Thursday, March 13, 2003

Lucky Crooks

Virginia Postrel said some interesting things about the "lucky fool" theory of the Internet bubble in a NYT article, and gives a followup pointer to a Business Week article here. Basically, the idea is that the people who start new businesses are wildly overoptimistic about their chances for success relativfe to the expected return. A few "lucky fools" (Bill Gates) make piles of money, while the vast majority of new businesses fail. Key point (from Virginia's Libertarian perspective) is that the risk doesn't justify the return. Libertarian theory assumes that businessmen are steely-eyed, totally accurate robots, completely dedicated to maximizing profit. From the Libertarian perspective, a large group of businessmen consistently misestimating probabilities requires Explanation.

My own experience with the dotcom bubble was that it isn't "lucky fools". It's "lucky crooks".

The Internet bubble reminded me all too much of the movie “The Producers”. The gimmick in the movie was that the producers sold a 20% interest in their play to about 20 different investors, and then produced a play that was guaranteed to fail. They could then pocket the money with no one the wiser. Of course, since this was a movie, it didn’t work that way.

Far too many internet startups worked like this:

  1. Venture capitalist gets together with some guys with an Idea and starts a company. The idea may be good, may be bad, may be ridiculous. VC doesn’t care. Question isn’t “will it work?”, but “will it sell?”
  2. VC gets a big chunk of money from various investors.
  3. VC takes half the money, puts it in his pocket as “fees”.
  4. VC puts his cronies into the new company as all the top brass, at huge salaries. If the VC is “helping” an established company, the old management are thrown out with a big pile of stock options.
  5. The new management spends money like water. Build buildings, hire programmers, go to trade shows, etc. Point is to make a splash. “Product” is irrelevant.
  6. The company goes public. The stock skyrockets, everybody cashes in. Gobs of money for everybody.

If the company never gets to step 6, hey, it’s venture capital. You never expect to bat 1000. Anybody complains about details, well, let’s just say that Arthur Anderson didn’t invent creative accounting. And the VC can afford lots of lawyers.

Point is, the VC makes his money at step 3. After that, it’s essentially irrelevant whether the company ever does anything at all. Now, note that from the standpoint of getting new ideas out into the business world, it doesn’t matter whether the company goes bust or not. Once the company gets into the public view, the ideas are out there. Any patents will get bought up by established companies, who may or may not do anything with them. (The current state of the patent system is a subject for another rant.) Even if the patents never get used, the fact that

  1. Something can be done
  2. It’s worth doing
is a great stimulus to other people to come up with other ways of doing the same thing. Napster is a prime example of this phenomenon. Napster itself is gone, and I suspect its technology is tied up by the record companies to the point that it will never see the light of day. However, we have Gnutella, Morpheus, KaZaA, Freenet, and others doing the same thing, better.

Anyway, I guess the idea is that people are pretty good at estimating the results of their actions -- but they will almost ceratinly use a different "evaluating funcion" than you expect. A venture capatalist can (could?) make gobs of money without ever seeing one of his companies succeed.

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