Startup Boom a “Dangerous, High-Stakes Ponzi Scheme”: Silicon Valley Investor

“Startups spend almost 40 cents of every VC dollar on Google, Facebook, and Amazon.”

Chamath Palihapitiya, CEO of Palo Alto-based Social Capital – a “technology holding company” – and an early Facebook executive responsible for increasing its userbase (he left in 2011 to found Social Capital), has been accused of being outspoken before. And after his excellent but, well, outspoken commentary in his firm’s 15-page first annual letter, he will surely be so accused again.

As he lays bare how the startup and venture-capital ecosystem works – who ends up as “bag holders” is “not who you think,” he says – he steps on toes and says out loud what everyone is trying to keep quiet. Of course, these dynamics cannot last, and he says “It’s time to wait patiently as the air is slowly let out of this bizarre Ponzi balloon created by the venture capital industry.”

Below are the most salient excerpts on this topic from Social Capital’s first annual letter:

“Big Tech [‘the Googles and Amazons of the world’] will get bigger and will leave less room for obvious companies doing obvious things. The demands of innovation are going up, and the quality of the ideas and teams working on those ideas matter now more than ever in this David v. Goliath landscape.”

“Of course, one would think that investors should become more circumspect about the utility of their capital during times like these. Curiously, the opposite is currently true and is setting up for a massive rude awakening.”

“Since the great financial crisis, the quantity of capital that has made its way into the tech ecosystem seeking to fund the next generation of successful businesses has steadily increased. We don’t just have big companies anymore. We also have big funds [such as the Softbank Vision Fund, ‘which has a minimum check size of $100 million and a target of $50 billion per year of investment.’]”

“However, these mega-funds only tell half the story: there has also been a continuous surge of seed capital flowing into the industry as successful founders, builders, and fund managers reinvest their own money into the earliest stages of technology startups. They invest not only in pursuit of future returns, but also for the social cachet associated with claiming, ‘I’ve backed the next big thing.’”

“Whether small or big, everyone wants into the party.”

“The collective returns reflect the new reality that venture capital does not deliver a premium for its investors. In fact, the VC industry reliably trails the S&P.”

Today in VC investing, “The hardest thing for most startups today is the path to market: first finding product-market fit and a way to reach customers, and then building a ruthless machine to acquire, monetize, and retain them. Because of this, when the VC industry invests capital into fast-growing startups today, the plurality, if not the majority, of invested capital will go into user acquisition and ad spending, for better or worse (usually worse).”

“Startups spend almost 40 cents of every VC dollar on Google, Facebook, and Amazon. We don’t necessarily know which channels they will choose or the particularities of how they will spend money on user acquisition, but we do know more or less what’s going to happen.”

“Advertising spend in tech has become an arms race: fresh tactics go stale in months, and customer acquisition costs keep rising.”

“Unfortunately, today’s massive venture-backed advertising, sales, and user acquisition playbook has morphed into one that champions growth at any cost.”

“And it is creating a big bill that will soon come due.”

“One important reason why ‘growth for its own sake’ has come to dominate the tech industry is because of the powerful network effects that come from size (again, the byproduct of living in a world dominated by Big Tech).”

“In an internet-connected world, several kinds of businesses – platforms, marketplaces, aggregators, and social networks, to name a few – stand to become enormously valuable and profitable should they reach a certain critical mass. There’s a reflexivity to these network-based businesses. They reason, ‘as we become large, our product will become better and our business more valuable. Therefore, we should spend money to become large. We’ll obtain that money by raising equity at a high valuation, which is justified by how large and valuable we will become once we spend the money.’”

“In a world where only one company thinks this way, or where one business is executing at a level above everyone else – like Facebook in its time – this tactic is extremely effective. However, when everyone is acting this way, the industry collectively becomes an accelerating treadmill.”

“Ad impressions and click-throughs get bid up to outrageous prices by startups flush with venture money, and prospective users demand more and more subsidized products to gain their initial attention.”

“Such is the world of user acquisition in tech today: as growth becomes increasingly expensive, somebody must be footing the bill for all of this wasteful spending. But who?”

“It’s not who you think, and the dynamics we’ve entered is, in many ways, creating a dangerous, high stakes Ponzi scheme.”

“The Shuffle Game: Over the past decade, a subtle and sophisticated game has emerged between VCs, LPs [limited partners], founders, and employees. Someone has to pay for the outrageous costs of the growth described above. Will it be VCs? Likely not. They get paid to allocate other people’s (LPs) money, and they are smart enough to transfer the risk.”

“For example, VCs habitually invest in one another’s companies during later rounds, bidding up rounds to valuations that allow for generous markups on their funds’ performance. These markups, and the paper returns that they suggest, allow VCs to raise subsequent, larger funds, and to enjoy the management fees that those funds generate.”

“Picture this scenario: if you’re a VC with a $200-million fund, you’re able to draw $4 million each year in fees. (Typical venture funds pay out 2 percent per year in management fee plus 20 percent of earned profit in carried interest, commonly called “two and twenty”). Most funds, however, never return enough profit for their managers to see a dime of carried interest. Instead, the management fees are how they get paid. If you’re able to show marked-up paper returns and then parlay those returns into a newer, larger fund – say, $500 million – you’ll now have a fresh $10 million a year to use as you see fit.”

“So even if paying or marking up sky-high valuations will make it less likely that a fund manager will ever see their share of earned profit, it makes it ​more likely they’ll get to raise larger funds – and earn enormous management fees. There’s some deep misalignment here.”

