Why Venture Capital Doesn’t Scale Part 1: Gone Hunting for Unicorns, They Found Moby Dick

Venture capital doesn’t scale, and I want to talk about why. Lately, it seems that startups in any sector — not just cleantech — are looking for massive funding and a provider’s promise not to interfere. The reality is much different from what you see on Shark Tank. Young organizations aren’t looking for $100,000 for a 10% stake. They’re looking for many millions.

And from the venture capitalist’s point of view, many millions and the right deal with the next Facebook or Google could generate mind-blowing returns. And it’s all the better if we don’t need to interfere.

Just imagine it! If a million dollars in 2020 will become fifty million by 2025, then twenty million dollars could become — say it in Dr. Evil’s voice with me — one billion dollars!

How lovely it would be to see that kind of money with minimal effort on your part. It would be easy, aside from the formal board meetings and phone calls or too much egg nog at the occasional holiday party. That’s why today’s eager market has cultivated a sense among VCs that we must always go bigger, invest more, take the big risks because every once in a while, the payoffs will be worth it. Sometimes it feels like playing roulette in Vegas.

And frankly, that’s always how the game has always been played. But venture capital doesn’t scale.

Unicorns Exist

Those huge returns don’t only exist in the realms of energy or tech, by the way. Consider Tractor Supply, a farm and DIY supply store that’s been supplying America’s heartland with baling wire, buckets, and work boots since the 1930s.

• In the last two decades, Tractor Supply has grown its net sales more than tenfold, from $759 million in 2000 to $7.9 billion in 2018.
• According to Business Insider, it also boosted its net income from $16 million to about $532 million over the same period.
• TSC is one of the best-performing stocks of the century — performing twice as well as Apple, for instance. 

And that explains why venture capitalists give one questionable startup after another massive cash injections (not that Tractor Supply was questionable), even when venture capital doesn’t scale. They’re chasing unicorns. And the thing about unicorns is that they do exist. They’re just hard as heck to catch. And sometimes, investors discover a whale of a problem instead.

They Might Find Moby Dick

“As for me, I am tormented with an everlasting itch for things remote. I love to sail forbidden seas and land on barbarous coasts.”

― Herman Melville, Moby-Dick or, the Whale

The New Yorker published a fascinating story by Charles Duhigg in November 2020 titled How Venture Capitalists Are Deforming Capitalism. It’s worth the read. 

Duhigg’s tale is mostly about the enormous sums of money VCs are throwing at dubious companies, and it uses as an example the extreme personality exploits of Adam Neumann, former CEO of WeWork. Duhigg describes how a handsome, charismatic young Israeli-American from New York Pied-Pipered his way (not a word, but it should be) into the hearts of hopeful venture capitalists.

Why WeWork Worked — At First

Sharply dressed and oozing charisma, he bounced around the nation from one major metropolitan to the next. He purchased commercial real estate and opened WeWork co-working office spaces with leasing rates well below the local average. To drown the competition, he goes farther than lower rent. He also offered lease buyouts or three months of free rent to move in. 

At a glance, it’s the PERFECT example of a traditional monopoly. We see the big corporation swiping the feet out from under local small businesses because it has enough cash on hand to do so. That’s how the game is played. A big player takes a big loss to damage the competition and inches up their product pricing later.

It’s called price-fixing, and it’s practically tradition. Andrew Carnegie did it with steel, Rockefeller did it with oil. Microsoft did it for a time with IT. Walmart seems to have done it in the big box retail market. Saudi Arabia and Russian oil providers attempted it in 2019 to cripple US oil production. The threat to consumers is an eventuality of a high price for an inferior product. 

Over time, however, many monopolies will flounder. It’s the nature of business and the product life cycle — especially today with global trade and lightning-fast communication. Someday there will be a better mousetrap, and then 300 knockoffs will spawn from it. 

What Happened to WeWork, and Why Is It an Example of How Venture Capital Doesn’t Scale?

WeWork co-working spaces were cropping up like Starbucks in 2010, and Neumann was picking up investors all the time. Everyone keeps throwing huge amounts of money at a business that’s secretly hemorrhaging cash — and at one point losing millions of dollars by the hour. VCs want to be on the big train with the charismatic engineer. It doesn’t matter where they’re going. 

