'Santa rally' hopes shatter on S&P 500 selloff
Bulls' hopes for a year-end rally in the S&P 500 were already on shaky ground following continued trade war noise surrounding the Huawei CFO arrest, but Friday's sell-off has likely put them to rest.
Head of Equity Strategy
Summary: The startup life-cycle pattern of attracting cash, building a brand and selling out to big tech for a fortune has become increasingly familiar. It is ultimately destructive to new ideas, society and the global economy and it has to stop.
Yesterday, I received the sad news that Quandl, a financial data infrastructure service, had been acquired by Nasdaq. Another one gone, I thought. In June, it was GitHub, a web-based hosting service for code version control using Git, that was acquired by Microsoft for $7.5bn. The list goes on and on. Many small companies are sold to the big ones adding tailwind to the depressing trend of industry concentration which is bad for competition, compensation and the vitality of our market economy. I believe we have systemic problem and it has been exaggerated with the startup culture over the past 20 years. It can only stop if the culture and aspirations change, but it requires a complete change in attitude from venture capital firms, private equity firms, founders of companies and management of established companies.
Independence as a virtue has died
Today’s so-called startups have a very different agenda than companies founded in earlier decades. First, they are heavier users of venture capital which is abundant due to low interest rates. Secondly, many startups go about and talk endlessly about “changing the world” and selling a mission while taking other people’s money. But the data show that these lofty aspirations come cheap. Most of today’s founders are willing to sell any day. To cash in or exit, as they say in Silicon Valley. According to CB Insights data, 97% of exits in 2016 were mergers and acquisitions, and even more disturbing, most of these exits happened before Series B (Silicon Valley lingo for early funding; often before real revenue generation has gained full speed). In other words, the data suggest that many founders of today’s technology companies are driven by “the exit”. Build a business using venture capital and sell it to a company in the industry, and even better, sell it to one of the major tech monopolies swimming in cash willing to pay a steep premium for “adding tech”.
It’s my hypothesis that the combination of cheap money fuelling venture capital and a tipping point in industry concentration has engineered a culture or ecosystem that is trapped in a negative feedback loop; at least viewed from an economic point of view. The industry concentration has generated massive companies with profit margins significantly above historical norms. These companies exhibit low competitive pressures allowing them to have abnormal profitability which makes it less painful to pay too high a price for smaller competitors. The strategy for these quasi-monopolies is to kill the competition. Everyone in Silicon Valley learned this tactic from the former Intel CEO Andre Grove that wrote the famous book “Only the Paranoid Survive”; and Intel succeeded very well on this strategy.
The massive monetary power on the “buy side” happens to be in sync with a new generation of entrepreneurs that have been brainwashed to think in “exits and cash-in strategies”, because the faster you can exit the faster you can build a new business using other people’s money so you add serial entrepreneur to the CV. The VC industry is also happy to facilitate earlier liquidity events, as it’s beautifully coined in Silicon Valley, as it makes their reporting numbers in the fund look better. There is nothing worse than no exits/IPOs if you want to raise more funds and get more management fees to pay ever more in compensation. So exits to the technology giants have become the convenient options for venture capitalists because initial public offerings are more bureaucratic, takes longer time (because companies often need to be profitable) and secondly you may get a lower valuation than selling privately to Google.
The virtues of independence and competition seems to have disappeared among the new generation. The days are gone when young people had aspirations to build lasting businesses and compete against the big companies. The ultimate mission is the exit and then post it on Instagram for instant gratification. Maybe one day it will all change and founders will begin to say no to acquisition offers and aim to build lasting businesses; and if venture capitalists are on board then this independence entails going public, because they want their investment back after all. One of the few in the technology industry that goes against the current ideology in Silicon Valley is David Heinemeier Hansson who is the creator of Ruby on Rails and the company Basecamp. He often talks about the flaws in the Silicon Valley modus operandi and about the idea of building a sustainable business with a focus on profitability.
Industry concentration: No end in sight?
For the past two years we have been very vocal about monopolies and in general industry concentration in our presentations. In a recent study from 2016, it was shown that more than 75% of US industries have experienced an increase in concentration levels over the past two decades. This concentration has driven up profit margins, positive abnormal stock returns and increasingly better M&A deals. We ended up in this situation due to lax antitrust enforcement in the US as the current paradigm is that as long as there is no consumer welfare loss then it is not a problem.
This has been the recurring argument for letting Amazon alone despite increasing evidence of negative effects on industries from their market power. Back in September we covered antitrust enforcement and Amazon arguing that it is potentially the modern version of Standard Oil. If our hypothesis is right that the current ecosystem is trapped in a negative feedback loop then the only way to change this is by changing the rules and increasing antitrust enforcement. Lower industry concentration is better for competition, markets and the economy.
On top of improved antitrust regulation across many industries the culture around startups need to be changed. Everyone involved in this segment would be off fighting the big companies instead of selling out to them at the first opportunity.