Dr. StrangeValley
Or how teachers, nurses, and union workers subsidize the R&D departments of tech monopolies.
During my 7 years in The Bay Area - I’ve cultivated a disillusionment so bitter that I was barely able to stomach HBO’s Silicon Valley. It turns out that tears of laughter and sadness both taste salty.
So, I think it’d be disingenuous to not disclose how many bones I have to pick with the romanticization of tech and everything surrounding it. However, there are plenty of journalists (and Netflix docs) exploring how technocrats are the opposite of the saviours they may believe themselves to be, and I don’t feel a need to pile on.
I want to write about something more fundamental and systemic:
How does Silicon Valley get all its money to fund start-ups? And where does the money go?
Most people have this impression:
“Don’t really rich people make big bets in technology, and even though most fail, the winners make up for it all?”
Despite all the critique launched against Silicon Valley, I’ve never really read anything that challenged this basic assumption. We challenge how only rich people are able to make these big bets, we abhor how many of these bets are for ridiculous ideas, and we are nauseated by how much money the winners end up aggregating (and the labor market disruptions that lie in their wake). But, the overall framing is left untouched, and this is where I want to prod.
Myth #1: Venture capitalists invest their own substantial wealth in start-ups.
Although each partner at a VC firm will put in some of their own money, that personal money often only makes up 1%-5% of the total fund. The other 95% comes from limited partners (LPs) (“limited” because they put in money, but do not make strategic or management decisions).
Unfortunately, I wasn’t able to find consistent data for this, but by (unscientifically) mixing a few data points and some insider anecdotal information, I’d say that about 30-40% of VC money comes from 1) pension funds, 2) insurance companies, and 3) banks - with pension funds being the largest one. In all three of these cases, the general public essentially entrusts money to these institutions with the expectation of potentially withdrawing it in the future. For example, you pay into a pension every month, and withdraw it when you retire; you pay into your premiums every month, and withdraw it when you make a claim; or you deposit money into your savings account at a bank, and withdraw it when you need it in the future. Because these institutions know that they’re holding onto your cash for a fixed period of time, they invest it while they wait.
Additionally, sovereign wealth funds (funds run by governments, namely Norway, China, and the UAE) - if we consider them to be money entitled to the public - make up another 10%-15% of VC money.
In short, almost 50% of money that eventually funds start-ups are indirectly invested on behalf of the average citizen.
Although only about 1-3% of US and Canadian pension funds are allocated to VC, their sheer size means that there’s a lot of money to play with. For example, the Ontario Teacher’s Pension Plan has $221 billion invested in a portfolio, and pension funds in OECD countries total $34.2 trillion invested. To put that into perspective, the entire GDP of the US in 2019 was $21 trillion.
Of the ~$120 billion invested through venture capital each year in the U.S., I’d posit that up to $55 billion came from average citizens.
All this is to say, that every time you see an ad or article about a start-up and you think to yourself “Why do rich people invest in such asinine ideas?”, or “All these rich start-ups are ruining our communities, our critical thinking skills, and our labor markets”, or “I can’t believe start-ups get to blow all their money on giant salaries for twenty-something tech-bros”, I want you to remember that a giant chunk of that money comes from average citizens via pension funds, insurance plans, and money saved with the bank.
Myth #2: Start-ups burn money.
Now that a bunch of pension money has arrived to a start-up, here’s how they’re going to spend it:
60% salaries (much of which funnels directly into Silicon Valley via taxes, housing, living costs, etc)
20% advertising (mostly via Facebook and Google)
10% cloud computing and SAAS tools (mostly via Amazon Web Services and Microsoft Azure)
10% everything else
(This is also extrapolated from a messy set of articles, interviews with start-up teams, and start-ups I’ve advised or worked for.)
Almost 30% of money invested in start-ups goes straight to paying Facebook, Google, Amazon, and Microsoft for their services.
Of the $120 billion that got invested in startups this year, we can posit that up to $36 billion went towards paying Facebook and Google for ads, and Amazon and Microsoft for cloud services.
Looking from the perspective of the start-up, you might describe the money being “burned”. But, if you zoom out and look at Silicon Valley as a system, all that money stays in the system. Startups didn’t ‘burn’ their money, they moved it into the bank accounts of tech monopolies; they moved it into the Bay Area housing market; and they moved it into the thousands of Teslas autonomously driving up and down Hwy 101.
