House Money
House Money
An analogy from poker to help explain what's going on in Tech
In recent posts, I highlighted how rampant inflation has left American consumers unhappy, and poll numbers for the US government have plummeted despite a booming economy. As a consequence, the government pressured the Federal Reserve to “do something”. The Fed has responded accordingly. On November 30th, Fed Chair Jerome Powell gave a much-covered speech in Congress where he acknowledged inflation as a significant problem and expressed his intention to fight it, even in light of the looming omicron-variant
This marks an epochal shift in central bank policy. With too much inflation around, for the first time in over a decade the “Fed-Put” is removed. This adage describes how the Fed had responded to economic downside risks with measures that push asset prices up. It is now replaced by what could be called the “Fed-Ceiling”, where rising asset prices trigger the removal of central bank support
As discussed before, the sector most vulnerable to this new mindset is high-growth tech, including crypto and venture capital. After Powell’s speech, a marked sell-off ensued in high-growth stocks and Bitcoin, as I predicted in my last post. Private markets are unharmed so far as bullish funding rounds continue to be announced (e.g. Airtable’s $11bn valuation on $120m sales)
This post provides considerations on the high-growth tech sector which I hope will be useful to my many readers with exposure to this area, be it through investments, through work or as founders. These thoughts rest on the concept of “house money”, which is introduced below
House Money describes a human behavioral bias observed in casino games such as Poker or Blackjack1. In those, players fund their bets from two sources:
Hard-earned cash, which provides the funding for the initial bet. This is money earned outside of the casino, e.g. with a working wage
House Money, which is money earned from winning bets and paid out by the casino operator (“house”)
Humans tend to place much riskier bets with House Money than with hard-earned cash. It’s a bonus, so the pain of losing is much smaller
The larger and the more frequent the winnings, the more careless we become
Accordingly, the bets made with House Money are more likely to cause losses. There are two ways to protect against this bias:
Experience: After seeing wins drained away again by a string of careless bets, awareness is higher the next time around
System: An objective set of rules removes human emotion from the equation. This is akin to counting cards at Blackjack. It is also the often referenced investment process money managers stipulate to follow
Neither experience nor system provide bulletproof protection. In particular, because a powerful human emotion called FOMO can override them
In the investment world, high-growth technology stocks, VC investments and cryptocurrencies have experienced a huge bull market, and the amount of winnings is staggering
VCs and growth investments were the best performing asset class of the past five years with average IRRs of ~22%+. Cryptocurrencies went up ten-fold in market cap over the past three years. Software-as-a-service companies saw a ~5-fold expansion in their valuation multiple over the same time frame
There are many anecdotal stories of 10x or 20x investments in VC or >100x investments in crypto markets
Given this backdrop, it is fair to wonder to what degree the House Money effect is at play
Let’s look at some telling signs, first from public markets:
The top ten publicly listed cloud companies trade at a EV/Sales multiple of ~50x. In other words, you pay $50 for each $1 of sales. Sales, not profit. Keep in mind, these are not Seed or Series A investments
Over $700bn in SPAC mergers have been formed over the last two years, almost all in tech. Brokers estimate >90% of them to run with fantastical financials, down to outright fraud in too many cases (Nikola, Lordstown etc.)
Meme stocks AMC and Gamestop still account for market caps of ~$15bn each
Robin Hood, which derives 75% of its revenues from the unethical practise of selling its customers’ order flow while pretending the orders would be “free” (and that practise about to be banned in the US and in Europe, and already banned in the UK), still has a market cap of ~$20bn
Online signature company Docusign paid its executives a total of $2.6bn share-based compensation, on revenues of $1.96bn
In cryptocurrencies:
Cryptocurrencies currently amount to $3 trillion market cap. Excluding Bitcoin as a macroeconomic store-of-value bet, this leaves $2 trillion market cap for the remaining 6,000 coins, including meme-based Dogecoin and Shibacoin with $20bn market cap each
As my regular readers will know, I am a big fan of the emerging real-world use cases, but revenue from these is still small. It can be very generously estimated between $200m and $4bn.2 This puts the asset class on a 500x-10,000x EV/Sales multiple
Much of the money invested in NFTs stems from recycled crypto gains. The highest profile projects may keep or grow their value, but there is also plenty of this to be found: “Someone paid $650,000 for a non-existent yacht in the metaverse last week”
In IPO markets, which are the endgame for venture holdings:
Well known online-brands such as Doordash, Allbirds, Duolingo, Warby Parker, Transferwise, C3 AI, AirBNB and others have all been IPO’d in the last months at nosebleed valuations and a narrow free float
Retail investors are excluded from the IPO subscription process. Attracted by the brand and oblivious to valuation, they squeeze up the price on the first day of trading when they are allowed to buy. Existing shareholders are having a field day as they sell to them. After that, the share price deflates. All examples have materially declined since their IPO (-30% to -50% or more)
These are truly amazing companies. But does that justify using them as rip-off vehicles? How much longer can that go on?
