It’s Not a Bubble, People; It’s a Pyramid Scheme | Hacker News Reader

It’s Not a Bubble, People; It’s a Pyramid Scheme

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173 pointscwan58 comments

Mark Cuban's statement is only true if the VC financings are simply a buyout of previous investors. Many of Facebook's recent financings were capital injections + buyouts of founder and early VC shares. I don't believe this is the norm. Simply, VCs at round t-1 typically participate in round s > t and if they don't, future investors will not buy them out. If they did, it would simply mean that none of the money going to firms like Twitter and Zynga is used for investment.

Thinking about this a bit more, Mark Cuban is essentially arguing that recent VC investments are equivalent to the activity that takes place on Second Market and others like it. If that was so, Twitter, Zynga and Facebook would have to buy all those servers and pay their employees out of profits. Of course, most of these VC-backed firms aren't profitable, so VC money must be going to the firm.

Surely it wouldn't mean much if $100 out of the last round to facebook went to operations with the remaining money cashing out employees and investors, so where's the line?

What if half the round cashes out prior investors?

Is there any way to find out if prior investors are cashing out or not, and if so how much?

Lot of people including Mark Cuban predicted that Youtube is a sinking boat and that Google made a horrible mistake in buying it. Look at the present situation - youtube is raking in 1B per year.

Any market leader facebook/zynga/twitter with their user base can become a cash cow with enough focus. No one else in the world get internet companies like valley/US does. This is the single most reason every other country's .com company gets traded in nasdaq.

Agreed.

It seems human beings are really bad at mathematics, we could spot a quality, but not the quantity.

In Spain people thought houses near the beach were always in demand by Europeans because of the good weather(quality), but failed to understand there is a limit to the money they will pay for it(quantity).

With facebook people could see the value it gives to the world witch is real (quality) but overstates the amount facebook is going to give back.

facebook is a pyramid scheme designed to make uber-rich the current shares holders(Zuck and employees hold near half the company stock), witch is great for them, bad for those that payed the overprice.

There is some serious witch hunting to be done in this thread.

Toss them in a river.

If they sink they are innocent.

If they float they are in a bubble.

Or you could just weigh them against a duck !

One thing that the last boom showed is that the first well executed play in a segment captures the segment and makes competition nearly impossible. Examples Google, Amazon, and eBay. The investors are betting that Facebook, Groupon, Zynga, and Twitter have captured their segments and further competition is impossible. The gamble is whether those segments are now closed. They weren't in the case of Alta Vista and Myspace.

I agree that the investors are making that gamble. A better way to look at Google though is as a company that made major breakthroughs in two segments (search, advertising) and then executed brilliantly for years while benefitting greatly from its rivals' (Yahoo and Micro) sustained incompetence. Which of the new group has breakthroughs in two segements? Which is on track for years of sustained brilliant execution? Which will be lucky enough to have incompetent rivals?

It seemed that MySpace belonged in the former group not too long ago, dominating competition like Friendster. With only ~10% of the world's population on Facebook, it may still be too early to speak definitively about the future.

Sure, but at the same time I think it's worth also taking a moment to think about this number. 10% of the world's population has an active Facebook account. That's staggering. The best number I can find for MySpace is 100 million active users. It's easy to misrepresent the scales involved just because they're so very large, but the difference between 100 million and 600 million is huge. 17 year olds are fickle consumers. 53 year old Aunt Sue is not. How many people still have a paid AOL account simply because they don't want to lose their email address? AOL's stayed alive for YEARS on them. I don't think Facebook is particularly overvalued: it may not be what all of your friends are using 5 years from now, but it's going to be a very, very big and profitable company for many, many, many years.

I wouldn't take face cook's claim that they have 600M active accounts to mean that they actually have 600M active users. If you wander very far from your own "neighborhood" you'll reali ze that there are a lot of bogus accounts used by spammers.

But aren't bubbles and pyramid schemes the same thing? The article should really define bubbles if it wants to argue they're different from pyramid schemes.

Bubbles are usually fueled by public manias (e.g. tulips or real estate). Pyramid schemes are planned frauds.

Ok, but both rest on the "greater fool" theory...

