WHAT IS SILICON VALLEY’S ROLE IN THE ECONOMY GONE awry? It is easy to blame the ability of technology to replace human labor for declining wages and increased wealth inequality. But technology is being used for cost reduction rather than to empower people and to reach for the stars not because that is what technology wants, but because it is what the legal and financial system we have built demands.
For all its talk of disruption, Silicon Valley too is often in thrall to that system. The ultimate fitness function for too many entrepreneurs is not the change they want to make in the world, but “the exit,” the sale or IPO that will make them and the venture capitalists who funded them a giant pile of money. It’s easy to point fingers at “Wall Street” without realizing our own complicity in the problem or in finding a way to bring it under control.
I had always made the unquestioned assumption that financial markets were simply one face of the overall market economy. It was Bill Janeway who first brought the distinction between financial markets and the real market of goods and services to my attention. In his book Doing Capitalism in the Innovation Economy, he wrote: “I have come to read [the history of the innovation economy] as driven by three sets of continuous, reciprocal, interdependent games played between the state, the market economy, and financial capitalism.”
What did Bill mean by calling financial capital out as a separate player equivalent in stature to government and the market economy? The more I thought about it, the more sense it made of my own experience. In my business, a private company started in 1983 with $500 in used furniture and office equipment as its starting capital, though now approaching $200 million in annual revenues, I’ve always lived in the real economy of goods and services. Originally a technical writing consulting company, we got paid when we found customers willing to hire us to write their manuals, and spent many an unpaid hour looking for new customers. Once we became a book publisher, we embodied our expertise into products, and sold them to customers who wanted to learn what we knew. We grew the business by developing more products, finding more customers, and hiring more people. Once we added conferences, we had to find people willing to pay us to attend or sponsor them. Debt, when we were able to use it, was generally secured by receivables and inventory, tying our growth directly to the underlying fundamentals of finding and serving new paying customers. Having to find people who will pay you for what you create clears out an awful lot of wishful thinking.
Over the years, it became clear to me that many of the companies in the technology industry we are part of were playing by very different rules. They were not getting paid by exchanging goods and services with customers, but by persuading investors to give them money. Perhaps customers would come along eventually, but as long as the company could find investors to finance their next round, perhaps all the way to an IPO or acquisition, a company could just have “users” instead of customers.
Early in my career, venture capitalists still funded entrepreneurs in the hope that they would build companies with real revenues and profits, but in the years leading up to the dot-com bust, it seemed that the game had changed. Entrepreneurs were not creating true companies but a kind of specialized financial instrument, a financial bet not that dissimilar to the CDOs that bedeviled the banking industry in the years leading up to the 2008 financial crisis a decade later. I see much of the same misdirection of entrepreneurial energy in today’s overheated Silicon Valley boom.
These companies, often sold for billions of dollars, are valued not based on some multiple of their sales, profits, or cash flows, but for expectations of what they might become, promoted like fake news in a market of attention. This effect is central to understanding the hypnotic allure of financialization.
I got my first taste of the multiplicative possibilities of the betting marketplace of expectations when we sold GNN to AOL in 1995 for $15 million, and then watched the stock portion of the purchase price balloon to $50 million as AOL’s value continued to increase. (Our stock would have been worth over $1 billion if we’d held it to AOL’s peak.) We’d built GNN by reinvesting the profits from our publishing business, exploring an exciting new medium that we thought we’d eventually turn into a real business. When we sold GNN, we received more than we could have earned in a decade selling our books at the rate we were selling them in 1995.
GNN was one of a series of purchases, along with Dave Wetherell’s BookLink and Brewster Kahle’s WAIS, that AOL bought for a collective amount of about $100 million in stock. The purchases signaled to the market that AOL was becoming an Internet company. I watched in awe as AOL’s market capitalization rose by first a billion dollars, and eventually many, many billions.
AOL didn’t actually succeed in transforming itself from the dominant company of the dial-up networking era into the leader of the commercial Internet, but the expectation that it would be able to do so made it possible for it to buy Time Warner, a company many times its size in the real market of goods and services. The AOL Time Warner merger was a colossal disaster, and the value of the combined company was eventually written down from a peak of $226 billion to less than $20 billion. It is not inconceivable that the same could happen to a company like Uber, whose purchase of self-driving truck startup Otto was as much a signal to investors as it was an investment in the actual development of self-driving trucks and cars.
The ratio between a company’s revenues, cash flow, or profits and its market capitalization is one of many imaginary numbers that make up the world of financial capital. In theory, the intrinsic value of owning a stock is based on the net present value of its expected future profits. In practice, it is that net present value times the expectations of millions of potential buyers and sellers.
The price of a stock is fundamentally a bet. Will the company’s earnings from the real market of goods and services be greater in the future? If so, it is worthwhile to own a share of that company.
When a company fails to deliver value that lives up to that bet, but still cashes in through IPO or acquisition, the wealth that is gained by startup founders and early investors is taken from public market investors. This is a risk that both sides of the bet willingly take, and it has provided enormous fuel for innovation because it encourages innovators to take risks in hope of future rewards. But in overexcited markets, it’s too easy for many startups to aim to cash out with “dumb money” while the getting is good, with no real plan for ever delivering real revenues or profits.