“Highly marked-up valuations, which should be a cost for VCs, have in fact become their key revenue driver. It lets them raise new funds and keep drawing fees…. [T]he modern venture model translates into higher costs of, well, just about everything. We have higher salaries, higher rents, higher customer acquisition costs, Kind bars, and kombucha on tap!”

“So if it’s not VCs, who ends up holding the bag?”

“It’s still not who you’d necessarily expect. Later-stage funds, who invest large follow-on rounds into these marked up companies, do indeed pay inflated prices – but they also usually get their money out first upon a liquidity event, and are also happy to exist in ‘Fee-landia.’ In some cases, high prices may even work to their advantage. They’re able to hold certain late-stage companies hostage to their high valuations by demanding aggressive deal structures in return for granting “Unicorn Status” (the billion-dollar valuation that VCs so crave). Unlike in other pass-the-buck schemes, the bill is not getting passed from early investors to later investors.

“The real bill ends up getting shuffled out of sight to two other groups.”

“The first, as you might guess, are early stage funds’ limited partners, particularly the ​future​ limited partners that invest into the next fund. Their money, after all, is what pays the VC’s newly trumped up management fee: marking up Fund IV in order to raise money for more management fees out of Fund V, and so on, is so effective because fundraising can happen much faster than the long and difficult job of actually building a business and creating real enterprise value. It might take seven to ten years to build a company, but raising the next fund happens in two or three years.”

“The second group of people left holding the bag is far more tragic: the employees at startups. The trend in Silicon Valley today is for a large percentage of employee compensation to be given out in the form of stock options or restricted stock units. Although originally helpful as a way to incentivize and reward employees for working hard for an uncertain outcome, in a world where startup valuations are massively inflated, employees are granted stock options at similarly inflated strike prices.”

“Overall, you can understand how this arrangement endures: VCs bid up and mark up each other’s portfolio company valuations today, justifying high prices by pointing to today’s user growth and tomorrow’s network effects. Those companies then go spend that money on even more user growth, often in zero-sum competition with one another.”

“Today’s limited partners are fine with the exercise in the short run, as it gives them the markups and projected returns that they need to keep their own bosses happy. Ultimately, ​the bill gets handed to current and future LPs (many years down the road), ​and startup employees​​ (who lack the means to do anything about the problem other than leave for a new company, and acquire a ‘portfolio’ of options.)”

“The antidote is two-fold. First, we need to return to the roots of venture investing. The real expense in a startup shouldn’t be their bill from Big Tech but, rather, the cost of real innovation and R&D. The second is to break away from the multilevel marketing scheme that the VC-LP-user growth game has become.”

And at the other end of the boom spectrum that cannot last, the Fed is warning about “leveraged loans,” lambasting the favorite strategies of “collateral stripping,” “incremental “facilities,” “cov-lite,” and “EBITDA Add-Backs.” Read… The Fed Broadsides $1.3-Trillion “Leveraged Loan” Market  
 

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  59 comments for “Startup Boom a “Dangerous, High-Stakes Ponzi Scheme”: Silicon Valley Investor

  1. worldblee
    Nov 7, 2018 at 1:31 pm

    This article has so many valid points. I work on the edges of this tech/VC madness and don’t get hit with the same issues he mentions for employees and LPs but all the factors he mentions seem spot on to me.

    • Dale
      Nov 7, 2018 at 3:24 pm

      I work in tech as well, and see the effects of VC. This perspicacious note should be combined with the description of the VC industry by Ellen Pao. Although her focus was on sexism, for me the real value was in showing that the VC fund managers are not at all focused on investing in potentially profitable funds, but rather on maximizing their personal returns– two very different objectives. Pao relates how the VC senior managers would rather invest 2x, 3x, 4x as much in a prospective startup if it were to their own credit rather than that of a junior manager.

      The ponzi scheme has worked well since at least 2011 when I first started seeing it first hand. How long will it last?

  2. Rob
    Nov 7, 2018 at 1:43 pm

    I think the 10 year return for VC funds after March 2000 was zero on average and if you took Facebook out it was negative. From memory.

    • Dave D'Rave
      Nov 8, 2018 at 2:36 pm

      Agree. The VCs were making amazing ROI in the 1980s, and were making pretty good money in the 1990s. After 2000, not so much.

      I think that it is an ecology problem: After people on the East Coast got the word that Venture Capital was the best investment around, we got an inundation of wanna-be VCs, fresh from the Harvard Business School. Today, there is a gross overpopulation of MBAs in the VC business.

      What we need are predators, to reduce the population.
      Any suggestions?

  3. CRD
    Nov 7, 2018 at 1:51 pm

    Chamath is spot on with many of the points he makes.

    “Picture this scenario: if you’re a VC with a $200-million fund, you’re able to draw $4 million each year in fees. (Typical venture funds pay out 2 percent per year in management fee plus 20 percent of earned profit in carried interest, commonly called “two and twenty”). Most funds, however, never return enough profit for their managers to see a dime of carried interest. Instead, the management fees are how they get paid. If you’re able to show marked-up paper returns and then parlay those returns into a newer, larger fund – say, $500 million – you’ll now have a fresh $10 million a year to use as you see fit.”

    This is the dirty little secret of venture capital. To be a successful VC, you don’t need to find the next Google or Facebook. You need to be able to raise new funds.

    This is the reason VCs often move like a herd. As long as your firm’s portfolio looks like the next portfolio, and you can mark up some of your portfolio companies’ values, you can keep the flow of funds coming. There’s very little incentive to back genuine innovation and true moonshots.

    “Startups spend almost 40 cents of every VC dollar on Google, Facebook, and Amazon. We don’t necessarily know which channels they will choose or the particularities of how they will spend money on user acquisition, but we do know more or less what’s going to happen.”