Yes

A pyramid scheme is a very specific type of fraud: starting with a very small group and adding tiers of people, using the entry fees (whatever the pretense) of the lower tiers to pay dividends to those in the higher tiers.

I think he's making "a distinction without a difference".

Pyramid schemes, Bubbles and Ponzi schemes are all instances of what Hyman Minsky called Ponzi Finance. They all "recycle" new "investment" money coming in as their operating income.

http://en.wikipedia.org/wiki/Hyman_Minsky#Minsky.27s_theorie...

A "pyramid scheme" makes it more explicit that the earlier entries get more. If you make that less explicit, what else do you have but a "bubble"?

The reason not to worry about these variations is that there aren't really three distinct variations of this theme but three million, with one born every minute - along with the suckers.

I've been wondering recently - a phenomenal amount of money and investor excitement is circling around these few big companies. If it turns out that they are overvalued and the 'bubble' does burst, does this mean there could suddenly be a surplus of capital and investor attention that will spill over into smaller, less well known businesses?

If everyone who is waiting to get their piece of Facebook or Groupon suddenly thinks better of it, could they decide to redirect their money toward smaller interests, increasing the availability of capital for 'the rest of us'?

If the 'bubble bursts', then isn't it more likely that they'll be scared away from the sector in general and just invest their money somewhere else?

That's what I'm asking. I don't think it's particularly clear cut.

If the people pumping up the value of Facebook are thinking strategically about the tech sector - and see Facebook as the best place in the tech sector to put their money - then perhaps. If they're just opportunistic, looking to make big bucks on a new household name during a time that the old household names aren't doing too well, that's another thing entirely.

Eventually, that is the beneficial effect of a bubble bursting. On the downside, the short term of a bubble bursting brings risk aversion and particularly aversion to debt.

I'm in agreement with the linked article that the "valuations" of companies like Facebook and Groupon are facially absurd. Facebook is worth $60 billion? On what planet? Yes, they have a lot of users, but are they monetizing them to the degree necessary to sustain that valuation? Facebook's books are a black box so we may never know, but my strong suspicion is no.

The little mini-bubble going on in some tech startups as well as the bubbles building in asset classes like commodities are the direct result of nearly every nation in the world pursuing the "beggar thy neighbor" (read: currency devaluation) strategy at the same time. The money pouring off the printing presses and/or being borrowed by national governments is heading straight into these types of investments. When that cycle ends, prices are going to drop like a rock.

Back to the original comment, the "boring" or smaller companies being ignored in the frenzy will benefit from that, eventually. But first the damage done by bubble will have to be healed, and that can take awhile.

>could they decide to redirect their money toward smaller interests, increasing the availability of capital for 'the rest of us'?

Probably not. That money is pretty much stuck there, as VC is an illiquid investment. Money invested in Groupon isn't going to get paid back until they have a "liquidity event", like being bought or IPOing, or until you can sell it to another investor. However, it's possible a larger fraction of new VC investments could be targeted at "the rest of us".

I was actually referring to the cloud of people who may be planning on participating in an eventual IPO rather than those who have already invested.

Well it's definitely not a one-for-one distribution, but those Groupon dollars do make it around. Our site has Groupon ads popping up almost constantly, and actually tend to yield a higher clickthrough.

Massive injections of capital into Internet businesses do help overall economy of web startups. The danger, like the Yahoo comment earlier, are the spotty business models and expansion that are built on that frothiness. Cause when it goes, it's those startups that crumble first.

The ones that figure out a business model that isn't tied to a flush VC climate should be ok. eBay as I recall, did just fine after the first bubble.

It will have gone full circle when Facebook, Groupon and Twitter will have an IPO. VCs and other investors will get their money back and individual investors will absorb the losses of the collapsing pyramid.

All bubbles are Pyramid schemes. That's the definition. See The Financial Instability Hypothesis by Hyman Minsky:

http://www.levyinstitute.org/pubs/wp74.pdf

http://en.wikipedia.org/wiki/Hyman_Minsky

When the economy reaches the third phase of "Ponzi Finance," entities must recruit additional investments to meet their interest payment obligations. This is the classic pyramid scheme and also frequently called a bubble when it's referring to a financial market.

