‘Disruptors’ haven’t fixed anything
There’s not much money in solving real problems
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The last quarter of 2022 has been a bad one for corporate grifters. In November, a federal judge sentenced Elizabeth Holmes, once the youngest-ever “self-made” female billionaire as founder of the healthcare startup Theranos, to more than 11 years in prison for fraud. This month, Holmes’ former boyfriend and business partner Ramesh “Sunny” Balwani received just short of 13 years in prison for his part in the scam.
On Oct. 14, a federal jury found Trevor Milton, founder of the electric vehicle company Nikola, guilty on three counts of fraud. And in November, “micromobility” company Bird informed the SEC that the company had overstated its revenue for more than two years. Bird now faces potential bankruptcy.
Each of these cases represents a failed attempt to take tech industry “disruption” out of the world of ones and zeros and into the land of real, material problems like healthcare and transportation. The uncomfortable truth they underscore: there’s too much money in rearranging the deck chairs on the sinking ship of our crisis-plagued society to invest in turning things around.
Venture capital loves businesses that only exist on computer monitors. Of the 65 top “unicorns” in Silicon Valley (private companies valued at $1 billion or more), 57 of them can be characterized as software or data companies of one sort or another: 88%. The same holds true globally: 88% of the top unicorns worldwide sell software, data, delivery, or direct-to-consumer retailing.
Companies without a product you could “stub your toe on” attract capital because they have high levels of “operating leverage.” All businesses have fixed and variable costs -- the money they need to spend no matter how many products they sell (fixed), and what they spend to facilitate each new sale (variable).
If a business has high variable costs, then each new sale costs the business significant new money, and bottom line profits -- the money leftover after those costs -- grow more slowly. But if the company’s costs are mostly fixed, then once those are paid for, each new sale is pure gravy. Operating leverage is the ratio of fixed costs to total costs, and the higher the leverage, the more an increase in sales delivers an increase in profits.
This makes sense: if a delivery app doubles its user base, it may need to pay Amazon Web Services for more cloud capacity. If an automaker doubles, they may need to build a huge new factory -- intangible products have higher operating leverage and more profits for every dollar of new sales.
The concept is so powerful that it extends beyond just the tech world. Looking at the top of the Fortune 500, besides the oil and gas companies, you have to get to Ford at #22 before you find a company that actually makes something -- not just marketing, merchandising, or financial services of one sort or another. Apple is number three on the list, but Apple outsources its manufacturing; its business is design and support services. Even automakers like Ford outsource 80% of their manufacturing to third parties.
This bears repeating: even for the companies with their names on tangible products, their official business is rarely making those goods. It is designing, marketing, and maybe distributing them. These are much higher margin businesses than manufacturing, which means that these companies can claim to be more profitable, with higher returns for their investors.
They still have to pay to have the things manufactured, of course, but that moves from the first part of their balance sheet -- the cost of goods and services, the part that gets subtracted from revenue to calculate gross profit -- to operating expenses, the “fixed costs” that make them more leveraged. They can impose those prices on suppliers dependent on their business, especially if they are in poorer countries with trade deals that drain long-term capital away from their industries.
As for the small number of those unicorn companies making real products, they rely on the one source that can tolerate lower margins for longer: the government.
Of the 14 companies on the two unicorn lists we referenced that actually make and sell physical products, more than half depend on government money.
Three are in biotech -- even in the United States with privatized healthcare, 49% of medical costs are paid by federal, state, or local governments.
Two are Chinese companies backed by state-owned enterprises.
One is Skydio, a drone company backed in part by In-Q-Tel, the CIA’s venture capital arm.
Another is PsiQuantum, a quantum computer company with large early contracts with the U.S. military.
SpaceX also makes the list, effectively a privatized U.S. government agency.
Two of the companies do seem to be addressing real problems -- Impossible Foods by creating consumer alternatives to the meat industry, and Zume in trying to eliminate single-use plastics. Others, like the 3D (i.e. plastic) printing company Carbon and nicotine delivery device maker JUUL are likely making things much worse. And if the experience with “world changers” like Theranos and Nikola is any indication, at least a handful of these firms are likely to be outright frauds.
As long as innovation is just a function of money-making, new ways to rearrange the dollars in the bank and to spy on people will have an inside track on investment. As long as companies in one part of the world can force prices down the throats of companies in other parts, there is a lot of upside in overloading your business with salespeople and executives while letting someone else worry about making your products.
And as long as all of that is the case, there is not much capital left for our real problems, a huge opportunity for con artists ready to take advantage of desperation and the myth that private investment can fix the very disasters it’s created for us all.
Our only investment advice: Pre-order Rob’s book.
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