have access to Sequoia, Benchmark, Accel, and Andreessen Horowitz, they will probably have excellent returns.

The only other place you see returns in VC are in new managers. This is generally true for PE funds as well, but it's for a very specific type of emerging manager: the principals and partners from the brand-name shops going to set up their own fund for the very first time. They still have all the brand cache of their previous employer (along with a Twitter following in some cases), they still have all the contacts, clout, and their deal pipeline is essentially a shadow of the deals they saw at, say, Sequoia. Even if Sequoia passed on a deal, that doesn't mean it's a bad deal. They miss things sometimes.

Those funds tend to do quite well on their first funds. They tend to do less well on their second funds and less well still on their third funds. Why? They raise more money on each subsequent fund without improving the quality of their deal flow. Arguably, their best deal flow exists in their very first fund since those deals have traces of ones they would have seen right before setting up their fund. Perversely, most institutional LPs don't have meaningful emerging manager programmes, and are reluctant to back a first fund, so they miss out on a lot of this deal flow. Those same LPs then make the mistake of investing in fund 2 or fund 3 before the returns from fund 1 are realised. Each subsequent fund tends to be easier to raise capital for, and as a result AuM increases. This generally results in lower distributions to paid in capital (DPI) for follow-on funds than for first funds, but most investment consultants, endowments, foundations, pension funds and family offices simply don't invest in first-time funds (mostly because those funds don't pass operational due diligence at investment consultants like Cambridge Associates, Albourne, or Mercer).

This situation is compounded by the fact that 10 years ago, the average time between fund raises was more like 3.5 years. Now, it's 2.25 years. That means you have GPs basically always raising capital instead of focusing on deals and LPs committing capital before DPI is known on the last fund. Frankly, it's really dumb, but institutional LPs aren't the cleverest investors in the world. They're asset allocators, and when it comes to VC, they're essentially gambling.

B2B SaaS VC is certainly more attractive returns-wise than B2C or physical B2B. B2B SaaS tends to be subscription revenue, switching costs are higher, and domain expertise can shut out some competition. B2C is sexy (and very fun to talk about) but customers are fickle and if you're selling a physical product, there's way more capex involved to scale; so even a winning exit can lead to mediocre returns. The competition for the best deals in B2B also got so competitive that B2B VCs started dipping their toes in B2C and applying the same valuations.

I have directly been told by some VC-backed founders that they are solely in it for the money and nothing else. Many founders now start a startup with the goal of an exit within 3-5 years. Even as a capitalist myself this is extremely concerning given the increase in bad actors, zero-sum games, and poor decision-making a la short-termism.

At school (mind you, I went to one of the WORST high schools in London as an immigrant, they permanently closed down 12-13th grade shortly after I left) they told me that if you hold the price of a product below what it costs to produce, so that every time you sell the product you lose money, it is called “price-fixing”. They also said that this is illegal and firms would sue each other if they suspected competitors of such tomfoolery.

Operating privately as an unprofitable company for 3-5 years is understandable in some cases as you’re investing either in growth or heavily in R&D (i.e. deep tech). A simple B2C company could be operating like this for 8+ years and float on the stock exchange (mind you, still unprofitable and no moat) and Silicon Valley would still call this a "growth strategy", or “hyper growth” that is "capturing the market" by "pursuing more users" until it achieves an "inflection point", upon which they will increase the price to start making a profit. Let’s not be disrespectful now, most of these companies are “disruptive”. Except this rarely happens.

Are some of these products great? Sure. Do they make our lives easier? Sure. This doesn’t warrant their existence when the numbers don’t work. It is being forced.

Through the “democratisation” of investing (a la Robinhood), some poor uneducated retail investor then picks up the tab, and provides a lucrative exit for the VCs.

Whole thing comes across as a game of musical chairs or hot potato. Everything works as long as you're not holding the turd at the end of the game.

The price for Ubers, scooters and Airbnb rentals is going up as tech companies aim for profitability. Interesting that this move comes after they’ve gone public (exactly 10 years after launch!). As the top comment on NYT stated: “Uber takes losses for a decade to decimate the taxi industry and now that it’s accomplished that goal Uber charges what taxis did.” Except most won’t pay these prices. I’ve already seen many friends in the Bay Area look at purchasing a cheap vehicle to replace Uber as their mode of transportation.

