Monday, April 30, 2012

Micro 101 Lesson: The Price System Matters

I wanted to add a little more from yesterday's post on Venture Capital.

The New York Times had an interesting piece about how a lot of start-ups (at least in the social media/Internet market) aren't generating revenue and would like to keep it that way.
When small start-ups I’ve spoken with do make money, they often find it difficult to recruit additional investment because most venture capitalists — and often the entrepreneurs they finance — are not interested in building viable long-term businesses. Rather, they’re interested in pumping up enough hype and valuation to find a quick exit through an acquisition at an eye-popping premium.
The full article is here.

This is a very interesting trend. Here are a bunch of start-up companies with a bunch of investors waiting in line to fund them. And the entrepreneurs are trying to avoid concrete results, and focusing on speculative growth. The article used one obvious example. Instagram has $0 in revenue, but sold for $1 billion.

I think this pattern, in particular, will be a key cause of bubble growth (and bust) in this industry. One of the first things I learned in my Micro 101 class is the importance of the price system. Revenues are pretty good signaling devices for producers and investors. They show how valuable a good is to a consumer. No one really knows how much the big social websites (Facebook, Twitter, Google+, etc.) are valued by users, because they're all free!

This means that it's difficult for investors to know whether all these new start-ups are going to do well. Is there ever perfect information and predictability in a company? Of course not. But if the price of lead tennis balls was $0 - you would expect that investors would avoid investing in lead tennis ball factories. The only problem is that there's no way to tell which start-ups are making lead tennis balls and which are making the next Facebook.

I'm sure there has been more in-depth research on this. But the main point is that we should be wary of investments that aren't based off of much information.

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