    And another 40 cents goes to real estate, directly (commercial office space) and indirectly (residential via the inflated salaries that must be paid so that employees can afford to live in the SF Bay Area).

    The thing is…the LPs either do or should know all this.

    • gary
      Nov 7, 2018 at 9:46 pm

      “you can keep the flow of funds coming”

      Yes, but where do all these “funds” keep coming FROM? Is there some infinite well out there?

      (that was not a rhetorical question)

      • Alex V
        Nov 8, 2018 at 6:13 am

        Pensions funds. Saudis. Chinese.

        • JonLaughing
          Nov 8, 2018 at 11:43 am

          If true… then who cares about the Saudis and the Chinese. Let them waste their own (recycled $USD) and have fun doing it. But to have a US based pension plan involved is madness. Pensions and insurance companies and trust companies used to be conservative for good reason. Match long term liabilities with long term assets and have a happy life. But no more, and that leads us back to the zero interest sillynesssss of the Fed.

        • J Bank
          Nov 8, 2018 at 1:17 pm

          Religion. Seriously.

  4. Bobber
    Nov 7, 2018 at 3:06 pm

    It seems to me they forgot to identify the biggest bagholder. When these artificially inflated unicorns do IPO’s, the IPO investors get nailed when the company gets re-valued by the markets (i.e., see SNAP).

    • Adam Smith Engineer
      Nov 7, 2018 at 10:35 pm

      One minor issue with this is that Snap (and many other companies) actually IPO a very small portion of their outstanding shares.Typically 5% I think. In time, more shares might be traded, but still the percentage is small. Yes, those who buy these shares in the open market might be harmed, but most of the wealth created or lost happens behind the scenes.

      • fajensen
        Nov 8, 2018 at 7:49 am

        If one was into conspiracies, one could think that maybe someone could conspire on “trading up” the 5%, then, based on “The Market”, one could borrow against the 95% privately held stock … and that is how they make money.

  5. Howard Fritz
    Nov 7, 2018 at 3:08 pm

    Excellent article Wolf, this explains why VCs are willing to invest in firms which have a very low ( or nonexistent) probability of becoming fully fleshed out companies, such as Blue Apron or Theranos which have also been covered here. This lead the question is there an end in sight for these Ponzi scheme style investments

  6. OutLookingIn
    Nov 7, 2018 at 3:29 pm

    Investing in ‘Fantasyland’.

    Google, Amazon, Facebook, what are nothing more than “services”.
    Someone first has to make money the old fashioned way, by manufacturing or producing a product, to engage these “services”.

    In the “real” world away from Fantasyland, these real wealth producers grow less and less. The solid foundation of the economy developes more cracks as it continues to crumble at an ever increasing pace.

    • JZ
      Nov 7, 2018 at 5:13 pm

      You Don’t seem to get the part that like wall street future traders own the farmers, these tech guys OWN the commerce. No matter what you produce, you have to market through them. Yes, they are NOT the initial wealth creator, but they are in the position to transfer the wealth you created to them. Who build the internet? The verizon and ATTs, and google can make them google’s slaves. In an age where everything is digitized and symbolized, wealth transfer has NEVER been this easy and centralized. A small Cab company used to be able to survive in localized market and now they are Uber’s bitch.

      • Dan Romig
        Nov 7, 2018 at 6:09 pm

        Many farmers contracted out their 2018 soybean crop at over $9.00 per bushel before planting this spring. Those that didn’t are looking at $7 right now.

        • gary
          Nov 7, 2018 at 9:59 pm

          Are you suggesting that the $9.00 farmers are getting a benefit from Wall Street?

          Of course they are in this instance, but you have to realize that over the big picture Wall Streets takes in more than they pay out.

          And since the futures system is at a “superior level” to the farmer, they are in a position to do “exploitation” (although on the surface it looks like a “win-win” deal between the farmer and the futures system)

        • Dan Romig
          Nov 8, 2018 at 7:58 am

          Gary, not really a benefit from Wall Street, but a way for farmers to lock in prices at harvest/delivery by using the commodities markets.

          JZ stated that wall street future traders own the farmers, and I was giving an example of how farmers can use commodity markets for their benefit.

          My father and I owned a wheat seed breeding and genetics company for nearly two decades, and I can tell you that most farmers and seedsmen are pretty savvy business people.

        • JZ
          Nov 8, 2018 at 11:57 am

          My point is that without future’s market, the farmers can NOT even start planning their business. That is to say, yes, the farmers is the seen wealth created but because their position depends on future’s market, part of the wealth will be transferred to the future’s traders. Let alone the future’s traders can use all kinds of tricks to manipulate and controls the market such that they will squeeze the maximum out of the farmers.

          Same way as Amazon and google. After they killed all the traditional retail and advertisement channels, merchant depends on “them” to run business. One has to analyze pricing and racketeering power in the system and those tech companies are NOT in the fantasy land, they are to all businesses like future’s market to farmers and Uber to taxi drivers.

    • polecat
      Nov 7, 2018 at 8:02 pm

      Hey ! I got an idea. Lets get one of these essential, and vital VCs to fund a satellite launching startup that can locate, and nudge, a few passing asteroids, say, the size of the Transamerica Pyramid .. towards the very same .. uh .. ‘wonderous incubation hubs of ‘progress’ (e. i. Silicon Valley) … and see what happens.
      I don’t think such a scenario could do any worse than what .com and the digital ‘giants’ have done over the last 20 years to totally f#ck up our society. Maybe they could throw in a extra trajectory or two towards High Finance … just to be sure.

