Bubble Valuation Part I: Sneakers, Fire Fighters, and McKinsey

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Click here for a more analytical Part II: Fun with DCFs and Stock Comp.

My parents believed in conspiracies. It was a manifestation of distrust of power in any form. If you think about it, the stories behind events like Watergate or Iran Contra are so batshit as to compel a generation to develop conspiracy theories for just about everything. Fool me once, right?

So I remember them cheering every line by Dan Aykroyd’s character Mother in the 1991 film Sneakers, from claims about faking the moon landing to the CIA’s involvement in the Managua earthquake. Not necessarily because my parents believed the theories, but rather because it gave voice to a seemingly logical, yet underrepresented, distrust in government (before the web provided a bullhorn for nutjobs, of course). One of Sneakers’ many successes comes from balancing Aykroyd’s out-there conspiracy theories with Sidney Poitier’s frustrated reaction for comic relief all while the heroes themselves are caught in one of those out-there conspiracies. If you haven’t seen it, do so—I’m not the only one who feels this way. Sneakers is subversive without seeming so, with a postscript that generates a kind of fictional universe dramatic irony where we know more about the world than its population.

And that’s exactly what’s so compelling about conspiracy. Conspiracy allows us to structure narrative where there is none, to believe ourselves smarter than the horde at large, to recognize a subtext that others have clearly missed. Conspiracy is awfully good at bringing order to what is merely chance—a universe determined by the decisions of millions of people often disinterested in anything other than themselves. Conspiracy can be a shorthand for a mess of incentives and the folks who have benefited disproportionately—at least that is when the conspiracies don’t involve alien abductions or Kenyan birth certificates.

Viewed in this way, conspiracy might come from a cynical, untrusting place, but it’s idealistic in nature. Somehow vast as in “vast right-wing” or “vast left-wing” only involves a relative handful of selfish people looking to bend the world to its will instead of a massive number of selfish ones looking to get while the getting is good. Evil might indeed be banal, but in a conspiracy, evil is the realm of supervillains, not your neighbors.

Shit, it’s also probably comforting to think that there’s someone, somewhere in charge, even if their results aren’t very good. Returns regress to the mean, after all.

Imagine a system where highly-paid Ivy League grads invested public pension dollars into investment firms run by even more highly-paid Ivy League grads?

Imagine if these firms invested in a lot of companies run by other highly-incentivized (if not also highly-paid) Ivy League grads who then sold their businesses for a ton of money to public companies run by other highly-paid Ivy League grads?

Imagine all of those folks switched roles all the time from LP to GP to startup CEO to large company CEO and back.

Imagine a system where it appears that a ruling class makes a lot of money and a large number of folks work earnestly yet unsuccessfully for high-risk lottery tickets to join it.

Ugh. Of course, of course, that’s not exactly how venture capital works. It’s just money. It’s just incentives. But imagine what it might look like to someone outside the system. You know, someone who’s priced out of San Francisco real estate and calls into Michael Krasny’s Forum on NPR.

It might look like a cabal, like a conspiracy.

Even if it’s not.

In 2007, a senior advisor for the private equity and venture capital firm where I worked asked me rhetorically, “Do you know why so many of the presidential candidates are in DC today?”

The International Association of Fire Fighters (IAFF) was holding a presidential forum, and each candidate from each party was coming through to appeal to the union ahead of important March primaries. With more than 300,000 members in 3,200 locals, the IAFF reached almost every community in the United States. Hence the forum was more important than any state a candidate could be visiting that day instead.

“Now compare that to this so-called Private Equity Council which only has six members.”

He had clearly made this argument to others in the firm without success that creating an organization to represent six members with hundreds of billions in capital could only galvanize public opinion against its causes. Act alone, and you may fly under the radar (or you may not). If you do organize, certainly don’t tout it. An organization of six kajillionaires arguing for tax benefits for carried interest doesn’t look like a union to the public.

It might look like a cabal, like a conspiracy.

Even if it’s not.

In 1999, The New Yorker published an essay by Nicholas Lemann called “The Kids in the Conference Room” later collected into a fantastic book called The New Gilded Age: The New Yorker Looks at the Culture of Affluence edited by David Remnick. I found my copy among twenty-five sitting on a shelf at Morgan Stanley because of another collected essay entitled “The Woman in the Bubble” about my boss at the time.

Lemann discusses the rise of McKinsey & Co., and in general management consulting and investment banking, as the stepping stone par excellence for elite college grads in the 1990s. As Lemann describes mordantly, “To get a business analyst job at McKinsey is to add another glittering credential to your string, since you’ve beaten out so many people to get the job, and working there offers the comfort of knowing you’ll be among your own kind (applicants have to submit their SAT scores). The world’s infinite possibilities haven’t been reduced by a whit, only enhanced.” Of course, elite colleges (and elite pre-schools) benefit from serving as the gatekeeper to these elite careers. Higher tuition, larger endowments, plum administrative salaries—sending kids to McKinsey instead of to study Italian neorealist films or the lexicon of Finnegan’s Wake in grad school has its distinct financial advantages.