WeWork lost (let’s say it in Dr. Evil’s voice) two billion dollars in 2018. 

Then, in August 2019, WeWork publicly filed its IPO paperwork. The sparkling pied-pipering unicorn becomes a giant nemesis — a white whale.

• Within the next weeks, WeWork came under intense scrutiny from the media and investors.
• There were concerns about WeWork’s path to profitability and Neumann’s behavior.
• Ultimately, WeWork delayed its IPO.

Then, attention shifted to Neumann’s inappropriate antics, and he stepped down from his role as CEO on September 24. SoftBank, WeWork’s biggest investor, took control of the company on October 22. Per Business Insider, SoftBank gave Neumann $1.7 billion to step down from his position as chairman of the board. Then, a month later, WeWork laid off 2,400 employees. Investors cringed, and a few probably cried themselves to sleep that night. Because venture capital doesn’t scale.

It reminds me of a wholly contrasting essay, published in the New York Times in 1970, when economist Milton Friedman argued that a business’s sole purpose is to generate profits for its shareholders. If you’ve been reading my blogs for a while, you might remember I’ve mentioned this before.

Let’s take a closer look. 

A Corporation’s Sole Purpose Is to Make Money 

We live in interesting times. Many investors and American consumers want to do business with a corporation they feel is socially responsible. In our daily lives, we try to buy products that we perceive to be environmentally friendly. Pre-pandemic, we were focused on buying fuel-sipping vehicles, recycling what we could, and keeping plastic straws and grocery bags from reaching the ocean. 

And that’s all well and good. We should be very aware of our environment and treat this earth like a treasured and irreplaceable home. We should be treating ourselves — our bodies — with that same respect.

However, historically, corporations haven’t been in the business of making the earth a better place. They exist to make money for their shareholders, and a good paycheck for their employees is a sometimes pleasant side effect. The concept of green business and carbon footprints is relatively new, and much of it is marketing hype. American consumers have the best intentions, and corporations take advantage of that. 

Are “Green” and “Healthy” Corporations Telling the Truth?

Look at Panera Bread, for instance. Per their website, Panera began in 1980 as a single cookie store in Boston and is now a leading restaurant brand with more than 2,300 locations in the US and Canada, 140,000 associates, and annual sales in the billions. (Did you do the Dr. Evil voice by reflex?)

In recent years, Panera has touted the image of clean, healthy whole foods because that’s what consumers want. Now privately held by JAB Company, Panera doesn’t care if you’re unhealthy, overweight, or pre-diabetic. Many granola-eating, mountain-hiking, Prius-driving customers would be surprised to learn that every soup you can order at each of the 2,300 locations in North America arrives pre-made and frozen, in a huge plastic bag. 

Healthy, warm, green Panera tosses thousands of plastic bags every day. Other restaurants do it too. All the time. Tossing plastic bags the thousands. (Plastics that, I might add, depend on petroleum to manufacture, but I digress.) We expect that sort of behavior from McDonald’s and Taco Bell. After all, that’s where you eat if you don’t care about yourself and the environment, right? But the idea that Panera Bread uses and tosses the same plastics had many customers gasping and clutching their pearls in 2019. 

So you see, it’s all hype. And the business is doing what it’s supposed to do: make money.

‘Don’t Be Evil’ Fell by the Wayside 

I’m not here to bash Panera. The food is decent especially the everything bagel. But any time a company starts pitching themselves as healthy, green, or even mildly concerned, it’s time to take a close look at their operations. Sometimes they’re above-board, but sometimes they’re not.

At least a few of the monopolizing corporations have the decency to be honest about their doings. I’m reminded of Google’s historic IPO in 2004. Google went public at $85 a share, a ridiculous price for the day, with a slogan of “Don’t Be Evil.” They rescinded that motto in 2018. So I guess they’re down with evil now. 

Ultimately, WeWork made some huge mistakes. Investors can indeed prop up a mediocre company until the competition fails. But as a venture capitalist, my goal is to find both the real unicorns and the sturdy draft horses (plain, but earning), and above all, avoid those Pied-Pipering white whales where venture capital doesn’t scale and investments fall flat. In a future post, I’ll talk more about how VCs artificially prop up companies.