      • MC01
        Nov 8, 2018 at 2:23 am

        Polecat: Wolf, several other esteemed members of the WS community and one of my professors (now retired) live in the Bay Area, so I would advise some caution during the aiming process.

        Plus where am I going to get updates for my iOS? I am surely not going back to one of those lousy flip-up phones.

        • polecat
          Nov 8, 2018 at 11:51 am

          Ok. Let me revise that scenario to blast said asteroid(s) into smaller, more manageble .. uh .. ‘aggregates’so as to make a deep impact on the primary targets (specific bad actors), thus minimizing any collateral damage, and allowing our gracious host, and other innocents, to remain viable, with only a little cosmic dust deposited on the surrounds…

  7. Shawn
    Nov 7, 2018 at 3:41 pm

    Yup pretty says it all, a massive Ponzi scheme. Back in ‘13/‘14 I was asked to interview for a startup in SF. It was a < 10 person, series A, 11 million dollar VC funded company to build Korean dating app. The CEO, CTO, CFO etc where UC Berkeley grads that year. It goes to show you that a fool with someone else’s money will invariably be parted.

    • MC01
      Nov 8, 2018 at 9:14 am

      You could have just stopped at “dating app”.

      Personally I cannot think of a worse investment since they all work the same way: try to attract funding, come up with a sorry little piece of software, spend a lot of that startup money to hype their product on “unbiased” review websites, not to mention FaceBook and Twitter, put up a paywall to raise some quick cash when investors start fretting, create an army of bots to fool both their own now downright alarmed investors and the poor saps who paid for a six months “premium” subscription into believing their “ecosystem” is full of fun-loving voluptous ladies while in reality there are only men in their late 30’s working 16 hours a day and finally succumb when said workaolics start flooding the Internet with reviews ranging from the “completely negative” to “this is a scam!”.

      To quote the Pearl Jam song “I guess it was the beatings that made me wise”. ;-)

      • Harrold
        Nov 8, 2018 at 11:56 am

        Dating apps are a strange business in the better your app is, the shorter your customer stays around.

        So the best business plan might be to create dating apps that don’t work very well.

        • MC01
          Nov 9, 2018 at 2:48 am

          Back when I invested in these things (so now you know how I blew my hard-earned money) there were all sorts of marketing studies on how people choose dating apps.
          Word of mouth and end user reviews were constantly listed as the top factors for choosing Service A over Service B: in short potential users wanted to hear from satisfied customers, ordinary people like them who had a great experience. Selling these things is very different from selling a car, where you just need to pay magazines and websites.

          Intriguingly enough when negative reviews on our app started to (deservedly) pile up, I noticed more than an uptick in positive reviews. Not enough to be downright suspicious, but enough to counterweight the average negative rating of previous reviews.
          I don’t know if these reviews were written by paid-for PR farms or by developer employees, but they were as fake as the Amazon reviews for Cave Alien.
          We saw an uptick in traffic and especially subscriptions following these underhanded tactics which was great short term, but led to a pretty devastating backlash after a few months, as the poor saps who had paid up for our “premium” service hit us back with some well deserved scathing reviews. And I don’t even want to think about what they were telling their friends and colleagues.

          Personally I believe there’s a potential market for these things out there, but after what I saw form the inside out first and what I learned about “social media” business practices later I can well understand why people don’t even want to touch these things with a 10ft pole.

      • 728huey
        Nov 11, 2018 at 9:06 pm

        That sounds like Ashley Madison from a few years ago. It was supposed to be an app where married people could literally hook up with potential mistresses to cheat on, and they would always put out some flashy commercials with porn stars to promote the service. Then someone hacked into their database, and it turned out that most of their “customers” were fictional people created by bots.

  8. Bay Area Girl
    Nov 7, 2018 at 3:47 pm

    This is so interesting. I used to work for one of these unicorns when I first got out of college (didn’t know any better).

    They offered me options but refused to tell me the number outstanding.

    I later found out the company’s valuation was 2 billion when I joined. Given that I was working with their data, I knew there yearly profit – they made about 200 million a year before expenses. Maybe they took home 150 million at their peak in profit. This was there peak and they have happened to substantially decline from there. How this valuation was determined, I still have no idea.

    About 5 months after I joined, Goldman Sacks decided to buy in at a ‘3 billion dollar’ valuation (that’s what they said to the media anyway). Common shares were only paid out at a 2.45 billion valuation. I was pretty sure at the time all these valuations were bogus, not sustained by real revenues.

    The worst thing is that this startup is that many of the early employees made NOTHING. They did make money ( 5th employee made 3 million – very little considering how valuable the company was) on their options but could not afford to pay a million in taxes and could not sell their options (as the company was not public). They had to trade their options into a third party to pay their tax bill.

    Those of you thinking of working for a startup don’t! If you have to, pay taxes on your options immediately.

    • Graeme
      Nov 7, 2018 at 6:21 pm

      This is not my experience with how options work.

      An option is granted with a value based on the price of the company at the time the option is granted. Therefore, as an early employee you might get say $100,000 of options representing 1% of a $10million company.

      When you come to sell, say the company has done really well and increased in value 50 times. The company is worth $500million, your shares are worth $5 million, and you owe unpaid tax on a grant of shares worth $100k, so maybe $50k in tax, and $100k to buy the shares, plus whatever capital gains tax on the increase in the shares

      This could represent a problem if you’re trying to buy your options without also selling the shares, but that’s not how options are intended to work. You should only be exercising options at a liquidity event, where you have the opportunity to sell the shares and realise a capital gain in order to pay the tax due.

      It sounds like a lock in to the shares – and it is – but its the better than paying 50k in tax and 100k face value of the shares to buy the shares them start of the process, when you have the risk that they will eventually be worth $0.

