Yep, there’s an oxymoron for you to start the day. Of course capitalism cannot exist without profits. The profit motive is what drives all free-market activity. Buyers and sellers exchange products for money because they both expect to gain something from the transaction. Workers aspire to make more money than their cost of living. Employers expect to be left with a surplus from the work their employees get paid for.
At the heart of our free-market capitalism is, of course, the profit-driven business. Without profits, capitalism cannot survive.
Amazingly, this notion has been lost on an entire new generation of so-called entrepreneurs. Centered around the so-called tech industry, start-ups and investors operate less and less on the premise that their business return a profit, and more and more on the notion of capital gains. It is not until these businesses go public that they are forced to accept the traditional concept of selling a product at more than it costs to produce it.
However, the idea of profitability is not even the eventual goal of these businesses. The eventual decision to make an IPO and enter the stock market is increasingly driven by the necessity of keeping investors happy than of any interest in earning a profit.
In a sense, our new generation of “tech unicorn” entrepreneurs live their lives more like executives of non-profits than leaders of traditional businesses. They treat investors like non-profits treat their donors.
This is, of course, an unsustainable model, and we are already beginning to see the signs of this. The latest IPOs from tech unicorns have resulted in ridiculous market values for companies that have never turned a profit. Those values are not anticipations of future profits, but the results of hyped-up expectations aimed at yielding capital gains for investors/donors who were generous enough to pay the bills for the start-up.
Until, that is, they themselves had to make a return on all their investments/donations.
The non-profit approach to corporate management is isolated to the “tech” industry. There, on the other hand, it seems to encompass almost anything that prevailing irrationality will classify as “tech”. Even a car manufacturer can fit under that realm. Elon Musk ran Tesla as a publicly traded company for ten years before he finally could report an annual profit.
One does not have to look far to see how profits are as rare among tech unicorns as real unicorns are in real life. It is striking how these companies dash to the stock market, how they don’t even bother to make sure they make money before they transition from private ownership to the stock market. And investors appear to have a high tolerance threshold to this attitude; as Kate Clark reported last year over at TechCrunch:
Much like a seed-stage investor must bet on a founder’s vision, Wall Street, given a choice of several unprofitable businesses, has to bet on potential market value. Fortunately, this strategy can work quite well. Take Floodgate, for example. The seed fund invested a small amount of capital in Lyft when it was still a quirky idea for ridesharing called Zimride . Now, it boasts shares worth more than $100 million.
Clark also notes that Amazon was unprofitable when it went public in 1997. However, it is important to note that Amazon was one of the first successful internet-era IPOs, and in their case the internet was not even the main theme of their business. Amazon started as a home-delivery book seller, using the then-novel idea of the internet as their way of facilitating order processing. They simply took the idea of the postal-order catalogue of the late 19th century, adapted it to the computer age – and ran with it.
Back in the 1800s, the railroad was the technological revolution that gave birth to a new version of retail business. Instead of having a store in each city, the postal-order businesses would have one or two warehouses, strategically located, then distribute their catalogues to every household and collect orders and make deliveries by mail.
Amazon took the same concept to a new level, but just like Sears-Roebuck a century earlier, they simply applied new technology to good old retail trade. It was a winning concept, one that many others have followed. But Amazon is no more a “tech” company than Sears-Roebuck were.
Nor is AirBnB a tech company any more than a travel agency or a brokerage firm. Uber is a taxi company. DoorDash is a micro-format version of FedEx. The fact that they reach their customers by means of a telephone application does not immunize them against the need for profitability.
Over at Techcrunch, Kate Clark notes two variables that are cause for concern regarding this profit-free new niche of American capitalism:
In 2006, it was the norm for a company to make its stock market debut at 7.9 years old, per PitchBook. In 2018, companies waited until the ripe age of 10.9 years, causing a significant slowdown in big liquidity events and stock sales. Fund sizes, however, have grown larger and the proliferation of unicorns continues at unforeseen rates. That may mean, eventually, an influx of publicly shared unicorn stock. If that’s the case, might Wall Street start asking more of these startups?
There is a connection between the longer gestation time and the eventual IPO. In fact, if these tech unicorns could, they would continue to operate as private businesses. It shields them from the merciless profit requirements that are associated with the stock market. But they cannot stay away from the IPO; all they can do is delay it as far as possible.
