Financial Hits and Misses

🎧 An audio version of this article is available below and on Spotify, Apple Podcast, and beyond.

We live in a crazy world. Consider the following story: A startup raised money for a business that operated in a legal gray area — and later became illegal in many jurisdictions. The startup subsidized its offering to attract customers. It encouraged customers to get into risky situations. The company lost money for years and was constantly hounded by lawmakers. And yet, the world's most prominent investors flocked to invest in it.

I'm talking, of course, about Airbnb. Once a company is successful, it's easy to forget how unreasonable it was to invest in it.

Some say that Airbnb is unique and that, despite the legal uncertainty, investors supported it because its founders were of exceptional character. But Airbnb is not the only company that fits the description above. Uber, too, launched a business predicated on skirting the law, putting customers in risky situations, subsidizing rides, and losing money for years. And unlike Airbnb's Brian Chesky, Uber's Travis Kalanick was not a "nice guy."

Others say that Uber, Airbnb, and other companies that grew through the 2010s benefitted from a unique period of low-interest rates that will never return. But Uber and Airbnb remained solvent and raised more money even as interests rose and the economy shut down. And, in any case, real interest rates in 2022 are not so different from in 2008, when Uber and Airbnb were founded.

Even today, Airbnb and Uber's business can seem questionable. Fourteen years after its founding, Uber is still losing money. Airbnb just posted its most profitable quarter ever. But a recent announcement from CEO Brian Chesky highlights how little has changed since the company was founded:

Let's put this in context. According to Airbnb's website, the company facilitated transactions between "more than 1 billion guest arrivals" to properties managed by "over 4 million Hosts." That's a lot of people. And yet, only in 2022, the company is finally starting to verify the identity of every guest and host. It took Airbnb a decade and a half to implement a standard safety procedure that is par for the course in a hotel.

This is not meant as a jab at Airbnb or Uber. It is meant to highlight the obvious red flags in some of this era's most successful companies.

Our economy depends on investors who bet on such companies, despite these red flags. To understand why, consider the following data points from Sebastian Mallaby's history of venture capital:

• A survey of 7,000 startup investments over 30 years found that 5% of the total capital deployed generated 60% of all the returns. In other words, 5% of the money went into companies that became big enough to eclipse the whole portfolio.
• Y Combinator, a venture capital fund, found that 75% of its 2012 gains came from just 2 of the 280 startups it bet on. If YC had missed out on those two companies, it would have lost the bulk of its gains.

As Peter Thiel wrote in Zero to One, "The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund." The dependence on big outliers means investors cannot afford to stay out of deals that might become big. This is not true in traditional finance. As Sebastian Mallaby explains:

"The celebrated hedge-fund stock picker Julian Robertson used to say that he looked for shares that might plausibly double in three years, an outcome he would view as 'fabulous.' But if venture capitalists embarked on the same quest, they would almost guarantee failure, because the power law generates relatively few startups that merely double in value. Most fail completely, in which case the value of their equity rounds to zero—an unthinkable catastrophe for a stock market investor. But each year brings a handful of outliers that hit the proverbial grand slam, and the only thing that matters in venture is to own a piece of them."

I mention all this in light of FTX's spectacular collapse. Earlier this week, I wrote, "Given the opportunity, most of FTX's investors would do exactly the same thing tomorrow. Their job is not to avoid failure; it is to avoid missing out on the biggest success."

Many readers pushed back and pointed out that FTX operated in a gray area, subsidized customers with unsustainable rewards, flaunted regulators, and had a CEO that behaved strangely and said outrageous things. Was any of this worse than what we've seen from Airbnb, Uber, and plenty of other successful startups?

Of course, FTX was also allegedly involved in actual fraud — taking people's money without their permission. They should be investigated and tried. But it's not something that investors knew about in advance.

This raises another objection: If investors did proper due diligence, they might have discovered the fraud in advance. Perhaps, but fraud occurs even under the most intense scrutiny — including in mature companies that are publicly listed and audited by the world's finest accountants (remember Enron?).

More importantly, venture capital investors must operate with limited time and information. They have to decide quickly, and their whole fund hinges on not missing that one big investment. This is why FOMO, fear of missing out, is often a reasonable strategy. If the investment turns out well, you're a genius. If it doesn't, you'll get criticized, but with some luck, you'll get to try again.

One does not need to go too far to see how the FTX investment could have turned out. Coinbase, an FTX competitor that offers similar services, became a public company in April 2021 and reached a market cap of over $80 billion. The peak valuation represented a 60x (6000%) return for Andreessen Horowitz, a venture capital firm that started investing in Coinbase years before its IPO.

All this is not to say that supporting questionable businesses and questionable founders is good for society or the world at large. That's a separate conversation. My point is only that investors will continue to make bets of this kind and will learn very few "lessons" from the collapse of FTX.

The record industry offers an interesting parallel. Did Amy Winehouse's death cause labels to stop backing women who are heavy drinkers? Did Kurt Cobain's suicide trigger a shift away from backing mentally-unstable men? I don't think so.

The need to bet on unknown quantities was always part of the game in the entertainment business. Stars were stars only after they became stars. And if they didn't, they were just another bad idea that didn't pan out.

The bigger question is why the rest of the economy is starting to follow the same playbook. More on that next time. Subscribe, so you don't miss it.

🎧 An audio version of this article is available below and on Spotify, Apple Podcast, and beyond.