      • Bay Area Girl
        Nov 7, 2018 at 10:35 pm

        Sorry I wasn’t really clear. So they gave out stock options (say 20k) at a strike price based on your join date. However I was not told what the strike price was at the time, so it was impossible if the stock price was going up or down.

        You can try to figure it out from the valuation divided by shares outstanding. I forgot exactly, but I wanted this information to evaluate the offer and they refused to provide me with any details. In hindsight, this was a red flag.

        I eventually found out after I joined and soob after they had a stock splitting event and I could not really understand what happened to my options after that. The company refused to share much info with employees. I left after about 8 months so I didn’t even vest and couldn’t exercise anyway since it was not public,

        This unicorn was not very professional at all, so I would not be surprised if this is not commonly how it’s done.

      • Bay Area Girl
        Nov 7, 2018 at 10:54 pm

        The problem for my friends who were early employees is that they never bought or paid taxes on their original stock options.

        There was no public market as this company had not still IPO’d. It was extremely difficult to buy or sell. You could only sell to the company, a third party intermediary or during a buying event.

        So when they were fired and both were, they were told they could only sell their shares back to a third party intermediary.

        They had to pay taxes on that money as if it was salaried income or were told by the third party company that they would be reported to the IRS (not sure if it’s because of they way it was structured or paid out).

        They both worked out deals with this third party company to pay taxes on that money for the shares. Both were able to cash out 10% of their options at an earlier event, but had to forgo the rest to pay taxes on money. One of my friends went into a deep depression over this and attempted suicide. Both totally screwed by the company which they had literally worked 90 hour weeks for years.

        • Mark B
          Nov 8, 2018 at 9:40 am

          Was involved with a startup in the 90’s bubble that at least went public. (Meaning at least I could sell on the open market and not be captive by the company.) I had good advice and sold enough shares immediately to pay the taxes, even though I had to pay short term gains. Was told I was ‘dumb’ to pay short term and that I should have waited a year. Then the stock tanked and some of those who told me I was dumb found their shares underwater but still owed the taxes. Part of the advice I received was to have a sell plan and stick to it…. sell so many shares every quarter no matter what. At least I sold some shares before the price tanked and came out modestly ahead.

        • wkevinw
          Nov 8, 2018 at 11:16 am

          I lived in the Bay Area for 20 years. Sat on planes and went to training with “tech employees” for decades.

          Once I sat on a plane next to a very bright guy who was leaving for a job as a carpenter with his brother in CO. Said he would probably go back to tech in a few years- burnout and didn’t see the big financial payout.

          Remember that you hear about the success stories. I have no idea what the number of techies is that leave burned out and not particularly financially successful.

        • Graeme
          Nov 8, 2018 at 11:19 pm

          Just came back to this now…

          Sounds like these people really needed to consult a lawyer or adviser. If you work options properly, by design they are a way for employees to benefit from upside from shares increasing in value, without being exposed to the downside risk of the shares decreasing in value. It sounds obvious, but it’s super important to understand the contract paperwork, what you are getting yourself into, and how the scenarios play out if you are ahead of behind. I have a feeling that a lot of heartache stories here could have been avoided if these people just better understood the contracts, and how they’re designed to be used

          What’s important to note is that stock options are exactly that – OPTIONS. This means that if the options are underwater (meaning worth less than what you have agreed to pay for them) you can choose not to exercise the options, and thus you never receive the shares, and therefore don’t create a tax liability. In that sense, if you understand what you’re doing you should never come out of having options down financially – which is an important protection for employees.

          This is why stock options are a really good way for employees to get involved in the success of a company. It doesn’t cost you money up front to receive them, and you only have to pay tax at the point that you exercise the option and turn it into shares. Of course, the point you turn the options from options into shares SHOULD BE MANAGED such that it is also be the same point that you are able to sell the shares for a profit, so that you can cover the tax liabilities that become due (and also pay the strike price of your options, which will be the value of the shares at the time the options were granted)

          For private companies, you also need to ensure that the clauses mean that you can turn the options into shares at future liquidity events (meaning fund raises where new money is coming into the company, and there is likely to be a willing buyer of the shares if they’re offered at a 10-20% discount to the round value), and also option holders should have tag along rights if there is a change of control of the company (meaning that in the case of a take over or sale, option holders have the chance to convert their options to shares and sell to the company purchaser at the same conditions as the other stock holders).

          Several of these comments seem to imply that people think you can end up having to pay a tax bill when you don’t have any income from selling the shares, and i would say that this is possible if you want to exercise your options but not sell your shares – but you really shouldnt be doing that – it’s not how these things are designed to be used and any decent lawyer would advise them against this.

          If you exercise options, and choose not to sell your shares, then yes of course you can end up losing money. This should be obvious. Any share ownership is subject to the risk of loss of value – which is why you should only exercise options at the point where the shares are sufficiently above water to cover the purchase price and the taxes due.

          It’s also the case that many shares don’t increase in value, because many companies stagnate or go backward. If your options don’t cover the purchase price and the taxes due, then the company hasn’t hit a home-run, and really “them’s the breaks” with the gamble of working in a startup hoping for a massive windfall.

          In summary, it’s a gamble. You have no right for the options to increase in value. Options are merely a way to gamble on the success of your company with downside protection in that you don’t have to buy anything up front, or pay any tax.

          Hopefully this makes sense

    • Dave Chapman
      Nov 8, 2018 at 2:46 pm

      Bay Area Girl: “They offered me options but refused to tell me the number outstanding.”

      I went on an interview like that. The job was moderately interesting, but the manager kept going on about “We can offer you 80,000 share options”. I asked him how many shares were outstanding, and he repeated “We can offer you 80,000 share options”.