The money didn’t disappear. In fact, a bunch of it circled back all the way around.
Myth #3: The most promising start-ups make it big and generate a lot of value.
There are generally only two ways to ‘win/exit’ with a start-up: a) IPO or b) get acquired by a large company. In 2019, of all the start-ups that had a successful exit, 90% were via acquisition rather than IPOs.
Unsurprisingly, Facebook, Google, Amazon, and Microsoft get their pick of the most promising startups. Here’s a list of all of them:
You’ll notice that the vast majority of acquisitions are private, and it’s unclear how much each exit cost, but let’s use Google’s acquisition of FitBit for $2 billion to illustrate my point.
On first glance, you might think, “Wow, Google was willing to pay $2 billion for FitBit, they must think that technology is really powerful to be willing to spend that much on it.” But, with what we’ve explored so far, we can now put this $2 billion into perspective:
Fitbit raised about $800 million in venture capital and their IPO, how much of that $800 million was spent on Google ads?
How much money was raised for all start-ups in the wearables space? How much of that money was spent on buying Google ads? Especially by the hundreds of failed startups in the wearables space?
Although Google spent $2 billion on FitBit, it had be reaping hundreds of millions from hundreds of start-ups trying to innovate in that space for years. Once FitBit was the clear winner, Google was then able to swoop in to buy (and benefit from) the winner.
Furthermore, the now Google-owned FitBit no longer has to pay for Google Ads, for Google Cloud computing, and other services. They benefit from the established mindshare and market share that Google has, as well as their resources at scale.
Prior to the Google acquisition, Fitbit was on track to lose $132M a year.
Fitbit-the-start-up was not a wealth generator but an R&D project, and only after being acquired did it stand a chance at generating real profit. But now it’ll do so for Google.
Start-ups are outsourced R&D projects paid for by nurses, teachers, and union workers.
And this cycle is found throughout the entire Silicon Valley ecosystem. Publicly-funded limited partners finance the innovation of an entire industry, and monopolies sit on the sidelines and wait for the winners. While they’re waiting, they collect service fees from every company (winning or losing), and when a winner finally emerges, they offer what seems to be a premium price, but - in reality - is much cheaper than if they attempted to innovate themselves.
Silicon Valley monopolies get the majority of the gains, while the public takes the majority of the risk.
Many would argue that this is the system working: if pension funds didn’t get a competitive risk-adjusted return from investing in venture capital, they wouldn’t be a limited partner; if venture capitalists didn’t get returns from ridiculous tech start-ups, they wouldn’t invest in them; and if tech monopolies didn’t see real value in the starts-up they buy, they wouldn’t be making acquisitions. Besides, doesn’t the pension fund also invest heavily in these monopolies? Everyone is winning, so what’s the problem?
The problem is that we believe in the heroic myth of meritocracy.
A core premise of American meritocracy is the idea that the more risk you take, the more reward you earn. However, the actual engine of capitalism (hint, it’s in the name) is that the more capital you have, the more capital you earn. Risk has nothing to do with it.
In the case of Silicon Valley:
Public workers take on the majority of the financial risk, even though they are the major capital investor. They can actually lose money if their pension funds pick failing startups.
Tech monopolies take zero risk. They just sit on the sidelines taxing the entire industry and then make an acquisition when there’s a clear winner.
Is this all entirely legal? Yes. Is this how a free-market is supposed to work? Yes. Is the literal definition of capitalism the ability to generate more capital from the simple ownership of capital? Yes.
[insert movie music and remove editorial discipline here]
My gripe isn’t with capitalism, but the supergluing of meritocracy with capitalism. Meritocracy has a moral proposition: that those who take risk ought to see reward, that those who are smart or capable ought to hold power and resources. By masking capitalism with the halloween costume of meritocracy, we turn capitalism into a moral proposition. Underneath the costume, the true thesis of capitalism is, simply, “those who have more money make more money”. It’s a feedback loop driven by the scared irrational part of our traumatized brains that says: “no matter how much you have, you will never be safe.”
The heroic myths of Silicon Valley, of high risk VCs making bets in the casino of innovation, reaping the rewards of their courage, is just another propaganda piece.
I just want us to admit it.