There is no better example of this IPO agony than WeWork. After a ridiculously over-inflated public-offering pitch, the whole balloon imploded – as Business Insider reported, the company wasn’t even close to profit – and by at least some estimates the value of the company fell by 96 percent. But while investors filed lawsuits against WeWork over what was little more than a non-profit fundraising scheme, other tech unicorns have successfully gone public without ever having made profits.
The reason, again, is sheer necessity. As Kate Clark reports, the IPO gestation period for these start-ups is 38 percent longer now than it was 15 years ago. Since they remain unprofitable, it takes longer before investors who are interested in profits, can invest in those companies. The original investors, on whose money the company was founded and has operated as a private business, have to wait longer for their payoff.
Having to wait longer for investment returns means greater risk for losses.
Here is where it gets problematic for the profit-free unicorns. It is nice and comfortable to operate a business without the profit requirement. You can sit around and play with stuff all day long, which in the “tech” industry means writing codes, experimenting with those codes and then writing more codes. (Or you can just write “oh my God I hate Donald Trump” on Snapchat if you so desire.) It is far less comfortable to have to confront your “innovations” with the reality out there. You know, the big reality, east of the Bayshore Freeway.
Yet the day of profit reckoning has to come. Every investor in a start-up company ultimately wants his money back, and he wants more back than he went in for. If he doesn’t get money back, his bosses – or shareholders – are going to become a bit grumpy. The longer the time period between investment and return, the greater the risk is that no return will materialize.
When you have invested in a company that has no operating profit on its horizon, all you have to hope for is the capital-gains return on your money.
Sell your stock for more than you bought it.
There is nothing wrong per se with realizing capital gains. It is the nature of the venture capitalist to bet on equity values for his money making. However, no business can rely on more than one generation of capital-gains investors – two tops – before its stock value goes from a promising deal to a speculative bubble.
This is where the IPO comes in.
A business that doesn’t generate profits is consuming its own capital to stay afloat. By all measures, this is how a non-profit organization operates, but the difference is that a donor to a 501(c)(3) charity is not expecting anything back, except a tax deduction and the advancement of a good cause. The investor who writes a big check for a “tech” startup needs to get his money back – or he will eventually go out of business.
As the start-up keeps operating through the 10.9 years Kate Clark reports, it eventually runs out of new fundraising stories to tell its investors/donors. Just like mortgaging your house to buy food and pay utilities eventually runs into a dead end because no bank will believe your story of future incomes, a profit-free tech unicorn eventually has to tell a new story in order to keep its investors and, ideally, get new ones.
That story is the story about going public.
There is just one problem. Once the tech unicorn comes to the IPO point its investors are in for such ridiculous amounts of money that it is practically impossible for any stock-market investor to rely on future profits in the stock purchase. This is painfully true for businesses that have gotten used to – built its corporate culture around – operating without having to worry about the bottom line.
So far, the unicorn IPOs are working. Riding high and fast on rare success stories, they can still pitch themselves as the next Google.
The IPO becomes the saving grace when your original investors cannot keep pouring more money into a bottomless pit. It becomes your path out of implosion.
In a sense, it follows the good old adage: go big or go bust. The problem is that once these companies go public and get the expectable boost in their share prices, they are dealing with a new crop of investors whose alternatives are infinitely greater than it was for the investors the tech unicorn dealt with when it was privately owned. A shareholder who buys stock in AirBnB can change his mind on a whim and buy Walmart or Coca Cola instead.
To keep those investors happy, you suddenly need to learn how to play that old-school game of capitalism. You have to learn a new game: profitability.
That can be painful. Tesla is a great example. Having recently reported its first full year of profits, they have found out that doing so comes with a hefty price tag. Tesla is now the worst car manufacturer on the American passenger vehicle market in terms of quality.
There is an obvious reason for this: neither Elon Musk nor Tesla investors have seen the company for what it really is, namely a manufacturer. For years on end they have lived in the dreamland where Tesla is a “tech” company. This has allowed them to tap into the profit-free culture of Silicon Valley and to skip out on the traditional requirements that other car makers have to adhere to. But as Elon Musk is gradually finding out, there is nothing more “tech” about building an electric car than one with a traditional internal-combustion engine. It’s just another powertrain. Just like GM or Honda, Tesla has to take in more money on its vehicles than it costs to build them.
Since Tesla doesn’t have a culture of product quality, and since the “tech” industry is dominated by short-sightedness and the attitude that there is always another investor around the corner, the solution to the for-profit requirement is also short-sighted. Cut quality, cut corners and crank out the cars as fast as you can.