      Hmmmmm. I very slowly explained to him how options work, and how it matters a lot whether there are 8 million shares out there or 8 Billion shares out there, but all he did was to repeat “We can offer you 80,000 share options”.

      I did not take the job, but to this day I don’t know if the guy was pulling a scam or if he was stone cold ignorant.

      Considering that a big part of his compensation package was in stock options, I would suspect “ignorant”.

      Oh, yeah, the company crashed and burned about 2 years later.

  9. Unamused
    Nov 7, 2018 at 3:55 pm

    Articles like this one, the previous one on MF, and many other here, should give you some idea of how utterly brazen business crime can be when the perpetrators really put their creativity to work. Not only has it become entrenched, it has become business as usual.

    Now that big-time corporate crime is no longer enforced you can expect to see it go hog wild. Financialization has escaped Pandora’s Box and no longer has any real limitations. That’s why the Dow is up over 500 points so far today, but just wait until it cruises past 30k. Gridlock is good, and chaos creates opportunities.

    As predicted, a triggering event was initiated yesterday. More can be expected in rapid succession. Players are moving fast ahead of the coming political scandals and the installation of a new federal legislature. My only advice is to find a quiet corner of the world and try to stay out of the way of history. This advice is likely to be useless.

    Good night, and good luck.

    • HowNow
      Nov 7, 2018 at 6:10 pm

      I’m hoping that scandals will be coming, but that’s wishing against the likelihood that the adversaries will be bought off before stuff hits the fan. I guess you have to get to a quiet corner…

    • ArcticChicken
      Nov 8, 2018 at 10:46 pm

      Unamused, you really make me put my brain to work and I don’t much like it (kidding). Essentially, what I think you predict will happen / is happening is this:

      -The election created a Federal Legislature situation which is going to result in absolute political gridlock and scandal fomenting
      -This chaos will mean the big finance dogs will be free to pump the market, and so have intentionally created a market “signal” that will ultimately cause a cascade of market rises
      -When the pump sends the DOW to 30,000 in some short order people will lose their minds ala BTC/ETH in November 2017
      -The pump will reach peak and the finance dogs will reap a ridiculous harvest from the suckers that hopped on at peak hype
      -???
      -Financial and political chaos, both domestic and international, followed by 1928-1938 Round 2: Electric Boogaloo commences on fast forward

      Am I close?

  10. Kent
    Nov 7, 2018 at 4:13 pm

    Have there been any high-growing, highly profitable Silicon Valley firms founded in the last decade? I can’t think of any. Seems like the low-hanging fruits been picked, and these folks are just chasing their tails.

  11. walter map
    Nov 7, 2018 at 4:26 pm

    “The fate of the world economy is now totally dependent on the growth of the U.S. economy, which is dependent on the stock market, whose growth is dependent on about 50 stocks, half of which have never reported any earnings.”

    – former Federal Reserve Chairman Paul Volcker, September 1999

    “Plus ça change, plus c’est la même chose.”

    – Jean-Baptiste Alphonse Karr

  12. OutLookingIn
    Nov 7, 2018 at 4:42 pm

    Time is quickly running out on this now, very late credit-cycle.

    The U.S. 3 month LIBOR is the highest in 10 years.
    Mortgage applications are at a 4 year low.
    Mortgage refinancings are 33% lower than a year ago.

    Meanwhile the Fed continues to raise rates and tighten going into a fast approaching economic maelstrom. Yet the Wall street greed fest carries on, like the ‘Mad Hatter’s’ tea party.

    The economic house is fully involved in flame and the fire engines are all broken down.

    • Bobber
      Nov 7, 2018 at 6:21 pm

      Yes, I see the 10 year went up to 3.24% today, a new high during this tightening period. I think that means this stock rally isn’t going anywhere. I expect a retest of recent lows shortly. This time, however, the downward force will be supported by a 10 year rate that is about 3.35%. Smart investors are selling into this rally.

      • nick kelly
        Nov 7, 2018 at 7:04 pm

        And what was today’s 500 + point rally based on? Trump’s mere suggestion that he will be bi-partisan.

        But fact: the winners of the House ran on extending medical coverage to everyone in a rapidly aging population.

        If the US adopted the single- payer model of the rest of the developed world (and among many savings reduced admin cost from 8% to the normal 3%) this MIGHT be possible without a tax increase.

        As it is, at the very least the new House will revisit the corporate tax cut. It will have no choice unless all pretense of budget responsibility is abandoned.

        Second point: any vague, lotto- type dreams of the Fed pausing must now be confined to the ravings of Mad Man Jim Cramer.
        Today he was opining that with this newly found bipartisan spirit AND a Fed pause. we could have a ‘really big rally’

        Uh huh. In other words what the Fed doesn’t want. Although the Fed won’t do it, today’s detachment from reality must have a few members joking about a .5 % boost.

        Then those inclined could really cry: ‘the Fed is crazy! ‘

  13. Guido
    Nov 7, 2018 at 5:38 pm

    Why is this shocking? IMO, this is capitalism at work.

    The principals investing into the fund should have figured the misalignment of incentives that their 2/20 rule created. After all, we are told 3 million times an hour that these elites made their money because they are smarter than us all.

    Then there are the investors in the IPO. Everybody who has watched the dot com bubble on knows that IPO system is another case of fox watching over the hen house, namely the banks that buy up shares of the company and then take them IPO. Is it any surprise that you have Groupon and Snap kind of companies that are touted to be next Google in making? Hell, even FB could not sustain its stock price after the first day. Traders (day and otherwise) know what they are getting into and they repeatedly get their hands burnt. Here it looks like the case of smart traders on wall street eating away the lunch of people who deserve to lose their shirts.