And finally, in private markets:
In the third quarter of 2021, more money has been invested in VC than in the entire 1999/2000 tech bubble together. Much of this money is reinvested from earlier gains, the textbook definition of House Money
In this frenzy, private market multiples have now gone from triple-digit EV/Sales to quadruple-digit EV/Sales (!). Below is a summary with recent deals for start-ups with single-digit-million sales and billion-dollar valuations:
In many conversations I had recently, founders and VCs report of low/no due diligence efforts, pre-emptive bids and multiple term sheets with loose conditions. It’s an extremely hot market right now
The flood of money puts founders in front of unparalleled challenges
A typical Series-C/D/E pattern is to reward firms with revenues in the $10-50m range with $100m-1000bn cash to be invested into the operating business
This money is typically used for hiring. Head count often doubles or triples over 12-24 months, from low 100s to near 1000s
This is a historically unprecedent situation. Small business with often relatively young founders have to manage huge scaling operations, with an extraordinary amount of funds available (House Money?)
How many management teams are experienced enough to scale at such speed? How many will increase cash burn, churn and operational complexity into a potentially more competitive, slowing market?
Where do things go from here?
Rather than making a prediction, let me first highlight the arguments in favour of a continuation of the current state of high growth tech…
Humans have changed and the House Money effect is better managed this time around
We live in an exponential age. Any damaging House Money effects are overcompensated by the dramatic acceleration of technology
Inflation has peaked, and the Fed will soon reverse course, back to its accommodative policies
… and what would speak against it:
Humans haven’t changed
Inflation doesn’t go away and the Fed doesn’t change course. The rug is pulled under the assets spelled out above, and afterwards everyone will say “all the signs where there”
It may very well end up being a combination of all these dynamics
However, if we assume that the easy-money era is coming to an end, the critical question is whether a tech cool-off would have a broader impact on the economy
In 1999/2000, the collapse of the New Economy bubble destroyed ~$2 trillion in market cap and ushered in a painful recession from 2000-2002
The size of frothy sectors may be similar this time around (cf. crypto $2 trillion market cap excl. Bitcoin). But the economy is twice as large today, household balance sheets are in very strong shape and corporates have largely remained on the sidelines (instead of going head-in like TimeWarner with AOL in 1999)
Unfortunately I don’t have an answer to this question. So far, it’s too complex to tell. However, I remain optimistic that the economy could keep growing either way
In conclusion:
To my friends in VC, I would encourage from my humble observations to go early, go into seed and incubation where valuation matters less, go into less competitive geographies (Europe?), avoid term sheet battles with winner’s curse, use niche positioning or reputation to have exclusive access
To my friends who are founders, I would encourage to raise capital now and then treat that capital like raw eggs and be extremely mindful how to spend it, avoid running the risk of big step ups in cash burn which would require even bigger raises down line when circumstances may have changed
To my friends with investments in any of the very vulnerable areas spelled out above, I would continue to recommend to book gains. There is always a time for certain styles, and the time for high-growth will surely come back, but sometimes it’s good to harvest
Additional Resources:
A most thoughtful deliberation on the state of the VC market by the founder of venture firm Lux Capital, Josh Wolfe. I can only recommend it (here)
A great read on stablecoin Terra, the center of a functioning alternative to traditional payments systems and a good crypto-real world use case (here)
A brief summary of the dynamics of the crypto-sell off this past weekend by the CEO of the biggest market maker in crypto, Alameda Research. Stablecoin lending demand, which I had introduced recently, is driven by market makers like Alameda who exploit these inefficiencies (here)
Higher end of estimate includes NFT-sales on Opensea etc. as well as in-gaming revenues (mainly Axie Infinity). Lower end excludes those, assuming NFTs mostly paid from crypto gains and Axie Infinity recent run-rate decelerating. Excludes exchanges or DeFi revenues which are intra-ecosystem