Investing In Bubbles, Pt. II

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Two years ago I read a great book describing the creation of the computer. The period between 1930 and 1960 was one of war, paranoia, and frenzied product development. At all costs, the government would spend on the necessary resources to win. It reminded me of Bill Janeway’s description of bubbles, which I want to spend a few minutes on again this morning. 

By my understanding of Janeway’s framework in “Doing Capitalism in the Innovation Economy”, downstream price insensitivity happens when speculators fall in love with a category, from tulips to gold to beanie babies. I’ll excerpt my past post* to save a click:

In his mind, a bubble is a period of significant price insensitivity around a certain type of problem, either ‘downstream’ or ‘upstream’. The upstream direction is a case like the creation of the computer, or the internet: a government is enmeshed in geopolitics that lead policymakers and politicians to believe that at all costs a certain problem must be fixed. War tends to be a good example of that. The United States had to build a better bomb. And if that meant creating a new way of crunching numbers quickly, then they would spend and deploy as many resources as necessary to ensure that outcome. The downstream direction, on the other hand, is when speculators fall in love with a space: like tulips in the Netherlands, gold at plenty of moments in time, or dot-coms in the late nineties. In these cases, private investors, with increasing (and often alarming) indifference to price, drive the value of any individual object in the ecosystem through the roof temporarily.

In a brilliant application of design-thinking, he concludes that there are opportunities for fantastic creation in these moments, as innovation happens through trial, and error, and error, and error, and error. Errors are expensive; somebody needs to underwrite them. 

I’ve been thinking about this a lot lately, as have we all. But I want to make note of something important. Many readers know this, but not all: a lot of the on-demand economy companies that are growing the fastest — the startup household names in grocery, logistics, delivery, and transportation — lose money not just on a monthly or annual basis, like a software company. A number of these companies lose money *on every transaction*. That is, they are selling a service or a product today at an economically irrational price. The faster and the bigger they grow, the more money they *lose*, not make. While I recognize that no-revenue high growth startups have a similar challenge, I find it particularly pernicious in a space where the gross margins are negative, because the revenue suggests cashflow – it’s like having a lemonade stand where you *pay* .5¢ per glass on a hot summer day, and then when your stand takes off, you are hailed for it. Let that sink in for a moment.

There are a few conclusions worth drawing from this. 

On the one hand, if the market turns, even in the slightest, and the later stage venture financing starts to require positive gross margins (not contributing margins, or even EBITDA), the question of how to reward, retain, and protect the supply side of these marketplaces, the worker classes who act as couriers, drivers, and deliverers will become painful.

On the other hand, consumer demand can be a *very* powerful driver. And even for Uber, the biggest company in this category, growth is still utterly astounding. Most people in the world still haven’t heard of it. And the magic of getting a cab delivered to you, pushing a button to have someone take your junk, or clean your apartment, or deliver you a hot meal, may be sufficiently magical as to actually change conventional wisdom at scale. And once conventional wisdom turns, then there’s no stopping those services that can continue to execute. The consumer may be willing to keep going, while the unit economics stabilize, because our behavior will be locked in. This is quite possible. It’s still incredibly early days on the demand side.

Both of these things can, and likely will, happen simultaneously. Just like it took the dot-com bubble to create Google and Amazon, perhaps it will take a massive wave of dramatic price-insensitive negative gross margin growth to create the mobile central nervous system of the future. But many shirts will indeed be lost along the way.

*Investing In Bubbles, Pt. I

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