    Then there are the employees. As Taleb would put it, these are IYI — intellectuals yet idiots. They have degrees from good schools, will regurgitate algorithms that they have spent years learning by rote, and are told repeatedly by the media that they are creme-de-la-creme. Yet, these people fail to ask critical questions. They never wonder what happened to people before them and never seek out those who know. All because of the hubris of being young and thinking they are smarter than the rest. The irony is that they are very bookish and books are nothing but wisdom of age and repeated experience distilled into a few pages. Yet, even as the wisdom of age walks all around them, they won’t probe. This is why the market of people in late teens to mid twenties is so sought after. They will believe anything so long as it is about saving the world. Whose fault is it that they toil away their most energetic years only to discover that they have been robbed? In fact, they pay hundreds of thousands of dollars in going to school. This is what they pay the VC and founders to learn some real world lessons. Very fair deal to gain knowledge, wouldn’t you say?

    IMO, this is the theory of evolution at work. Just another Nature movie is what we are watching. If the actors who are getting eaten alive don’t care, why should we, the viewers, care?

  14. William Smith
    Nov 7, 2018 at 5:50 pm

    All this financial engineering going on is proof that we are quickly reaching “peak tech.” Small computers (called smartphones or tablets) are now only incrementally refining the tech, there is no actual innovation. The same thing happen to radios, which were big clunky affairs until Japan refined and miniaturized the tech. But a radio is still just a radio, and a computer is still just a computer (and AI is just hot air). In fact, I would argue that we are reaching peak tech for most things, and that everything is now becoming a commodity. In the past a lone inventor could come up with a breakthrough product. However now it takes teams of scientists working in various universities to make even minor advancements. The science is now getting very laborious, tedious, expensive, time consuming and boring. Even the (very expensive) particle accelerator is having trouble finding anything of world shattering interest. So where will these idiot VCs go when people wake up to the fact that their dollars are going up in smoke and mirrors? Tech IPOs should be called FTMs (fleece the market) and anyone who accepts options should be called a mug with a huge tax bill.

    • july
      Nov 7, 2018 at 9:50 pm

      I love your comment. So true, so overlooked. You are so spot on when you mention it takes teams of tech-bro’s to make a minor, often meaningless alteration to something. There is such gross inefficiency, over spending, over valuation in the ENTIRE tech sector down to the employee level.

      It should also be pointed out that today’s tech-bro’s are not at all innovators. They are not Steve Jobs, they are not Bill Gates. Their dad’s and grandpa’s paved the way for them.

      Everyone has completely over-rated this every single corner of the tech industry (and down to the employee level).

      Blockchain is going to be a huge disaster btw. Everyone is so in over their heads.

      • William Smith
        Nov 7, 2018 at 11:54 pm

        And the reason for this is the decline of the polymath; who does not think “within the box” because he has access to lots of very different boxes. The education system is responsible for this malady. “The Closing of the American Mind” (Allan Bloom 1986) is well worth a read to understand the problem. The real innovators of the past were not victims of the new rotten educational paradigm and the myopia that the modern education system enforces. Peter Theil (VC) called degrees “a dunce cap in disguise” This is one thing from him that I am totally in agreement with. The thinkology of “we have been taught this and it is god’s own truth” *scientism* attitude (especially in the medical area) is a result of this (new) myopic education system. In truth, science keeps changing its “mind” all the time. Today’s “laws” are tomorrow’s discredited theory (Eg. the theories of Sigmund Fraud). If you go in with an attitude of never questioning “conventional wisdom” then you will never make true innovation because your imagination has been effectively excised by the dirty (so called) “education system.” This thinkology area is a reason why certain countries like Japan are very good at refining things but not too good at actual innovation. The mind of America was once free (rugged trailblazers opening new frontiers) but is now drowning in the hedonistic vomitus of its own “affluenza.” We might be reaching peak technology, but there is another area very rich in possibilities that the current scientism has totally excluded. It is in this space that I expect the most fruitful of innovations in the future to originate.

      • medialAxis
        Nov 8, 2018 at 3:06 am

        “Blockchain is going to be a huge disaster btw. Everyone is so in over their heads.”

        Yes, but it will produce a lot of well trained programmers who are well versed in blockchain tech (mainly permissioned blockchains) and all paid for by the likes of the banks, both central and private. The brightest of these programmers quickly realise permissioned blockchains are not where it’s at (innovating, in a sand box, subject to regulations is an oxymoron). These bright sparks will move to work in the crypto space, on the likes of bitcoin and the Lightning Network, where true innovation is happening. Where you don’t have to ask permission (there’s no one to ask), you just do it. These youngsters are not investing their money in today’s economy, that have none to invest (besides why would anyone want to perpetuate it). They are investing their time and effort in the future economy, the economy they will live in, bring their children up in and retire in. As I keep saying, the revolution will not be centralised (I’ve even written it on a T-shirt)

      • Duke DeGuise
        Nov 8, 2018 at 10:45 am

        Bill Gates, an innovator?

        Well, if you consider using intellectual property laws to construct a monopoly, then yeah…

    • sevensec
      Nov 8, 2018 at 7:57 pm

      Having a first-hand view of basic science research at my work, I definitely agree on this view of diminishing returns in tech. I’d add it applies not just to smartphones etc. but also to biotech. For instance, we have now thousands of spectacular, billion-dollar medical research complexes across the world that collectively struggle to produce even a single new usable antibiotic class (what few we get are variants on molecule types found in the ’60s).

