Venture capital investing is responsible for producing some of the most prominent companies in the world — Google, Facebook and Airbnb were all small startups before they were propelled by the might of VC money, and became some of the biggest companies of all time. But a prolific Silicon Valley investor has said that modern startup investing isn’t quite the same as before — and he’s used some strong words to describe it.
Early Facebook employee Chamath Palihapitiya, who was also an investor in companies like Slack and Palantir, has said that modern venture capital investing is a giant Ponzi scheme. “We are in the middle of an enormous multi-variate kind of Ponzi scheme,” Palihapitiya, who’s now worth over $1 billion, said when asked about startup investing in an interview. Palihapitiya says the structure of the investing industry creates incentives which might not be aligned with the the best interests of entrepreneurs.
“(Investors) aren’t people writing cheques out of their own balance sheet. These are people doing a job with other people’s money,” he says. It’s a job that pays well, but investors earn money in two ways, explains Palihapitiya. One is through a fixed fee, which is a percentage of the money they manage, and the second is through a share in the profits that their investments make. This creates incentives for investors which require that their invested companies grow at all costs, says Palihapitiya.
“They give you a million dollars, and then you go to your first board meeting,” he says. “How fast are you growing? Grow faster,” investors tell founders. Palihapitiya says that this growth isn’t organic — companies can’t improve their product-market fit overnight. Instead, they spend their money on advertising. Palihapitiya says that 40% of money that companies raise goes to in advertising on Google, Facebook and Amazon, instead of being used to improve their product.
But the money does show results — companies who spend money on advertising see a temporary increase in their user bases. This comes in handy to get another set of investors on board. Palihapitiya says that investors then tell other investors how fast the company is growing, and urge them to invest in their next round. “Some other firm they are buddies with invest in the Series B,” says Palihapitiya, This investment is done at an increase of 4-5x over the initial valuation. The first round investors are happy — they now have a return to show for, and they now have, on paper, a successful track record of picking out young startups.
This process repeats for other rounds. The Series B investors similarly give the company more money to grow, 40% of which is against spent on Google, Facebook and Amazon. Once the company has some superficial growth to show for, it raises the next round at an even higher valuation.
This is where the Ponzi scheme aspect of the whole process begins, says Palihapitiya. The investment fund that had first invested in the company has by now seen its investment grow manifold. It decides to float a new, even larger fund. It arranges for more money, and begins investing in more companies, starting the process off again. But now the fee structure of VCs begins coming into play — remember investors earn money from a fixed fee which is a percentage of the amount of money they have under management, and a share of the total profit they generate. At a high enough level of money they have under management, they can simply make a good living off their fees, and not have to worry about the actual profits they generate at all.
“If (investors) have $500 million under management, and they’re collecting a flat 2% on the fees, that’s $10 million a year. If you have 4-5 partners, investors are making $1 million a year, and they’ll make this for the coming 10 years,” says Palihapitiya. At this point, investors don’t care about how their invested companies do — the money they have under management is large enough to give them very comfortable returns for the foreseeable future. “The incentives in this industry are the most out-of-whack they’ve ever been,” he says.