Ponzi scheme, Pyramid scheme and bubble are all synonyms.

Not really. A bubble can be a self-organising Ponzi scheme - earnings from Yahoo came from advertising which was paid for by capital going into the tech bubble; and the pre-GFC US economy was arguably one giant bubble (with earnings being paid by people who were willing to do overtime to keep their million dollar houses out to the hock), but it's not quite the same thing.

They do have the same (or similar) dynamics though.

You can't just equate Minsky's 'Ponzi Finance' with a 'Ponzi Scheme' just because they both have the word 'Ponzi' in them. Minsky used the idea of a Ponzi scheme in creating his own technical term to describe speculative borrowing.

Also, Minsky's theory of financial instability doesn't apply to all bubbles, it's a theory concerned with financial instability as a result of increasingly speculative debt and borrowing. You can have a bubble without debt.

I suppose Cuban's comments ring true if you think that Twitter and Facebook are adding no value.

I am unsure how any rational technology-minded person could state that they add no value; the idea that a technology which is one of the first Governments try to ban when they are under fire -- that the technology must not be worth anything -- is pretty staggering.

Facebook has a pretty clear path to socially connecting THE ENTIRE WORLD via the Internet, and has proven it can do it in a cashflow-positive way.

I fundamentally don't understand the 'bubble' complaints right now: these companies are the anti-boo.com's of our time: Wildly successful, working, scaling businesses which millions of people rely on every minute to do their work and socializing.

Focusing on valuation for smaller companies also seems silly to me: the YC class that just got $150k per company will be able to punch out some incredibly great and useful technology for that money. In 1999, that money would have purchased 2-5 servers, and no co-location for them. Really. You can worry about a bubble, but if these companies even produce 300k in value, then the investors didn't invest in a bubble, they got their principal back plus a little.

I do think it likely we'll swing back to a slightly less founder-friendly funding regime at some point in the future, but it may also be that we're just at a new plateau given what's currently possible in software. Another shift might change funding dynamics again in our industry; but right now, a whole lot of useful tool can be created for a couple hundred thousand dollars.

Cuban never said anything about those companies adding no value or being worth nothing. He just said they might be overvalued.

Well, calling it a chain letter / pyramid scheme is incendiary without a doubt. On the other hand, we're talking about Cuban, so I guess your point stands. Once de-Cubanized, he said just what you said.

"Facebook has a pretty clear path to socially connecting THE ENTIRE WORLD via the Internet, and has proven it can do it in a cashflow-positive way."

Yes, I see that they can connect. And maybe tomorrows revolutions will use facebook -- but the fact remains that I value my privacy and those of my social relationships. That's just it.

You might, but all the people using Facebook really don't. Especially the whole 13-33 contingent raised with the internet - the convenience of being able to keep in touch with your friends circle is worth more to them than their privacy.

If you think privacy concerns are going to hinder Facebook's profitability you're completely wrong.

Maybe tomorrow's? Today's revolutions are already organized on Facebook.

This is unoriginal. And as someone else stated on FT, the last layer of the pyramid scheme is probably aimed at dumb money. Unintelligent mutual funds (mis) guided by S&P and Moody's ratings for inflated assets. Just like it happened in 2006-2007. I believe more "AAAA++++ would buy again" ratings from random people on auction sites than credit rating agencies. It's a scam with many players. The agencies get their cut, too. And there's no downside for them (mostly).

Edit: it happened with government bonds, too; in fact it seems they move on to the next scam every year.

S&P / Moodys are rating companies for debt, not equity. The investment proposition for someone lending a company money as a secured creditor is very different to someone investing equity, and I'm not sure that it directly results in investors getting any profits.

Yes. I'm wrong. But the ratings of the debt of corporations are highly correlated with their valuations.

Edit:

To be clear, I was talking about dumb money. Usually indexed funds and such. Enron was part of S&P 500 for years.