The enormous leverage provided by the marketplace of expectations is the key to all that is good about Silicon Valley, but also all that is bad. On the good side, this leveraged financial adventurism allows for huge waves of Schumpeterian “creative destruction.” A company like Amazon, Tesla, or Uber is effectively able to capitalize future hopes and dreams into current cash value and use it to finance a world-changing business despite losing money for years. This is a good thing. It’s what capital markets are for: to provide the money that lets entrepreneurs large and small take risks. To the extent that a company grows into its expectations, it will eventually be valued at a ratio closer to the true net present value of its future earnings. On the bad side, many a company that is highly valued today may never deliver on those expectations.
Economist Carlota Perez makes the case that every technological revolution has been accompanied by a financial bubble, which funds investments in futures that have not yet come into being, investments that can be tolerated only because for every hundred failures there is a breakthrough so large that it pays off all the failed bets. “Occasionally, decisively,” Bill Janeway notes, “the object of speculation is the financial representation of one of those fundamental technological innovations—canals, railroads, electrification, automobiles, airplanes, computers, the Internet—deployment of which at scale transforms the market economy.”
That is true, but this system also disproportionately rewards luck, and even the destruction of real economic value. Bill Janeway said to me, “The process is inherently wasteful, what I call Schumpeterian waste. Progress through trial and error and error and error. So of course luck comes into the game.” In short, there is many an Internet multimillionaire and even some billionaires who were just on the lucky end of a failed acquisition.
But that’s not the end of it. What if I told you that there was a magical way to take a dollar of company profit and turn it into a currency worth, on average, $26? What if I could take a dollar of company profit and turn it into a currency worth hundreds of dollars? Thousands? That’s exactly what public company stock (or private company stock on the path to a plausible IPO or sale to a company that has already gone public) represents.
The price-earnings ratio of a stock is the difference between the actual net present value of a company’s future profits and its market price. Amazon’s P/E ratio is 188 at the time I’m writing. Facebook’s is 64, Google’s 29.5. The ratio for the entire S&P 500 is about 26. That is, for every dollar of profit it makes today, Amazon gets $188 in stock value, Facebook gets $64, and Google gets $29.50. For a company like Uber, which has no profits yet but is valued at $68 billion by investors, the ratio is essentially infinite.
That leverage makes stock an incredibly powerful currency, which swamps the purchasing power of the ordinary currency used in the market of real goods and services. Amazon’s profits in 2016 were just shy of $2.4 billion, and its book value (the actual value of its cash, inventories, and other assets less its liabilities) $17.8 billion, yet its market capitalization at the end of the year was $356 billion.
George Goodman, a financial writer who published under the pseudonym Adam Smith, calls this “supermoney.” (In his preface to the Wiley Investment Classics edition, Warren Buffett compared Goodman’s 1972 book of that name to a perfect game in baseball.) Supermoney is at the heart of today’s growing financial inequality. Most people exchange their goods and services for ordinary money; a lucky few get paid in supermoney.
A company that has been financialized—that is, is valued in supermoney—has a huge advantage over companies that are operating solely in the market of real goods and services.
If you have a company valued in supermoney, you can more easily buy other companies. At O’Reilly Media, we have made acquisitions from time to time, but as a privately owned business operating in the real market of goods and services, we’ve always had to value them based on a realistic multiple of their expected cash flows, paying for them out of our own retained earnings or debt financing against our cash flows. In one case, the net present value of a prospective acquisition based on its current sales and growth rate was about $13 million; a rival bidder snapped up the company for $40 million. Why could they do this? As a “hot” venture-financed IPO-track company, their own stock was valued at 5x or more what a comparable private company would be valued. Paying only a 3x premium to add to their growth was a reasonable bet. But don’t mistake it: It was still a bet on financial market expectations, rather than a bet on the real operating cash flows and profits of the business.
If all you have to pay employees with are actual earnings from your business, you are limited in how rich you can make them. If you can pay them in supermoney—especially in the super-supermoney represented by stock options (the right to buy a stock at today’s price but with no obligation to do so until it has appreciated in value), even more so if it is in supermoney cubed (pre-IPO stock options at 90% discounts from what even the venture capitalists are paying) you can hire the best talent.
If you have access to supermoney, you can operate for years at a loss. This is one reason—not just the superior customer benefits and economic efficiencies of their technology or business model—that Internet companies can disrupt older, less highly valued companies.
Yes, Uber’s service is superior in terms of availability, convenience, and customer experience to traditional taxi and limousine service, but could it so easily have overpowered the incumbents without access to billions of dollars in investment capital, which allowed it to subsidize lower prices for consumers and pay incentives to drivers? Arguably, funding that kind of innovation is what capital markets are for, but it’s also possible that that capital can be used to destroy existing businesses without building something sustainable to take their place.