      Much is now made of “Big data” in science, but it mostly means not finding anything especially new or powerful, but finding things in a form so obscure and complex that all involved can simply assume it represents marvelous progress. I have gone to scads of presentations of such research in the last month or so–their formulaic and anticlimactic nature grows more striking every year.

      It seems we are just now (barely) waking up from a golden age of technological low-hanging fruit. This is nicely summed up by Robert Gordon’s work, and also the working paper from Stanford last year, “Are Ideas Getting Harder to Find?” (short answer is: yes–and exponentially so.)

      It is supremely interesting to see how far financialization and VC games as described above can succeed in distracting from this fundamental difficulty.

  15. Bobber
    Nov 7, 2018 at 8:02 pm

    I noticed many of these jokers and their media wannabe’s like to refer to themselves as “serial entrepreneurs”. It’s a delusional segment of society.

  16. Petunia
    Nov 7, 2018 at 8:36 pm

    VCs are investors in idea factories. They invest knowing that very few of the funded projects will yield a reward. Regardless of where they get their money and how they structure their funding, they are the only true “investors” left in the markets.

    In the end, all valuations come from paying customers.

  17. van_down_by_river
    Nov 7, 2018 at 8:43 pm

    Great read. My immediate thoughts are 1) The total sum of money invested in all of these unicorns combined is too small to matter. 2) Many of these unicorns will go public and be absorbed into a massive stock market, even though many will go BK it will not cause even a blip in peoples diversified stock portfolios 3) Anyone willing to work for options with high strike price is probably working to gain experience, not income – basically an extended internship – and that’s their business.

    There is still more than enough easy money sloshing around to easily paper over this little bit of misallocated capital. With inflation heating up central banks are still gushing money – the Fed is supposedly the tightest of the bunch but they have the FFR pegged near 2% and still sit on over $4 trillion of “assets”! Savings still pay negative real rates! How is that tight monetary policy. Plus the Fed can say whatever they want, the money sloshing around the market says the Fed will loosen not tighten. Who you gonna believe the Market or the Fed?

    The Fed has it’s boot on the neck of the dollar, they made the decision to kill it off long ago, might as well sit back and enjoy the show. Unfortunately when the flood comes there will be no high ground to provide refuge – we will all drown together when the government needs to sell a couple trillion at a bond auction and the Fed is the only buyer that shows up.

    • OldEngineer
      Nov 11, 2018 at 12:26 pm

      It’s not just people looking for experience: For a young engineer in Silicon Valley, striking it rich on the options is their ONLY hope of a comfortable life in that area.

      About two years ago, I took a job at a small Silicon Valley startup. Mostly populated by Stanford graduates, but they made an exception for me because they couldn’t find a Stanford alumnus with the skill set.

      Most of the employees were young, and one of them held a master’s degree from Stanford, but admitted that he was making a small enough salary that he was still living with his parents because he couldn’t afford his own place.

      The numbers are ugly: average salary for an experienced engineer is around $100k. One-bedroom apartments are renting for between $2k and $3,500/month. Median house sells for $1.5m. If you get married to another engineer, your combined income STILL can’t afford that median house. Children? Forget about it!

      IF you both manage to land jobs at someplace like Facebook or Google, you might (just barely) be able to afford a house. If one of you loses your job, you’re screwed.

      On the other hand, if you can win the stock options lottery, then you can pay cash for that house and survive on a pair of average incomes. You may even be able to afford your wife taking the time off work to have a child or two.

      I left my family in our current home well outside California and went to Silicon Valley for a couple of months to scope out the job and places to live. At the end of three months, it was clear that this just wasn’t going to work, and I quit the job and went home.

      I do feel sorry for the people who grew up in that area: It’s home, and the economics are going to force them to leave their home and move somewhere strange, foreign and uncomfortable. I can’t condemn them for grasping at whatever straws they can to try and stay “home.” I did the same. For me, however, leaving my childhood home was the best move I made in my entire life.

  18. alex in san jose AKA digital Detroit
    Nov 8, 2018 at 8:00 am

    Someone forgot to pay their bribes …

    https://www.mercurynews.com/2018/11/03/h-1b-visa-fraud-feds-indict-sunnyvale-man-for-bringing-in-600-workers-illegally/

    Sorry for the Murky News link, but essentially more people smuggled in and paid something like $3 an hour to do tech. Routine here.

    • Shawn
      Nov 8, 2018 at 2:02 pm

      Wow! It’s more like about 25 to to 35 bucks an hour but the smuggler or Coyotaje charges FAANGs et. al. 65 to 80 bucks an hours. Yes, it’s been going on for decades, such are the scoundrels employed in senior positions within the tech industry here.

  19. Nov 8, 2018 at 11:35 am

    I first picked up on VC funds around 2000 when they were a conduit for massive fraud. When Abramoff and Delay wanted to move campaign money offshore this was the vehicle of choice. Internet casinos in the Caribbean were the destination. A lot of that money is still there, and found its way into Jeb Bush’s SuperPac. I have no reason to consider that this is still anything but a legalized fraud. That they put some money into big tech to cover their expenses, so much the better. When the global ponzi scheme blows up VC will be right there.

  20. Nov 8, 2018 at 3:07 pm

    Lots of truth in this article so why I prefer working with early stage AI startups to raise seed with enough customer traction then Series A with robust customer traction to get to $10M sales then get acquired for $100M before High-Stakes Ponzi Scheme from big funds manifests ;-) Scheme from big funds manifest ;-)

    Cheers….

  21. Bruce Kowal
    Nov 9, 2018 at 9:52 am

    What a terrific article here. You outdid yourself Wolf! This is being forwarded to a lot my friends and clients.

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