I don't get it. It sometimes is the case that early-stage investors sell off parts of their shares in later rounds, but this is not the norm. In which case yes, there is pressure on later investors to give high late-stage valuations for a company which had high early-stage valuations, but it's not the case that angels and early-stage VC's can ignore the company's final outcome and profit merely by bringing in later stage investors, which is the distinguishing feature of a pyramid scheme.

Any money paid for private or public companies is entirely voluntary on the part of the seller and the buyer. If you don't like what your investment manager invests in, it's easy to move your money elsewhere, unless you weren't smart enough to insure you had a way out of your investment promise. If you want to be one of the early investors who gains the most reward, then be one of the early investors who takes the most risk.

How is this different than the economy as a whole? Look at seniorage and Milton Friedman's take on what caused the Great Depression. As money circulates in a fractional reserve banking system it multiplies. The last guy holding the dollar is the guy who loses most. In times of exuberance that multiple is greater than 1 and in times of pessimism that number is less than 1 which is why consumer confidence is essential to the functioning of the modern economy.

Start thinking of money more as a piece of information reflecting scarcity of supply/demand, and realize that the faster information moves the faster money will cycle increasing it's rate of growth. It's called an information economy for a reason, because the commodity from which we derive most of our value is information. This is largely why it doesn't matter that China is taking "our" manufacturing base. You can point to the importance of things like iPhones being manufactured in China, but for the economy as a whole the AppStore is far more important than the manufacture of the phone. As information bandwidth increases globally so does money supply.

"Either way, when the chain ultimately ends, few, including Cuban, will feel terribly sorry for those left holding empty envelopes."

Except that lately it is usually the general public that is brought in, to help the investors no longer be the last in the chain. Maybe this will begin to happen with VC financing?

Along the lines of the quote I have read from several sources "when my barber and the shoe shine boy has a stock tip, it's time to get out."

I agree. In the 90's bubble the public got let in earlier. Now VCs and investment banks squeeze all the value out before the public finally can invest.

In economy, if you want to avoid bubbles/pyramid burst, you have to check who is investing (as stated by Warren Buffet)?:

The three "I" actors: - "I"nnovators: Time to invest - "I"mitators: Time to be careful - "I"diots: Time to leave

The key to success is to spot when the ecosystem's actors are switching from the 2nd to the 3rd category.

umm, hate to point this out but assuming Cuban's point is true (which is obviously highly debatable), the people with the most to gain are the founders (from being at the tip of the pyramid) aka most people on this thread hence there is probably a strong bias towards not recognizing the issue

Ponzi Scheme are everywhere: http://www.youtube.com/watch?v=ITMEZImvNio (Slow/questionable start... because he is trapping the guy)

But whose money is in those funds managed by the fund manager?

Probably your pension.

Not unless your pension manager has some really huge cajones.

That's not true. Pension managers are increasingly turning to fund of funds hedge funds, etc. It would only take fundA investing in a private equity or a social media financial product and then a pension manager investing in fundA for whatever reason.

What would the draw of a highly volatile pension investment be?

I would think that pension managers would be encouraged to keep something that would generally have a stable (but not necessarily particularly high) yield.

I don't doubt that this sort of thing happens for various reasons, but those managers would, by definition, be taking somewhat unusual risks.

The risks are often masked. This is an extreme example, but imagine a fund of ultra safe bonds and an investment in Zyanga, Facebook, Twitter, etc. Depending on the make up of the fund that particular funds risk profile may look similar to what might be called a moderate risk growth fund.

Now, a fund buys that fund and puts it with a bunch of other funds and now the risk profile is under another level of obscurity.

Now a manager buys that fund of fund and puts it with other financial products and that's your pension. Basically, the further you get away from the actual investment the more diluted the risk profile becomes. What could potentially happen is that a particular manager is buying products that somehow are invest in a particular sector (perhaps too heavily, and it is masked via the layering) and the sector pops and what he thought was diversity is actually concentrated risk.

s/cajones/cojones/

cajones .- crate, drawer, or box http://en.wikipedia.org/wiki/Caj%C3%B3n

Whoops. If I could still edit my post I would. I'll settle for an upvote here and hope people get the point :)

Agreed. http://bit.ly/tcangelgate is a good example of pyramid-scheme-like behavior.

The guy has a very good point.

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