If You Need Peter to Pay Paul, You Are In Trouble

Predictions abound this time of year.  If you are investing in seed stage VC, predictions for the next year are meaningless for new investments.  The only time they matter is for companies that will get traction, or for exits.  Since it takes around 7-10 years to build an exit a company, investors already made the “prediction” part back then.

Nassim Taleb gets a lot of press over his predictions. Here is his thought about 2016.  It’s behind a paywall at the WSJ so I apologize if you are not a subscriber.  One sentence really struck me.

The rule is: Investments with micro-Ponzi attributes (i.e., a need to borrow to repay) will be hit.

What entities might struggle?  Governments for sure.   The city of Chicago where I live has been borrowing from Peter to pay Paul for years.  Now Peter is telling the city that their credit is junk, and they are going to have to pay more for it.  Additionally, the tax base has shrunk, so there isn’t enough cash flow to cover the payments.  Puerto Rico is in massive trouble.  New Jersey, Kentucky, and other governments state, county, local are all on the clock.

Where in startup land might we see things like this?

Business models that have relied on trying to get volume to cover costs.  A lot of startups are using what I call the old “Japanese automaker pricing model” approach.  When car companies in Japan came to compete against incumbents, they started at the bottom of the market and they underpriced their cars.  China did this with steel too.

There are certainly startups underpricing their services.  They do it in the name of market share figuring that they will get profitable if they can get to scale.  People certainly wonder about the valuations of companies like Uber, Lyft, and Instacart. Going public would give every one a hard look at their business model. It would also give everyone a look at their cap tables as well.  Things might not be what they seem.

I have seen seed stage companies deliberately underprice their business to try and get market share.  One strategy for “ankle biters” is to compete on price.  Instead of coming up with something novel or new, they just see another startups idea and copy it.

I learned a long time ago that if all you do is compete on price, you are in a commodity business and customers aren’t loyal.  There aren’t network effects in a pure commodity business.

Public market tech startup valuation has faced a lot of headwind.  Sure, there is FANG, but when new startups like Etsy, Box and others have gone public the market makes them pay.  Bill Janeway says going public is “the new down round.”

Which market is right?  Public markets are more liquid.  They price in perceived value every minute of every day.  Venture investors can see the future and take advantage of information arbitrage years in advance by making educated probability based investments in startups.  But, public markets rarely if ever misprice a security.  They are more efficient.

Going public is generally a good thing for companies and the employees that work there.  I just wish the SEC would make it easier.