Beware of Snake Oil Software

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By Mark David Witte

College of Charleston MBA professor of economics     

 

Have I got a deal for you! First, hand me your investment money. Second, don’t ask what you’re getting in return because all I can offer you is potential.

What are we building? Software that acts as a middleman. We’re going to have so many users that our company’s name will become a verb. And you get the potential from owning a small share of our firm when we go public. It’s potential because we have no way of making any profit for years to come…or maybe ever earning a profit.

Sound crazy?

This is the sales pitch they’re giving at Uber and lots of other tech startups. It’s estimated that Uber lost $3 billion in 2016. And yes, you read that right: billion with a “b.” How could a company with that many users lose money?   Simple, they’re selling their middleman services at a price below their cost. It’s easy to get clients if you sell something below your production cost. Anyone want to purchase a $10 bill for $9.50? The only thing keeping Uber afloat is the venture capital and investment money flowing into the company.

Those investors are buying potential; in theory, when Uber goes public and sells shares on the New York Stock Exchange, those initial investors will get a nice payday. That’s what happened for many venture capitalists when they provided funding to internet darlings. Twitter has billions of users and created billions of dollars in returns for its initial investors.

There’s only one problem: Many of these companies fail to live up to their potential. Twitter, despite counting the leader of the free world as a happy customer, has never earned a profit. It’s estimated that Uber has never earned a profit. Amazon, one of the largest companies in the world by market capitalization, has a profit margin of less than 1%. General Motors makes roughly 10 times more money than Amazon. Meanwhile, the main reason Amazon is profitable is the cloud computing services it offers – not merchandise sales.

Economists have a concept called the “greater fool” theory. Here’s how it works. Let’s suppose you see a sale on a lovely Dutch tulip bulb at $50. It may seem expensive, but if you can find someone willing to pay $55 then it makes perfect sense to buy it at $50. Some other “greater fool” will come along and buy it from you. Ultimately, only the greatest fool will pay the highest price and be stuck with a bulb. This is one explanation for asset price bubbles like the tulip mania that swept Amsterdam in the 17th century, or the madness that swept through Las Vegas during the housing bubble.

Why is this a problem? While venture capital has flooded Uber and other scalable startups around the world, it’s still very difficult for small and medium-sized firms to finance their growth. And these small and medium sized firms have employees and profits. Investors may anticipate only linear returns instead of riskier exponential returns, but at least they’re getting more than “potential.”

Additionally, our economy will get more than snake oil software. Twitter and Uber have created fantastic software. Both have changed the way people behave, whether through communication or travel. But a fantastic product sold below its cost does not create a fantastic company.

Sustained economic growth requires more than users and asset bubbles. To create long-term economic growth, an economy needs entrepreneurs with great ideas and access to capital to finance growth. Medium-sized businesses quickly run into barriers at the bank when it comes time to apply for a loan. Small businesses are often shut out of the lending market entirely and resort to high interest rate credit cards.

Data suggests most developed countries in the world are shifting from a manufacturing-based economy to a service economy. Twitter and Uber provide services that can grow from thousands to billions of users by adding more servers. Almost every other firm that sells an actual product or provides a simple service – vs. merely acting as a middleman – must grow at a more measured pace to keep product quality from slipping or costs from inflating. It’s difficult to grow at all when you can’t access the financial capital that showers down on snake oil software that has never sniffed profitability.

Perhaps one way to make America – and the world – great again is to invest in companies with tangible product and human capital, versus throwing money at tech start-ups that make big promises and enrich only a lucky few along the way, if at all.

 

 

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