As we saw in Chapter 11, stock options, which have played such a large role in Silicon Valley wealth, have also become a key part of the problem of income inequality. Even though Silicon Valley companies are actually better than many other companies at distributing the gains because they offer options to virtually every employee, those options are still overwhelmingly weighted toward founders and top management, with each lower rank of workers typically receiving a full order of magnitude less in value.
This may or may not be appropriate, based on actual contribution to the business, but the net-net is that a huge proportion of the productivity gains we’ve seen in the past decades have increasingly gone to a small group of managers rather than to all workers. And when the market gets excited, those people get paid in a currency that appreciates at a rate far in excess of anything possible in the real economy.
The amount of supermoney created out of thin air simply by issuing new options to employees is staggering. In 2015, for instance, Google’s stock-based compensation was $5.2 billion. The ability to print supermoney is proportional to your size, further accelerating the winner-takes-all economy. For a company the size of Google, whose market capitalization at the end of that year was more than $500 billion, that $5.2 billion in stock compensation represented only a 1% dilution of existing shareholders. For a smaller company, like Salesforce, with a market capitalization closer to $50 billion, 1% would only be $500 million—so Salesforce can afford only a tenth as much to hire engineers even though it has a third as many employees as Google. As a result, one analyst said to me that Salesforce would eventually have to be sold to a bigger company. This same analyst believed that this was ultimately the reason that LinkedIn was sold to Microsoft. They just weren’t big enough to be competitive as a stand-alone company in today’s market, he said. (This idea is suggestively compatible with new research by economists David Autor, David Dorn, Lawrence Katz, Christina Patterson, and John Van Reenen that suggests that the problem of income inequality is driven in part by the rise of superstar firms, whose outsize productivity makes them able to command a larger share of the market while employing a smaller number of more highly paid people.)
Another effect of stock-based compensation is that it requires companies to keep growing, encouraging them to aim for complete market dominance and value capture. As long as employees are paid in stock, even founders with voting control over their companies still face pressure from “the market” to keep their earnings rising and their stock price increasing.
The amount of money spent on stock-based compensation has for too long not been properly reported by many technology companies. Amazon and Facebook only began reporting their stock-based compensation as part of their regular financials using Generally Accepted Accounting Principles (GAAP) rather than via special “non-GAAP” reporting in their quarterly reports in the first quarter of 2016. Twitter, less profitable than the others, still doesn’t do so because it would show that far from having a profit, it is actually still operating at a loss when stock-based compensation is taken into account.
Even in the best case, when over time a company grows into its valuation and its shareholders earn their wealth in the real economy, there are damaging effects from having two currencies, one of them hiding in plain sight, that are valued so differently. If you are paid in ordinary money, you may still be able to buy a home, but perhaps you have to move to a less attractive location to do so. If you are paid in supermoney, you can afford to pay higher rents, or spend more to buy your home, driving up prices and even further increasing the distance from those working in the ordinary marketplace of goods and services. Not only that, if you are paid in supermoney, you can convert some of it into ordinary money and become an investor—placing bets in other new companies, in the broader stock market, in real estate—multiplying your wealth still further.
The impact on real estate is crushing for those who make their living in the real economy. In the absence of aggressive building of new housing, those paid in supermoney drive up housing prices to the point where ordinary people can no longer afford to live in a city like San Francisco. Meanwhile, government policies designed for an era when home ownership was a pathway into the middle class now exacerbate the problem. The tax deductibility of mortgage interest, allowed even on second homes, drives prices up even further, giving rich housing subsidies to those with the means to buy them and making homes even more expensive. A limit on the amount of mortgage interest deductibility would be corrective, but is blocked by the wealthy interests who benefit from it.
The negative impact on the real economy doesn’t end there. Investors focus on companies that will have huge “exits”—that will return at least 10x their investment. This quest for outsize winners has the perverse effect of starving ordinary businesses of capital. A company that may deliver real value but grows slowly and may never achieve global scale is simply uninteresting to investors.
Meanwhile, venture investors have come to have much the same risk profile as investment bankers, where gains are private but losses are socialized. Venture capitalists typically get paid a percentage of the fund as an annual management fee—usually 2%—so a VC firm with a billion-dollar fund will have taken out $200 million in proceeds over the ten-year life of the fund even if the firm loses money for its limited partners (the investors who put up the vast majority of its capital). Put another way, the $58.8 billion in venture capital investment in 2015 paid out nearly $1.2 billion to venture capitalists that year whether or not their investments ever succeed. This encourages VCs to raise larger funds and to deploy ever-larger amounts of capital even though evidence shows that smaller funds typically deliver better results.
Because supermoney is so powerful, for many entrepreneurs and venture capitalists valuation is also something to be gamed, in the same way as a website might try to game its search rankings or its social media engagement. Values are ratcheted up in a series of financings—ideally a rising value is based on actual progress, but sometimes existing investors will put in more money at a higher valuation as a way to signal confidence to additional later investors. As more money floods in, as happened during the dot-com bubble and arguably again in the current unicorn bubble, expectations become increasingly divorced from reality.
In the worst case, companies are formed not to serve real customers, but to be financed. Strategic “pivots” are made not to advance the actual business but to convince investors to place another bet even though the original business idea didn’t pan out.
