Coordination Failure: August 20, 2017 Snippets
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This week’s theme: Bubbles are (sometimes) useful; plus welcoming Mike Ghaffary to the Social Capital team!
Last week, we introduced the topic of financial bubbles: what happens when the demand curve for something inverts, and higher prices create more demand, driving prices higher still. Although we tend to think of bubbles in a negative light, there are a certain category of bubbles that actually do something very useful: they leave behind important infrastructure. Whether it’s canals, railroads, electrification, or fibre optic cables — the history of innovation is littered with speculative enterprises that go bust, but leave behind a valuable legacy. As Brad DeLong wrote in Wired in 2003, after the dust had settled from the dot com / telecom bubble: “Investors lost their money. We will now get to use their stuff.”
Why are these bubbles necessary? Why can’t we build that infrastructure under regular circumstances? To understand why, we need to explore an economic concept called coordination failure that reveals something interesting about what we take for granted in the startup world today.
Coordination failure can generally be understood as a situation where multiple players in an economic game have an opportunity to all become better off if they are able to coordinate and count on one another, but when they can’t successfully coordinate, all of them remain worse off. Here’s an example. Imagine you’re at the drive-thru window at McDonalds, where you pay cash at the first window and pick up your food at the second window. You want to pay money for food, and McDonalds wants to give you food for money. So far so good.
But suppose you can’t be totally certain or trusting that anyone will show up at the second window — what if you don’t ever get your burger? So you become hesitant to hand over your cash. If McDonalds has no way to guarantee to your satisfaction that your burger will be there, then you have no choice but to drive away disappointed. Everyone is worse off — you’re hungry, McDonalds did less business. That’s a simple example of coordination failure. In regular life, of course, we’re successfully able to eat the burger because there’s enough information, trust and precedent available for us to confidently hand over our money and proceed through the drive-thru. But what if the stakes are higher? Like, a lot higher — as in, someone wants you to hand over a hundred million dollars because they want to start a next generation cell phone company?
Now the problem starts to look more like this: you’re at the drive thru again, and you’re about to hand over money for the burger, and the cashier tells you: “Hey, just so you know, your money isn’t actually enough for us to cook the burger all the way through. We’ll get started on the burger, but at some point we’ll have to go to the bank and borrow more money in order to finish cooking it. We’re pretty sure we’re good for the loan, but we can’t totally be sure. Anyway, we need your money now in order to get started. Cool?” Oh, and the burger costs a lot of money, and they’ve never actually made a burger before, and they’re not totally sure how good it’ll be. Are you really going to give them the money? Or are you just going to give up and go eat somewhere else?
Now replace burger with ‘startup’ and you can begin to appreciate the problem.
The roadblock is this: when it’s hard to coordinate between the present and the future, it becomes risky for investors and the entrepreneurs they back to embark on an unknown venture if they know that the initial capital raised is insufficient to reach positive cash flow from operations. More money will be needed down the road. Furthermore, there needs to be a credible reason for both the entrepreneur and the investor to believe that not only will financing be available in the future when needed, but that the terms of that financing will be more attractive than the ones being offered today. The financier won’t do it because if someone else can hop in later at the same terms, then they’re getting a free ride off of her money; the entrepreneur won’t do it because he’d need to use the second loan just to pay off the first one. They both need some credible reason to believe that there will perpetually be financing available for their risky project, at increasingly attractive terms each time until the project can reach positive cash flow, or else you have coordination failure. The present and the future cannot coordinate to determine a fair price for the investment being considered today, so no one will be the first to act.
But in a bubble, everyone stops worrying about that. Fear of losing capital becomes superseded by a different kind of fear: FOMO. Bubbles give everybody involved a credible reason to believe that follow-on financing will continue be available, and at more and more attractive rates to boot. Which means, if you’re an investor, hey, we’ve gotta get started now! Hurry, before the price goes up! And if you’re an entrepreneur, Hey, we’ve gotta get started now, before the competition does! That’s what we need to break the coordination failure. Under bubble conditions, we willingly and enthusiastically embark on speculative projects that have no line of sight to positive free cash flow and must continue raising more and more money. But sometimes, that’s what it takes to fund these types of big, risky projects. The 19th century railroad barons, early 20th century electric utilities, and end of the 20th century telecom providers that lived to tell the tale will back you up on that. Or just ask Bill Janeway, our own Venture Capitalist slash Cambridge economics professor:
Now let’s jump back to the startup world today. One of the important things that we take for granted in 2017 is the idea of follow-on financing always being available. We don’t usually raise a seed round while worrying, “But what if there are NO more series As in the future?” We don’t worry about coordination failure all that much; we simply trust as founders and seed investors that the Series A market will be there, and then that the Series B market will be there, and so on. As a result, we can confidently raise seed money for projects that we know cannot reach positive cash flow on that investment alone.
But let me ask you this question to ponder over the week: is investing into a seed-stage company that cannot get to positive cash flow on that investment alone all that different from giving out a loan to someone who you know will have to borrow more money just to pay you back your interest, let alone your principal? And didn’t we say last time that that latter scenario was the hallmark of a massive bubble? What is the difference between those two statements? Does it have something special to do with software, that’s different from every other industry we’ve ever known? We’ll try to answer that question next week.
Update: you can find the following week’s post here.
Elsewhere in the world:
Cheaper vehicles of all types:
Other reading from around the Internet:
And finally, a Monday-specific short story:
Big news out of Social Capital headquarters this week, as we’re delighted to welcome our newest partner, Mike Ghaffary!
Mike brings a whole lot of experience and perspective to the table, with an extensive string of successful past roles including co-founder of Stitcher, CEO of Yelp Eat24, and angel investor into companies including Strava, Optimizely, and Pocket. He’ll be joining the venture team, primarily focusing on Series A stage deals in consumer, productivity applications, and more. For today’s Snippets Bonus, Mike gave us some secret tips to share with Snippets readers so you can know the inside track on how he really feels about important topics such as:
- His number one ice cream: (cookies and cream, but under duress will admit an even stronger preference for Humphrey Slocombe’s Secret Breakfast, paired with Anthony’s Cookies),
- His entrepreneurial exploits in college (creating the most expensive App allowed on the App Store, selling for a cool $999.99),
- His other assorted skills (which include Street Fighter 2 and listening to Audible books at 3x speed),
- And his pick for best film of the last 20 years (Being John Malkovich)
On a more serious note, another thing that Mike really cares about — and you should too — is his involvement with Year Up. If you’ve never heard of Year Up, they’re an organization working in cities across the country addressing the Opportunity Divide: the hard-to-find paths available to the 6 million young adults in America who are out of work, out of school and struggling to make it back into the mainstream economy. Year-Up offers a one year intensive training program — half training and education, half internship — that guides students’ personal and professional development on their path towards economic self-sufficiency. IT, security, finance, and management roles are all in the cards, quickly: Mike knows first hand, both as a former Year Up board member and as a program partner at Yelp. Since its founding in 2000, Year Up as helped over 15,000 young people become employed at companies such as Facebook, Yelp, LinkedIn and Salesforce.com as well as enrolled back in school, thanks to a lot of hard work by its students, members, and everyone in the community who shares their values. So if you’re ever looking to make small talk with Mike, or you simply just want to find out more about how you can help, check them out and see what kind of a difference you can make. It’s probably a lot.
Have a great week,
Alex & the team from Social Capital