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Big Idea: Will Capital Kill Capitalism?

Posted on Wednesday, Dec 3rd 2014

2014 has been awash with capital. Showering money on young startups, VCs have become giddy, entrepreneurs dizzy, and sane industry observers aghast.

Right before Thanksgiving, however, Quartz published a story on the failing Fab, How went from a $1 billion valuation to a $15 million fire sale:

Flash sales site and retailer Fab’s rise was as meteoric as anybody’s in Silicon Valley: it went from scratch to $250 million in sales in just two years. A little more than a year ago, it raised $150 million at a $1 billion valuation, bringing it to a total of $310 million in venture capital funding.

Now it’s set to be sold to Irish manufacturing company PCH in a deal that could be worth as little as $15 million, according to TechCrunch.

There is a reason why fundamentals are called fundamentals. They are, er, fundamental.

There was nothing inherently wrong with the flash sales business model. There are companies that have been successful with the model. It’s not that you cannot build a business on that model.

There is, however, something grossly wrong about ignoring fundamentals consistently, and building a business that doesn’t pay attention to profitability and sustainability.

You need gobs of capital to stay alive.

And guess what happens when that capital is no longer available?

You die.

In an earlier piece, I also raised the subject in the context of our industry’s current obsession with offering value for free:

The Internet is full of people who expect that everything should be FREE. In Economics, this phenomenon is referred to as the Free Rider Problem: when people consume value without paying their fair share. Obviously, some people DO pay their fair share. This makes the ‘free riders’ take advantage of those who pay, making the whole equation unsustainable in the long run. Creating value is expensive.

Capitalism assumes that value gets created with the understanding that those who consume that value are going to pay for it. If that assumption is violated, the system, eventually, collapses.

If you are an Internet or Mobile entrepreneur in the twenty-first century, chances are you are, somehow or the other, being affected by this challenge. The Media industry, in particular, has dug itself a gigantic hole and climbed straight into it by offering content for free. Now, the apocalypse has set in. The industry is doomed to oblivion for the most part.

The Education industry, with MOOCs, had started going down that path, but at least is pausing to think, thank heavens!

A recent Developer Economics survey offered the following observation:

A new 10,000-developer survey by Developer Economics says that 50 percent of iOS developers and 47 percent of Android developers are “below the app poverty line” and making less than $500 per app per month. That means “the majority of app businesses are not sustainable at current revenue levels,” Developer Economics says.

Why do you think this is the case?

Because, developers are confusing ‘customer’ and ‘free user’. A free user is not a customer. Your goal is to get paying customers, not just free users.

If you have a product that customers don’t want to pay for, but they want to use for free, then you don’t have a business.

It’s a charity.

So, please be careful about giving lots of value away for free if you want to be successful as a business.

The free-flowing capital, of course, is what makes the above phenomenon possible for entrepreneurs: to offer value for free.

Except, what happens when the capital dries up?

You go out of business!

Facebook has showered over $20 billion on a valuation without revenue company called WhatsApp that sent the market bonkers. All young entrepreneurs started dreaming of their own bonanza day.

Fundamentals grew out of fashion the day WhatsApp was acquired.

None of this would be possible if capital weren’t flowing so freely, so irrationally, so stupidly.

We’ve seen this movie before.

Conceivably, the bubble will burst. Capitalism will emerge triumphant, making mockery out of those who have ignored fundamentals systematically.

Will it though?

There is a tremendous concentration of capital in the hands of a few right now, including companies like Facebook, Google, Yahoo, etc. who are known to make irrational decisions.

And the VCs are also falling over each other to see who can be more irrational. The VC cycle, unfortunately, is very long. It doesn’t correct itself that quickly.

So, at the end of 2014, I ask you to think about the question: Will Capital kill Capitalism?

I am going to provide a few points as a discussion starter, but this is a discussion I am inviting you into, not a lecture that I am presenting.

First, there are a lot of free services that heavily venture-funded startups are offering for free or at very low prices that are making existing small businesses who have to focus on fundamentals unviable. From laundry to home delivery of meals to transportation, these online services are useful, but I am not sure why fundamentals need to be ignored in building these businesses.

The same applies to many business services as well.

The problem that we’re creating is twisted consumer expectations: everything is EXPECTED to be free.

We’re creating a free-rider society.

We’re creating a capital-funded free-rider dynamic that ignores one of the fundamental tenets of capitalism: producers create value, consumers pay to consume value.

Once this basic assumption fails, society goes on welfare.

Is that what we want?

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