Once companies take money from venture capitalists, they are committed to aiming for an exit. A typical venture fund is a partnership with a ten-year time horizon. Most of the investments are made within the first two to three years, with some money reserved for additional investment in the companies that are most promising. Once an entrepreneur takes money from a venture capitalist, he or she is promising to sell or go public within the lifetime of the fund. Yet VCs know that the vast majority of their deals will fail. Jon Oringer, the founder and CEO of Shutterstock, put it well in his advice to entrepreneurs: “What venture capital firms do is spread some number of millions of dollars to some number of companies. They’re not really rooting for every single one. All they need is for a few of them to succeed. It’s the way the model works. They have a totally different risk profile than you do. This is your only game in town. For the venture capital firm, it’s one of a hundred games in town.”
I’ve watched companies be wiped out by their venture capitalists’ timetable, forced to sell without realizing much value at all for the entrepreneur because it was time for the VC to liquidate its position. I’ve also watched companies struggle to please investors rather than their customers. A perfectly good business, one that might eventually deliver tens of millions of dollars of revenue and meaningful profits if run properly, is told instead to shoot for the moon, because as a company operating in the real market of goods and services it won’t command the stratospheric exit that it might be able to fetch if properly positioned in the marketplace of expectations.
The amount of money raised and the timing of when it is raised can also make a big difference. As discussed in Chapter 4, Sunil Paul’s patents for on-demand car sharing predate Uber by the better part of a decade, but he was ahead of his time. By the time he launched Sidecar in 2011, two years after Uber had launched its service for calling black limousines on demand, and about the same time as Lyft started offering rides from ordinary people in their own cars, he was third in line. Uber and Lyft had both already raised massive amounts of money, and Sunil was never able to raise enough money to catch up.
GROWING A BUSINESS WITHOUT VENTURE CAPITAL
When I founded O’Reilly Media, I wanted to build a company that would be around for the long haul, so I was firmly committed to staying private. In my early years as a consultant, I’d watched many a client go from being an exciting startup to a treadmill focused on quarterly results. I didn’t want that future. I wanted O’Reilly Media to be like ESRI, founded by Jack and Laura Dangermond in 1969, or SAS Institute, founded by Jim Goodnight and John Sall in 1976, both private technology companies still going strong after decades of innovation.
My friendship with master venture capitalist Bill Janeway began when he and his partners asked me about investing in my company when GNN was lighting up the commercial web in 1994. I remember our lunch at a noisy sidewalk cafe in San Francisco, in which Bill and his partner Henry Kressel grilled me about my aspirations for the business. At the end of the lunch, Bill told me, “We will never invest in your company, and you don’t want our money. We’re smart guys, and at the end of the day, our goal is to turn our money into a lot more money. That’s not what you’re about.” I loved his honesty and insight.
Despite what Bill told me in 1994, he was a venture capitalist of the old school, making money by identifying and solving real problems, deploying patient capital to build companies with real customers. His specialty was to identify and acquire deep technology assets that were lying fallow at large companies, then put that technology together with a team of remarkable entrepreneurs to build a business. BEA (later acquired by Oracle), Veritas (later merged with Symantec), and Nuance, now a public company, were three of his home runs. He believes deeply in building real businesses, using the same philosophy as Warren Buffett, the value-investing genius of public markets, that valuing a company based on positive cash flow is the secret to successful investing. His own mentor, Fred Adler, had a saying that Bill passed on to me: “Corporate happiness is positive cash flow.”
Over the years, I passed up many requests to sell O’Reilly Media or to take on outside investors, instead preferring to spin out and sell projects such as GNN (sold to AOL), Web Review (sold to Miller Freeman), LikeMinds (merged with Andromedia and then sold to Macromedia), reinvesting the proceeds in the core business. I knew that without outside investment I couldn’t scale these businesses, but I didn’t want to give up the control that I had as a private company.
But I could see that there was amazing power in the Silicon Valley investment model. I watched how Yahoo!, started almost two years later than GNN, became an Internet sensation after they took in venture capital, and used it to scale the business at the speed necessary to keep up with the growth of the market. Of course, execution matters as well as money, and Yahoo! executed brilliantly in becoming the web’s first media colossus, handily defeating AOL, to whom I’d sold GNN as an alternative to taking outside investment into O’Reilly as a whole.
In 2002, Mark Jacobsen, at the time our VP of business development, started an internal venture fund at O’Reilly Media, which had several notable successes, including Blogger (founded by former O’Reilly employee Evan Williams), which we sold to Google, and ActiveState, which we sold to Sophos.
In 2004, Mark proposed that we raise a proper venture fund with outside investors, which we called O’Reilly AlphaTech Ventures (OATV). Bryce Roberts joined Mark as an additional managing partner. While I like to think that we are entrepreneur-friendly, we too have had to play by the rules of the venture game, which ultimately prioritize shooting for a supermoney exit.