And you can’t help but giggle now at Lemann’s prescience when he argues “the consulting vogue won’t last forever” given the late-90s pull of technology startups with “young hot shots … standing in the office of their converted warehouse space waiting for their IPO money to roll in.” However when the bubble inevitably pops, “technology will begin to look, to Ivy League seniors, risky—really risky, not just acknowledged-as-a-grace-note risky.” 2010s take note.

Lemann ends, fittingly, with a McKinsey-style three bullet point summary. The McKinseys of the world “stand at the end of a huge system that sends tens of millions of people to American public schools every year, administers the SAT to two million people, and processes more than a hundred thousand applicants to Ivy League colleges—all of this done either directly by government or by non-profit organizations subsidized by government—and then they pluck its very ripest fruit.”

It might look like a cabal, like a conspiracy.

Even if it’s not.

It’s the shorthand of incentives and long-term trends all ascribed to the particular actor currently benefitting disproportionately. No one set out to conspire for this to happen. It just kind of did. Incentives. Luck. Privilege. Maybe the hard work, wits—and greed—to take advantage.

In Silicon Valley these days you’re apt to hear that unlike the last bubble in 1999, many companies make real money. And of course there exist a large number of successful, profitable enterprises that can clearly re-invest in important employee retention perks such as lap pools and Halloween carnivals. At the same time, there are a number that aren’t yet profitable or won’t be able to sustain their current revenue or their current opex without additional financing made possible by extremely cheap capital happy to chase growth (Hello QE4!).

The current sentiment (eep… sarcastically summarized as “it’s different this time”) also assumes there weren’t companies making money back in 1999 or thereafter when things were pretty ugly. That every company was Kozmo.com. But in the lead up to Google’s IPO in 2004, I remember rebuilding the valuation models for The Woman in the Bubble’s team at Morgan Stanley with some shock at how reasonable some of the winners’ financials were such as Yahoo! and eBay. Certainly there were some stinkers like Ask Jeeves and CNET, but not all of them. You could definitely build a DCF to support a theoretical valuation. Like today, those valuations were based on long-term cash flow growth and market expansion and new products and the outright destruction of traditional industries as we know it.

For all the excitement of today’s companies making real money because of “network effects,” “software eating the world,” and, come on, “app install ads” and “monopolies”, there’s also this latent fear that popular services will stop being popular because some other service has become cool—if not less popular with consumers, then less popular with the fickle advertisers who foot the bills. It’s the other side of the coin to “disruption.” (Ick, I feel gross using that word.) To put it another way: wasn’t Facebook also supposed to be Instagram without paying $1 billion for it?

What if “Internet companies” have to be acquisitive now? Not just for growth, not just for accretion, but as a matter of course, to replace future product development? What would happen to public Internet valuations if acquisitions were considered a form of maintenance expenditure like capex? That’s the hypothesis I want to test. What if overvalued acquisition currency is the type of misplaced incentive that’s too-clever-by-half and looks incredibly shady when the bubble pops?

You know, like a conspiracy.

So. Imagine a system where large companies realized that lower barriers to entry created so much market noise that traditional R&D investment broke? Not in core products, per se, but in new products and adjacencies. Perhaps even the success of core products didn’t last as long as people once modeled.

Imagine if the odds against creating a successful new product were so high that large companies decided it was cheaper to buy the most successful startups rather than invest in core R&D? Especially if they could buy startups with overvalued equity. A steady supply of battle-tested companies would be nice.

Imagine if there were a large, underemployed generation of 20-somethings who each believe they should be CEO and focus on “strategy?” Like all inexperienced 20-somethings before them, by the way. And there was ample cheap capital from incentivized VCs/angels/incubators to allow our 20-somethings to each become founder and CEO of his or her own shitty startup.

Imagine our founder and CEO plays company 100+ hours per week for a modest salary and lottery ticket promises, even though the features she’s working on would be the responsibility of an assistant junior product manager at a regular company. But she gets psychic CEO benefits while waiting for a table for two hours at Country Fowl Comestibles.

Imagine if a cottage industry grew up around “foundering” supporting product press releases, celebrating failure, teaching hacking, selling hoodies, and providing on-demand snacks? “Foundering” could become the awful entrepreneurial cousin to Gawker’s concept of “writering.” Do you want to just fill-in-a-blank on a generic convertible note rather than deal with pesky lawyers or negotiations or even f***ing understanding the difference between equity and debt? We could make that happen.

In the end, imagine 1% of our junior assistant product managers/CEOs win the startup lottery and join that rarefied air of true executives, VCs, GPs, and LPs. And the other 99% of founders founder along until they found a winner. Mathematically, it only takes a hundred tries, a hundred hours per week, another hundred thousand dollars in angel investment.

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