Startup Venture Capital and Ponzi Schemes: A Valid Analysis?

By Sergio Romo, Co-founder of Investomex, a venture capital fund focused on Mexico and Latin America.

A few days back, a tweet from @fedecasas sparked an interesting discussion on my Twitter feed between the author of the blurb, @jonathanlewy  and me. The tweet read, “The role of venture capital seems more and more like a Ponzi scheme.” My first reaction was one of surprise (and disgust) – I couldn’t see any similarities between the two.

Wikipedia defines a Ponzi scheme as “a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from profit earned by the individual or organization running the operation. The Ponzi scheme usually entices new investors by offering higher returns than other investments, in the form of short-term returns that are either abnormally high or unusually consistent. Perpetuation of the high returns requires an ever-increasing flow of money from new investors to keep the scheme going.”

Throughout our conversation, @fedecasas sustained that many investors cede to the temptation to inflate the valuations of the companies in which they invest and, in turn, make money. That money comes from future investors, acquiring companies or public investors in the case of IPOs, who pay for that inflated valuation. This, according to @fedecasas, is comparable to what happens in a Ponzi scheme. Upon analyzing the conversation thread on how most early-stage startup investment rounds currently take place, the analogy doesn’t seem so out of line.

Today, most accelerators operate with a “spray and pray” scheme, investing in many companies and hoping that a few will really pay off. It is a completely mathematical model based on personal assessments of teams and a little bit of gut feeling.

Let’s say an accelerator makes 20 US$50,000 investments by way of convertible notes (debt) with a cap of US$1 million. This means that the investment will be capitalized in shares at a maximum valuation of US$1 million (the accelerator having obtained a minimum 5% of the company). The total amount invested by the accelerator in this example is US$1 million.

Many accelerators assume that the startups that have completed their programs already have an added value or pedigree (which is, in many cases, unjustified) and thus instruct their startups to raise their second round with valuations of around US$3 million. Continuing the example in which the accelerator has assured a 5% stake in each company, it needs at least seven of those initial 20 startups to close those rounds (5% / US$3 million = US$150K x 7 = U$1,050,000). Y Combinator, the most prestigious and successful accelerator in the industry, closes rounds of about US$6 million for its startups following its Demo Day.

High valuations favor less dilution for founders, which I believe is right. However, there is one big problem. Who pays for the earnings and capital appreciation of the accelerators? Can startups really justify such a high valuation?

This is where @fedecasas sees an analogy between the aforementioned methodology and a Ponzi scheme. Valuations are inflated and, sooner or later, someone has to pay. The most recent and extreme such case is that of Facebook, in which Wall Street investors paid for an exaggerated valuation of US$100 billion following various VC rounds only to see the value of the company drop to US$50 billion weeks later, incurring huge losses. Pieter Thiel, an early investor in Facebook, made nearly US$600,000 by selling his shares. A Ponzi scheme? Not entirely – liquidation events are different. Investors know that the prices they pay are not always real, and an essential part of fraud – deception – is not present. In Ponzi schemes, the victims are lied to and completely fooled. Nevertheless, it is important to note that something may be off with this kind of investment methodology.

The (good) accelerators are responsible for generating great amounts of value. They strengthen the entrepreneurial ecosystem and teach entrepreneurs to create products and change the rules of certain industries. Accelerators trigger entrepreneurship and change the way businesses start. Without a doubt, the (good) accelerators make a contribution to changing the world, starting with their local ecosystems. But to what point is this value generation justified? At what moment does this become detrimental to startups?

Here are some arguments regarding the disadvantages of current venture capital strategy:

– Future investment rounds may be blocked if investors are unwilling to pay a price they consider unjustifiably high (for example, for a company that has little traction, no valid market, low sales, etc.). Some accelerators include anti-dilution clauses that are not only unacceptable for some investors but also unfair to entrepreneurs. The valuation and participation they thought they had is lowered, because in following rounds, they are the ones who face dilution, not the seed-capital investors.

– On paper, accelerators’ yields are paid by later investors, who are expected to find a balance between adjusting to the practices and standards of the market and paying an inflated price to get in the game.

– The size of the returns on an exit (especially in the cases of startups that are clones of successful companies in the United States and Europe) is reduced or null. Because the startup was so over-valued, it is hard to justify a selling price higher than the valuation at which it closed its last investment round. There seem to be gains, but when the exit finally comes, the reality can be harsh.

– When the startups involved are from Latin America, sending them to the United States or taking a seed investment from an American entity implies having to play by a different set of rules. The big problem here is that when the Latin American startups (whose market is Latin America) seek out these high valuations in the United States, they don’t get them. They are forced to go back to their countries where such valuations are even less justifiable.

– If seven of an accelerator’s 20 startups can justify these high valuations (and this is very rarely the case), that means that there are 13 that can’t. Accelerators have to stop presenting the companies they think (and know) can’t do it and offer real values to investors. They can’t give in to the pressure to multiply their capital on paper.

– The world of entrepreneurship becomes a meritocracy. Instead of concentrating on growing their businesses, entrepreneurs are forced to shift their attention to justifying suggested valuations. It is a world in which only the most “apt” survive as opposed to one of growth at a natural pace of market penetration and product adoption.

– The accelerator’s value in the speed and agility of its investments is lost when three or six months later it becomes clear that one or two thirds of its portfolio is trash.

Taking into consideration their needs in terms of sustainability and profitability, while at the same time mitigating the detrimental effects of their investment methodologies, how can accelerators continue on as essential players in the startup world?

See the discussion, and share your thoughts:

This text has been adapted into English by Emily Stewart from its original Spanish publication.