Is it possible for entrepreneurs to get the benefits of Silicon Valley investment without some of the downsides of the traditional venture capital model? Bryce Roberts, my partner at OATV, thinks so. In 2015, he proposed an unusual experiment to me and to Mark Jacobsen. What if, Bryce asked, we came up with a way to invest in entrepreneurs who weren’t shooting for the exits, who wanted to build a company with revenues, profits, and cash flow in the real economy? Bryce pointed out that there were many more of these companies than people realized. Not just SAS and ESRI but Craigslist, Basecamp, SmugMug, MailChimp, SurveyMonkey—and for that matter, O’Reilly Media—were all quietly making money. More recently, Bryce noted that “ambitious founders have been trained that billion dollar exits are reserved only for those who follow a very defined playbook for ‘blitzscaling’ a business.” Yet in the last six months of 2016 there were seven tech M&A transactions with a value of more than $1 billion. Of those, only four were venture backed. Three had no investment at all from VCs.
This is not new. Other companies that were eventually acquired or went public, like Atlassian, Braintree, Shutterstock, and Lynda.com, had started out the same way, first reaching profitability and scale, and only adding investors late in life as part of a path toward going public or being sold. Taking on late-stage investors is a common tactic for successful private companies eventually seeking liquidity. After all, founders don’t live forever, and estate taxes will likely force the sale of a company after the death of a majority owner.
But what about startups? Is there a way that we could provide value to firms that want to make their mark in the real economy without putting them on the treadmill to an exit? Bryce came up with a creative solution, which he called indie.vc.
Indie.vc is modeled on Y Combinator, the classic Silicon Valley accelerator, which takes a small but meaningful stake in very-early-stage companies in exchange for a very small amount of cash, plus a lot of help in business planning, networking with other entrepreneurs, and eventually, showcasing the company to VCs. Y Combinator has been phenomenally successful, helping to birth companies such as Airbnb and Dropbox. But the focus of Y Combinator’s program specifically, and VC-funded companies generally, is on raising the next round of funding. In the case of Y Combinator, months of work and preparation are put into nailing the perfect pitch for a performance in fundraising called demo day. For VC-backed startups, the focus is on what milestones a team must hit in order to be attractive for their next round of funding—ideally at a meaningful multiple of the last funding round price.
With the indie.vc experiment, the sole focus of the investment and support provided is on getting the company to profitability and positive cash flow. “Real businesses bleed black,” Bryce likes to say. There is no discussion about what milestones need to be hit to be attractive for the next round of funding. There is no demo day. The investment stake we receive in return is in the form of a convertible note that either can be paid off at a fixed multiple in dividends if and when the company becomes profitable and cash flow positive, or can be converted to equity if the company later decides to take on investors and shoot for an exit.
In using dividends as a form of payout to investors, Bryce is following the same game plan as companies like Basecamp and Kickstarter. Jason Fried, the founder and CEO of Basecamp, notes that Basecamp makes tens of millions of dollars a year in profits and has paid out tens of millions in distributions.
A major selling point for entrepreneurs in taking less cash up front from investors and shooting for a slower growth, cash-flow positive business is not to pay dividends, but to achieve greater independence, freedom, and control. That control allows the startup to keep going as long as customers value the work, independent of the judgment of investors. Marc Hedlund, the founder and CEO of Skyliner, an indie.vc investment, writes: “[W]e and many peers have, in the past, invested huge amounts of time and energy in work we love only to see companies fold and all that effort go to waste. Too many startups fail. Too much of our work as an industry goes into the dustbin if growth is not immediate and meteoric.”
That control also allows startups to choose a business model that aligns with their values and purpose. The Information, which has become Silicon Valley’s go-to source for deep, thoughtful technology reporting, is a great example. Jessica Lessin, the founder and CEO, took no outside investment and made an early commitment to a subscription model because of what she saw as the inevitable corruption brought on by the advertising model, which requires high growth to succeed, and in which the pursuit of clicks and views overrides the pursuit of truth.
The jury is still out on these experiments, but they illustrate the stresses of the current model. Fed up with a system that gives rich and certain returns to venture capitalists but often little or nothing to the entrepreneur, startups are beginning to turn away from the financial market casino and trying to build real businesses again.
DIGITAL PLATFORMS AND THE REAL ECONOMY
In stating the importance of companies rooted in the real market of goods and services, I am not advocating a return to a world of 1950s-era small business, but to a reinvention of small business for the twenty-first century, enabled and empowered by networked platforms. I am also calling for a clearheaded dialogue about the power of those networked platforms to set rules that govern those small businesses—and the government’s role in setting rules that govern the platforms.
If the great Silicon Valley platforms are a model for the twenty-first-century company organization, then the people who matter to the platform are not just the employees in the network hub, the corporation proper. The participants in many of those platforms are individuals and businesses operating in the real world of goods and services: the host offering a room on Airbnb, the driver offering a ride on Lyft or Uber, all entrepreneurs of a sort. The iPhone and Android app stores don’t just offer products from Apple and Google; they are platforms for independent developers. Facebook and YouTube depend on both their creators and their consumers. Search engines, Yelp, OpenTable, and other similar sites succeed to the extent that they drive traffic to other businesses, not just to themselves.