Maybe Elon Musk will learn the automotive business at some point. Maybe he can actually turn Tesla into a sustainably profitable business. He seems to be transitioning from the “tech” dreamland into reality, gradually moving, as he is, both himself and his business from California to Texas. But to do so he and his executives must stop comparing themselves to Facebook and Google. They must start comparing themselves to Hyundai and Toyota.
Musk has one thing going for him. A car manufacturer can with relative ease make the transition from investor-based cash inflow to traditional profits. The inputs needed to build a Tesla (with acceptable quality) come with an easily identifiable price. To that price, they can then add a mark-up that people stupid enough to buy a Tesla will actually pay. This is not hard. Henry Ford did this a century ago.
It is much harder for service-based tech unicorns to make the same transition. While a car buyer can easily identify the value in a product, it is harder to find that value in the service provided by a business like AirBnB or WeWork.
The difficulties do not lie in the nature of the service itself. None of these companies, DoorDash, AirBnB, Uber, etc., produce anything revolutionary or even new. Despite the hype, they haven’t invented a new industry. Uneducated youngsters in the “tech” industry boldly claim that these companies have invented the “peer to peer” industry. It consists of matching buyer with seller: AirBnB matches a room to sleep in with a person who needs to sleep in a room; WeWork matches office space with people who need to rent office space.
This is called “brokerage”: you broker a deal between a buyer and a seller. Travel agencies did this long before the internet was invented. If you wanted to fly from Stockholm to Los Angeles with Pan American Airlines back in 1985, you called a travel agency and they sold you the tickets. They were the broker between you and the airline.
There is, of course, nothing wrong with offering brokerage services, but it is patently absurd to suggest that there is enough money in those services to merit the ridiculous $47 billion market value that AirBnB commands. Similarly absurd is it that DoorDash, a company that has specialized in delivering pizza, can be valued at $60 billion by the stock market.
Apparently, the demands for profit are beginning to take a toll on the new, young generation of “tech” entrepreneurs. Behold Bloom Energy, a company that wants to transform the way we heat and power our homes (Wall Street Journal, Dec. 9, print ed., p. A1):
BloomEnergy Corp. became a hot startup more than a decade ago by promising to upset the utility industry with devices that could power the nation’s buildings. … Bloom would sell [fuel cell] technology in “Bloom Boxes” running on natural gas and providing power more cheaply than the utilities on the electric grid. Silicon Valley bought in, and media attention followed. … As with many Silicon Valley startups, Bloom presented the kind of bold technological and revenue prospects that persuaded investors to look beyond profitability.
Just like so many other so-called tech companies, Bloom Energy has been able to live off investors for a good ten years now. The Wall Street Journal again (p. A10):
In 2009 [Bloom Energy] projected profits by 2010, according to board materials reviewed by the Wall Street Journal; but it has never reported a profit, losing over $3 billion since inception.
It is beyond me why someone would stay committed to a business whose losses run in the hundreds of millions per year, but that is a question for another day. The troubling part in this is that for every new “tech” company that can stay afloat on investor money without turning a profit, there are plenty of other companies that could become profitable if investors bothered to look their way.
Eventually, if this trend spreads, it redefines the role of the entrepreneur in our economic system. His role is no longer to develop and run a profitable company; his role is to be the circus leader of creative people who can try out wild ideas without any sort of financial accountability.
Brainstorming ventures are good; Microsoft started as a group of nerds hanging out in a garage in Seattle eating pizza and trying to figure out a better way to operate a computer. But there must always be a mechanism in place that can separate the good brainstorming products from the bad ones. That mechanism is the market profit the products can generate.
Without profits, the ideas are being fed by the continuous inflow of investment money, but investment money doesn’t make a profit in itself. It harvests capital gains because it can buy equity at a low price and sell it at a higher price; without profits, the chain of rising equity prices must continue indefinitely, with each new buyer living on the prospect of an unending chain of price hikes.
To work, this chain has to feed of new investors and new money constituting the next link in the chain. Each link must be bigger than the previous one, or else there will be no more capital gains.
By definition, this is a speculative bubble. Or, as it is also known: a pyramid scheme. That scheme ends when the investors that “look beyond profitability” run out of buyers of the stocks they hold. At that point, there is only one remedy: profits. Good old, capitalist profits. Sell a product for more than it costs to produce it.
If you can’t, you go bust.
An economy cannot exist without profits. Why? That’s a topic for another day. It is an important topic, though, so stay tuned. We will soon revisit it. In the meantime, click the Follow button and get all the updates as they happen!