We all know that valuations in the private markets are high at the moment and generally ahead of public market valuations. There are multiple reasons for this including principal agent issues in venture capital and most importantly the potential for exponentially increasing returns in network effects businesses. The one I want to focus on today though is a potentially wrong assumption about long run profitability.
Craigslist has not invested in a native mobile experience and as a result there are numerous startups chasing the opportunity to be a mobile first/only Craigslist replacement. Here are just some prominent examples: OfferUp, VarageSale, Mercari, and Wallapop (but there are several others). All of these companies have been growing rapidly and have raised significant rounds of funding.
It is entirely possible that one of them will build a marketplace (network) that’s an order of magnitude or more larger than the next. That may still not mean though that it can capture much value. Why? Because unless the other companies disappear entirely – as they maybe run out of money and have too high a burn rate – one of the vectors of competition will be the take rate. Now add to that the potential for fully decentralized networks to emerge based solely on blockchain protocols (for identity, transactions, reputation) and you have a scenario where even the winner is a lot less profitable than currently envisioned.
I have recently written about this possible outcome for marketplaces but am revisiting it today because I see a similar dynamic in almost every sector. Take SaaS companies as an example. There are many rapid growth SaaS companies out there and again if you extrapolate their current path you can easily tell a story that justifies their valuations based on future profits. The problem is whether those profits will ever be achievable, or if they are, whether they will be sustainable for long.
For instance, for almost every SaaS company that charges for features there are now new companies being built that give the features away with the goal of charging for some activity in the network that they are looking to build (Zenefits is highly successful example of that because they found a way to give the features away and make money right away).
Put differently: we may have entered a great period of profit destroying innovation where the benefits accrue more and more to the customers and not the providers. The only sustainable profits would seem to come from a network effect where the overall rate of profit is kept low enough relative to the scale of the network to prevent activity from slowly migrating to other networks. If that’s the case, then the high bidders on investments will be those who are most optimistic about future profits which in a competitive auction environment can result in the winner’s curse phenomenon. The average valuation for the company will be right but the winning valuation will be meaningfully above the average.
This view provides an explanation for why public market valuations may be saner at the moment than private ones. The trading process in the public markets will be influenced by all valuation views, whereas private market valuations are driven primarily by the highest bidders.
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Albert Wenger