If they are to break free from the mistakes of the failed philosophy of current financial markets, which too often hollow out the real economy and increase inequality, these platform companies must commit themselves to the health and sustainability of their partner ecosystems. This is not just a matter of idealism. It is a matter of self-interest. When platforms take too much of the value for themselves, they lose their way.
Video-hosting sites like YouTube are a good model for understanding how a network platform can generate new forms of employment while also allowing existing businesses to grow and participate in the platform. Before YouTube, could you imagine the costs of sharing a video with the world? Billions of videos, available to anyone? For free? After ten years, with revenue estimated to be over $9 billion, YouTube is reportedly still not profitable. Its cost structure for hosting and high-speed content distribution is enormous; much of the video has no advertising against it, and when it does monetize video, it shares that monetization with its creators. Fifty-five percent goes out to the video provider; 45% goes to the platform.
There is a thriving small business economy around YouTube. Hank Green, a YouTube star whose various channels with his brother, bestselling young adult author John Green, collectively have nearly 10 million followers, cofounded an organization called the Internet Creators Guild to “support, represent, and connect online creators” on platforms like YouTube and Facebook. Hank estimates that there are more than 37,000 people who make a full-time living posting to YouTube alone (ranging from those who are barely making a living wage to those pulling down seven figures), and almost 300,000 who make supplemental income. And that number is growing. “If ‘Internet creator’ were a company,” Hank says, “it would be hiring faster than any company in Silicon Valley.”
YouTube is a testament to the power of supermoney to do good. It is only by borrowing from the future that this infrastructure could have been funded. This is true of all the infrastructure of the Internet, from the providers who bring bandwidth to offices and homes, coffee shops and public spaces, to the countless free services we all enjoy. But not all of those who borrow from the future recognize their obligation to pay back their moral debt by making that a better future. Supermoney is not a gift. It is an obligation.
MEASURING VALUE CREATION
When used properly, the value created in financial betting markets is also realized in the real human economy. Google’s founders created enormous wealth for themselves—Larry Page and Sergey Brin are each worth somewhere north of $38 billion—and through stock options distributed to every employee, they have also created wealth for everyone who has worked for Google, as well as for those who invested in the company. But more important, they also have created enormous value for other businesses and for society as a whole.
Company financial statements routinely measure and report on the value captured by the company for its owners. Little is routinely done to measure the value that is created for others. That needs to change.
I was told by James Manyika of the McKinsey Global Institute that at a meeting of global business leaders hosted by Fortune at the Vatican in November 2016, CEOs were admitting to each other that perhaps they were measuring the wrong things. “We measure ourselves on shareholder value,” one said. “Should we have a metric around job growth, or income growth?”
There are already small steps in this direction.
Every year, Google chief economist Hal Varian and his team publish an economic impact report. In their 2016 report, they estimated that during the prior year, Google increased US economic activity for their customers by $165 billion. They base this figure primarily on a conservative estimate of the expected impact of Google advertising on the increased revenues of their advertisers. If they were to include what must be a far larger economic benefit to businesses found through organic search who are not also advertisers, the total would be far, far larger. That is probably the more important number. After all, Google and other search engines are how people find out about virtually everything. Research conducted by deal site Groupon in 2014 suggested that more than 60% of their traffic came from search.
But even ignoring organic search, and merely using Google’s figures for the positive impact of paid advertising, value created for their advertisers in 2015 was almost five times Google’s own $34.8 billion in 2015 US revenue. Given that Larry and Sergey founded Google in 1998, you can count the cumulative economic impact in the trillions of dollars. And the consumer surplus provided by free access to vast amounts of online information has to be much, much larger. As users of Google Search, we participate in an exchange of real value, receiving free search services, maps and navigation, office applications, video hosting on YouTube, and much more, in exchange for possibly clicking on some of the advertisements that those paying Google customers placed via the service. Even Thomas Piketty agrees that increased productivity and better diffusion of knowledge create more wealth for society and are among the forces that reduce income inequality.
In short, the trillions of dollars of value created for society as a whole is far larger than the supermoney value created for shareholders of Google (at present, approximately $562 billion). That’s what success looks like. It is what happens when a company creates more value than it captures.
Google is not the only company to regularly publish an economic impact report. It is becoming increasingly common for Internet companies to measure their positive economic impact. This is a step in the right direction, but it should ideally be systematized and made part of regular company financial reporting. It would be great to see standardized financial measures of the ratio between the value created for the owners and investors in a company and the value created for other stakeholders. This ratio is particularly important in the winner-takes-all world of online platforms. The value created for the ecosystem should be a paramount concern.
In the summer of 2016, crowdfunding pioneer Kickstarter commissioned a report from a researcher at the University of Pennsylvania, which concluded that since its founding in 2009, Kickstarter had funded a total of $5.3 billion in projects, creating 8,800 new small businesses employing approximately 29,000 people full-time, and working with another 283,000 part-time collaborators. Many of those projects doubtless failed, just like those backed by venture capitalists or started as local businesses, but many have gone on to great success. Some have even joined the supermoney economy. One project, Oculus, was later sold to Facebook for $2 billion, of which Kickstarter received nothing. (Unfortunately, neither did any of the project’s backers. It would have set a great precedent if, having won big, the Oculus founders had treated their initial backers as if they had been investors, letting them in on some of the windfall.)
