Ventures that require large upfront investments
I always planned on writing this once I learned more about economics. I don’t know exactly what I want to say and how to say it clearly, but I’m inspired now, so here we go…
Let me start with a concrete example to illustrate my point: education. There are tons of courses, books, tutorials etc. 99% of the time they communicate via text. What about pictures, animations, diagrams, videos, interfaces, games…? I think it’s obvious that concepts can be taught more effectively by using these mediums than by using text (or at least by using these mediums as a supplement to text). So why do most courses/books/tutorials choose to just use text by itself?
Because using the other mediums are a lot more expensive. It’s a lot cheaper, quicker and easier to write out some lecture notes than it is to draw diagrams, make animations, make videos… let alone making an interface or game that students can place with to illustrate a concept.
A lot of educating today is being done by people who lack resources. Most classes are taught by a single instructor who doesn’t have the time, resources or expertise to make animations and videos for their classes. A lot of informal education is done on the internet via blogs and tutorials. Similarly, it’s usually done by one person or a small team that lacks the time, expertise and money to invest in animations/videos.
I think that there are lots of opportunities to educate people using mediums other than simple text. If someone wanted to say, make an online Ruby on Rails class that took advantage of these mediums I think they’d do quite well. The problem is that doing so requires a lot of physical and human capital (you have to pay for the equipment, and have a bunch of people with expertise working on it).
You may be thinking — “Our economy has a solution to this problem: raising an investment. The problem you describe is real, and our society wouldn’t have progressed to where it is today without a solution. The idea is that an investor provides you with the resources you need to get started, and in exchange he receives partial ownership of the company. This is how tons of technology startups have arisen.”
Todays funding environment does indeed do this for some types of companies, but it fails to do this for other types. Let me explain.
Companies get funded in stages. First is the seed round where you get tens/hundreds of thousands of dollars. Next stage is a series A where you get a few million. Afterwards there are series B and C and D rounds where you could get up to a couple hundred million. Each round of investment requires a different degree of traction (the later the round, the more traction required).
So… the ventures that get funded are the ones that can be built in chunks. Ie. build the first iteration, get some traction, raise a seed round. Use the seed round to get more traction, use that traction to raise a series A. So on and so forth.
What about the ventures that can’t be built in chunks? What if the first iteration requires a large upfront investment? As far as I could tell, these sorts of ventures aren’t even pursued, because no one would ever fund them.
They way capitalism works is it depends on private citizens to pursue ventures. It depends on these entrepreneurs to recognize an opportunity, and provide something of value to people. If no one ever recognized (or took the initiative) the opportunity to sell pizza, we as consumers wouldn’t have the opportunity to buy pizza.
Capitalism works because we live in a big enough society such that if there is a opportunity to sell something and make money, someone is bound to pursue it. However, this only applies to ventures that can be started with a small enough initial investment. For ventures that require large investments, there’s only a handful of organizations with the resources to pursue them. Furthermore, they’re usually big corporations that are too bureaucratic to be innovative. So, a lot of ventures that would require large investments don’t get undertaken.
The way I see it, a rational investor should fund a venture if the expected value (returns * probability) is greater than the initial investment (adjusted for risk aversion). There are a lot of ventures that do require large initial investments, but that still have an expected value that exceeds this initial investment. So then, they’re worthy investments… if you’re not too risk averse.
In practice, a lot of investors are too risk averse for it to be worth it for them to fund huge ventures. But what about all the firms that invest tens/hundreds of millions in post-series A rounds? They seem to have the right risk profile.
In my opinion, the real problem is the formulaic approach that investors take. They need to see traction, and they won’t make investments that require intuition and foresight. Hence, only companies that can be built in chunks get funded. I think that there’s a huge opportunity to fund ventures that can’t be built this way. For example, invest $20M in a bunch of people to build a Rails course that uses animations and diagrams instead of just text.