Intel’s stock market investors were making a rational bet that a world-changing technology would earn a huge stream of future profits. Palantir’s, Uber’s, and DoorDash’s investors were betting on how other investors might value their stocks, much as 16th century Dutch investors bet on the “value” of unique tulips or mid-19th century British investors bet on the prospects for railroads in distant countries, many of which were never built. Some of these companies may eventually turn an operating profit, but it is likely that when they do, investors will realize that those profits don’t justify the sky-high valuations, which will then come back down to earth. As Benjamin Graham once said, “In the short run, the market is a voting machine. In the long run, it is a weighing machine.”—Tim O’Reilly

The returns have become decoupled with the value that companies add.

Nikola is a great example. Hindenburg Research put out a report stating that every claim Nikola has made about its new fleet is false. The initial promotional video of one of its trucks flying down the road was actually a truck being rolled down a hill with fancy camera work. The truck doesn’t fucking work. Nikola defended with something along the lines of: “we never said it worked, we just showed that we have an idea for a truck.” Within a week there were fraud allegations, the CEO resigned and was kicked off the board. Fast forward two months and their market cap is now $10.1 billion. This is a problem. A company is on the public stock market and worth 11-figures, after rolling a car down a hill. They have been caught in a massive act of fraud, that is now being federally investigated and led to the CEO resigning. Does this not worry you?

The reason is that there’s too much money in the SoftBanks, and they’re essentially spread-betting. Their reserves are limitless given that they’re sovereign wealth fund-backed. With billions of dollars of capital to deploy, much of it not theirs, they have no skin in the game. This is the underlying issue. Unless you enjoy gambling, one should avoid investing in (and fuelling) such companies backed by those with no skin in the game.

The current industry situation equates to a ponzi scheme. Most venture capitalists (charlatans) are glorified middlemen, living off management fees, with no operating experience or skin in the game, barely returning the fund, and if they do they achieve subpar returns (better off investing in an index fund and compounding). Isn’t the whole point of VC that if you are taking such high risks with capital allocation, it should be allocated to things that may change the face of humanity, and not the 5000th replica of the same B2C product or B2B SaaS or crypto-shit (as Munger calls it)?

Anyway, the SoftBanks of the world will continue to make ridiculous bets and find a way out of them. When SoftBank kicked out Adam Neumann, they brought in a former GP of their own fund to replace Adam as CEO of WeWork. They hyperscale, let it crash down to the ground, put their own people in to operate, take majority of equity, and then build them up and have a ludicrous exit. Obscene that they will actually win on that deal at some point. This is happening with several companies. It’s hard to see when this will change; until the whole paradigm changes and investors have skin in the game and actually worry about making their money back with any kind practicality.

As Ray Dalio mentions, in the study of history, we can see that human behaviour continuously repeats itself, and humans are susceptible to the same irrational decision-making process. When they look back at our present time in the history books, it will very much be perceived as a repetition of the same behaviour seen in the 1849 California Gold Rush. Most of the people who made money back then were those who “sold shovels” (and jeans, tents, pickaxes and other supplies and services) to the prospectors who lived hard lives panning for gold.

There is, however, a lot to be hopeful about. While it may seem like I’ve done nothing but complain in this post, I’m very much inspired by Lord Matt Ridley, and would consider myself much the “rational optimist” as he puts. There is a right way, and a wrong way to do everything. I want to see more of the Charlie Munger, long-termist way of doing things, whether you’re an entrepreneur or an investor. Look, I love this space - I’ve dedicated my 20’s to it entirely and will dedicate the remainder of my life to it; and so I want to see things done properly. If everyone (not just CEOs, but all counterparty groups) strived to improve their decision-making, to think and act more like Munger, the second-order effects would advance human and planetary evolution by several hundred years in a few decades.

The obsession with zero-sum games and short-term returns in the Silicon Valley bubble is not only causing financial structural damage, but it's holding back humanity and long-term capitalism. I'm not being overdramatic. The next generation of hyper-growth start-ups will be the Space-X and Neuralinks of the world. I’m very bullish on the life sciences, quantum computing, aerospace, autonomous vehicles, and several forms of “deep tech”. This is what we should be focussing on. These will push our boundaries beyond the consumer-centric obsessions and dopamine-fuelled consumerism of today. The focus will shift to pushing the human race to the next frontier. AI will basically change the face of human work and creativity will flourish (as we’re already seeing in the creator economy). The point is, if we continue to be so obsessed with short-term returns and growing pointless companies (i.e. optimising paid traffic ads) that are not advancing anything of note (like fucking mattresses), you get to a point where our best engineering and creative talent get paid the big bucks to work on pointless crap (irrationality). This must be avoided. Thankfully, the Elon’s of the world garner massive respect and are almost single-handedly pushing the right agenda forward. Long may this continue.

This is why we started rational vc.

For the few of you among us who are always truth-seeking while pushing the boundaries in the pursuit of greatness.

Authenticity, truth-seeking, long-termism.