While the absolute numbers are far smaller than those for Google, Kickstarter’s ratio of value captured to value created is far better. Since Kickstarter charges a fee of only 5%, that means the company’s total lifetime revenues were roughly $250 million, a tiny fraction of the value created. Because Kickstarter is a private company, and Yancey Strickler, its cofounder and CEO, made clear that he has no plans for the company to sell or go public, it’s impossible to estimate what Kickstarter would be worth if it were to do so. But Kickstarter is in the game for the long haul, committed to creating value for its participants rather than extracting it.
Kickstarter has gone so far as to register as a public benefit corporation, a designation that places a legal requirement on the company to consider its impact on society and not just on shareholders. Kickstarter’s founders told their venture capital investors from the start that they have no plan to exit, and have instead put in place a mechanism for making regular cash distributions to their shareholders, just like Basecamp and the indie.vc companies.
An aside: I’ve always had mixed feelings about public benefit corporations and their lighter-weight cousins, benefit corporations, or B corps, which certify to their investors that they do take factors other than shareholder value into account, but are not legally required to do so. I love the idea of public benefit, but I hate to accept the idea that a regular corporation is legally obliged to ignore it. Law professor Lynn Stout’s book The Shareholder Value Myth makes what appears to be a compelling case that shareholder value primacy has no legal basis, but Leo Strine, the chief justice of the Delaware Supreme Court, argues otherwise. And given that most US corporations are registered under Delaware law, Strine’s views carry more legal weight. Frankly, though, if there is legal precedent for the corporate obligation to disregard the interests of all but shareholders, I’d like to see it challenged and overturned.
Etsy, the marketplace for handmade goods, is also a benefit corporation, mindful of the benefits to its sellers. “Etsy sellers personify a new paradigm for business,” Etsy’s economic impact report announces. “For many years, the conventional and dominant retail model has prioritized delivering goods at the lowest possible price and growth at any cost. . . . In many ways, Etsy sellers represent a new approach to business, where autonomy and independence matter just as much as, if not more than, the bottom line.”
Etsy’s report is full of softer statistics and personal success stories. On average, sellers report that their creative business contributes 15% of their yearly household income; 17% use their creative business for rent or mortgage payments; 51% “work independently” (that is, their creative business is their sole business, or it is part of a mix of income from a variety of sources); 36% have a full-time job; and 11% identify themselves as unemployed.
Alas, Etsy provides a cautionary tale for those who hope that benefit corporation status will protect them from angry investors. In May 2017, two years after Etsy’s IPO, investor anger at the company’s lackluster financial results led to the ouster of Chad Dickerson, Etsy’s CEO.
Airbnb doesn’t do an overall economic impact statement like Google, Kickstarter, or Etsy, but regularly publishes studies of individual cities. For example, in its 2015 study of Airbnb in New York City, the company calculated that visitors staying with Airbnb hosts generated $1.15 billion in economic activity during the prior year and supported more than 10,000 jobs. A 2016 study claimed an economic benefit to the Netherlands of €800 million. There is of course some offsetting loss of income to hotels, so these numbers likely deserve further scrutiny. But it’s important to note that Airbnb’s benefit is distributed more directly to ordinary people and small businesses than are the profits of large hotel chains. Across all the cities they’ve studied, 74% of Airbnb properties are outside the main hotel districts. Airbnb guests spend 2.1 times longer than the average hotel stay, and spend 2.1 times more than hotel visitors, with 41% of it spent in local neighborhoods not usually frequented by tourists. While professional Airbnb hosts play a larger role in some markets like Japan, Airbnb is increasingly enforcing a “one host, one home rule” to minimize the conversion of rental housing stock to short-term rentals. Eighty-one percent of hosts share their own home, 52% of hosts have low to moderate income, and 53% say that the income from Airbnb has helped them stay in their home.
Even Uber, the bad boy of the WTF? economy, likes to tout their positive social goals. The origin story on its website concludes: “For the women and men who drive with Uber, our app represents a flexible new way to earn money. For cities, we help strengthen local economies, improve access to transportation, and make streets safer.” Consider how much more powerful this statement would be if there were published metrics, backed by reliable data, to support it. There is, at least, some measurement of consumer surplus. A third-party economic study of Uber pricing in North America suggested that during 2015, Uber had actually left $6.8 billion on the table by charging less than they could have.
China’s Alibaba, owner of the world’s largest e-commerce marketplace, Taobao, doesn’t issue an economic impact report, but the numbers speak for themselves: $256 billion in gross merchandise volume from nine million third-party sellers.
Unlike Amazon, which sells both products that it stocks and sells directly and products from third-party sellers, Taobao is like eBay, purely a marketplace for connecting buyers directly with third parties. And unlike eBay, which aggregates all products into a vast catalog, each Taobao merchant has its own storefront. Also unlike eBay, which under then CEO John Donahue was accused of turning away from the small businesses that gave it its start in order to favor more lucrative sales by big brands, Alibaba has segregated global brands into a separate site, Tmall, which has $136 billion in gross merchandise volume. And unlike both Amazon and eBay, Taobao charges no commission for its sales; all of its revenue comes from advertising, which merchants use to increase their visibility on the site. (Taobao’s sister site, Tmall, does charge a commission, which ranges from 3 to 6%.)
E-commerce sites like Taobao, eBay, Etsy, and the Amazon marketplace for third-party sellers can play a meaningful role in reinvigorating local economies. They should all measure themselves by the success of their sellers, report on it religiously, and aim to have the metrics for those marketplace participants, not just themselves, go up and to the right. After all, without the sellers, a marketplace is an empty shell.
Small businesses are the bedrock of the economy, providing nearly half of all private-sector employment. Policy makers must understand the role of platforms in bringing small business into the twenty-first century, measure their economic impact, and craft tax policies to encourage the creation of broader economic value, not just the value companies extract for themselves.
THE CLOTHESLINE PARADOX
What we measure matters. I first became fascinated with the curious fact that we often ignore and take for granted many types of economic value when, in 1975, I read an essay by environmentalist Steve Baer published in Stewart Brand’s Co-Evolution Quarterly, the successor to The Whole Earth Catalog. The essay was called “The Clothesline Paradox.”
“If you take down your clothesline and buy an electric clothes dryer, the electric consumption of the nation rises slightly,” Baer wrote. “If you go in the other direction and remove the electric clothes dryer and install a clothesline, the consumption of electricity drops slightly, but there is no credit given anywhere on the charts and graphs to solar energy, which is now drying the clothes.”
The Clothesline Paradox is a tool for seeing the economy with fresh eyes, essential if we are to correctly rewrite the rules. It is another of those general-purpose concepts that is an aid to seeing what others are blind to.
It is also a good reminder that economic value is realized in different ways at different points in the value chain, and important sources of value are often invisible or taken for granted. For example, Google and Facebook provide free services monetized by advertising, while companies like Comcast charge hefty subscription fees for access to those same services. Meanwhile, Internet users are often accused of being unwilling to pay for content, despite being the source of much of the activity that is monetized by both advertising platforms and Internet service providers.
At least ad-supported media is clear on the nature of the transaction: “We’ll give you free services if you’ll give us your attention.” Something is clearly wrong, though, with the map being used by the cable companies to frame this discussion. The cable company must pay for professionally produced television content; on the Internet side of its business, the cable company gets much of its content for free, created by the very customers who are paying them for access. Simply by comparing the cost of content for the cable companies and other providers of Internet services versus their content cost for television, you can see that it is the cable company, not the consumer, that is getting the free ride. Debates about net neutrality should be informed by Clothesline Paradox economics, not the extractive economics of financial value capture by big companies!
The Clothesline Paradox is a great way to understand the value of investments in basic research, and in particular, open science, where information is freely shared. Much of the basic research that pays such enormous dividends is funded by taxpayers, yet when government makes a claim on those dividends in the form of corporate or capital gains tax, far too many of the beneficiaries complain or seek to avoid it.
There’s an argument to be made that government should get a share at the point of origin, getting a stake in the supermoney outcomes just like investors do. In The Entrepreneurial State, Mariana Mazzucato details the role of government in funding the innovations that are embodied in products such as the iPhone, pharmaceutical and agricultural innovation, and the new private space race. She makes the case that startups commercializing government-funded research should pay royalties into a “National Innovation Fund” or issue a “golden share”—an undilutable percentage ownership to the public—precisely in order to capture a portion of the value as and if created.
That being said, it is also true that the value from innovation accrues to society in many unmeasured ways. In a 2004 paper, economist William Nordhaus estimated the amount of “Schumpeterian profits”—“those profits that arise when firms are able to appropriate the returns from innovative activity”—and discovered that from 1948 to 2001, only “a minuscule fraction” (2.2%) of the total value from technological advances was captured by their producers. The increase of human knowledge makes us all richer.
Sharing rather than hoarding knowledge can also be a powerful lever for competitive advantage. Companies too often assume that the best way to increase their share of the gains from innovation is to keep it proprietary. Yet as the open source pioneers of Linux and the Internet taught us, knowledge compounds when it is shared.
This is also true today in the fierce competition of artificial intelligence research. Yann LeCun, the head of Facebook’s AI research group, pointed out to me that most of the cutting-edge AI research today is being done at Google, Facebook, Baidu, and Microsoft. Key to their ability to hire the best people, he said, is these companies’ willingness to let their researchers share their work. Apple, which has a culture of secrecy, has been unable to attract top talent, and as a result, has recently had to change its policies.
Understanding where value is created versus where it is captured is equally important when considering the future of work. As we will see in the next chapter, the question of whether the next wave of automation will leave enough jobs for humans is deeply rooted in outdated maps of what counts as paid work, and what we take for granted and expect to be provided for free.