As has been widely noted, 2019 is going to be a big year for tech IPOs. While certainly nothing like the massive 1990s wave of internet IPOs, this year will see a big run of billion-plus-valued Silicon Valley behemoths going public: Uber, Lyft, Zoom, Pinterest, AirBnB, and more. The twist is it's going to be the year of the billion-plus-valued but still unprofitable tech IPO.
Pinterest, which went public last week, has yet to turn a profit. Same for Uber, whose IPO is still coming; and Lyft, which debuted last month. In fact, the overall percentage of IPOs that were unprofitable in the year prior to going public is back to the previous peak reached just before the dot com bust. And the stock prices of recent unprofitable IPOs are generally doing better than recent profitable ones.
There is a reason for it, which begins with the idea of "network effects," but hiding within that phrase are a whole lot of details, which range from the interesting to the sinister.
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Now, a lot of the unprofitable IPOs are biotech companies. They're unprofitable for the traditional reason that they're sinking a lot of research and development into some new treatment or innovation, and investors are willing to bet big on it. But the rest of those IPOs are mostly tech and Silicon Valley outfits. And investors are willing to bet on eventual big payoffs from them as well, but for a different reason. And that's where the network effects come in.
These tech IPOs are all platforms of some sort. Pinterest is a platform for cataloguing and sharing ideas and interest, AirBnB is a platform for providing rentals, Uber and Lyft are platforms for ride-hailing, and so on. The idea behind "network effects" is that any platform like this becomes inherently more valuable the more users — both buyers and sellers — that it accumulates. The more people who use Pinterest or Facebook or AirBnB, the more attractive it becomes to yet more users. The more users the platform has, the more value it can ultimately spit out to shareholders.
What's going on in the tech world right now is a kind of land rush in platform markets. Companies and their investors are willing to accept short-term losses in order to grab as many users as quickly as possible. The idea being that, the more users they can get initially, the stronger their network effects will be, and the harder it will be for a competitor to ever dislodge them.
There are risks though.
Network effects are not one-size-fits-all. The type of effects available and their strengths can vary enormously depending on the nature of the platform and what it does. If a platform has one giant network (think Facebook or Google), then network effects can be a lot stronger than platforms that are comprised of a lot of local clusters (think Uber or Lyft). Another thing is how available competitors are, and how easy it is for users to switch between them. With Facebook, for instance, once everyone is using Facebook, there's really no point to them using other platforms, so competitors are shut out. For a platform like Pinterest, it's not even obvious who their direct competitors are. But with Uber and Lyft, it's quite easy for users — or at least the people hailing rides — to switch between the two platforms. Once a platform has connected a buyer and seller, there's also the question of whether the two need to stay on the platform to maintain the relationship. Homejoy, which connected house cleaners with clients, was ultimately done in when the homeowners and cleaners, having established a relationship, stopped using the platform and just communicated directly.
In other words, the invocation of "network effects" can sometimes be closer to a marketing gimmick than a concrete business strategy. In which case, some of the Wall Street investors paying big bucks for stakes in these IPOs may be in for an unpleasant surprise.
There's another risk, too. And it gets into the sinister aspect I mentioned. As Marshall Steinbaum, a Roosevelt Institute fellow who works on market power, explained to The Week, most of these companies have slipped through various cracks in America's business regulations.
Facebook and Google enjoy sweeping power over the information that we all see and hear, and basically get to decide what information gets out there and what doesn't. Companies like that arguably ought to be regulated as public utilities, with rules forcing them to treat all information equally. But so far they are not. Uber and Lyft keep their costs low by claiming their drivers are independent contractors instead of full-blown employees, which allows them to avoid paying drivers minimum wages or health benefits. AirBnB is effectively a hotel provider at this point, but isn’t subject to the licensing structures and other regulations that cover the actual hotel industry. "These companies exist because they've been allowed to break laws that everyone else has to follow," as Steinbaum bluntly put it.
Then there's antitrust law, which operates on a very narrow standard these days: Basically, as long as a company's behavior doesn't result in higher prices for customers, its behavior isn't considered anti-competitive. That leaves companies an enormous amount of room to monopolize markets, undercut rivals, and vertically integrate by absorbing other businesses up and down the supply chain. (Think of Facebook buying Instagram, or Amazon buying Whole Foods.) Decades ago, antitrust regulators would've squashed that sort of thing.
Uber uses its big private investment backers to eat losses and charge extra-low fares that push out rivals. It has also used algorithms to design pay in a way that discourages drivers from working for rivals like Lyft. "Predatory pricing is a strategy that makes sense if you are a growing company in an environment in which network effects are important," Steinbaum explained.
We just learned that Facebook, upon identifying a possible rival to its messenger app, denied that rival access to Facebook's user data — effectively ending the competitive threat.
In a sweeping paper calling for a reform of antitrust law, Columbia Law School's Lina Khan documented how Amazon uses its platform to direct buyers towards many of the products it provides itself, and away from competitors. In other instances, Amazon uses those same powers to undercut sales to successful third-party vendors on its platform, driving down the vendor's market price until Amazon itself can buy them on the cheap.
This isn't just an unfortunate side issue. The ability to keep operating in these legal gray areas is integral to the value propositions these companies are making to Wall Street. If we started using old-school interpretations of antitrust law, forced companies like Uber to follow labor law, or treated Facebook like a public utility, these companies wouldn't go away. But they would become much more modest — the massive payouts investors are expecting would never come, and the companies' stock valuation would plummet.
This gets us back to the IPOs themselves. When we say Uber is worth $100 billion, for instance, there's no actual pile of $100 billion sitting around that Uber's owners can draw on. It's all conceptual value. And if Uber's play for maximum network effects fails, or the government actually starts regulating it, that conceptual $100 billion goes away.
The IPOs are a way to hedge against that risk. Historically a way to provide companies with fresh capital, IPOs are now used to cash out the pre-existing owners and investors: they turn that conceptual $100 billion into liquid cash the original owners can hold onto whether the company succeeds or not.
Combine that with the increasing use of tricks to make sure that founders maintain absolute control over their companies even after going public and what you have is a situation where tech entrepreneurs get to have their cake and eat it too. They'll stay filthy rich whether their monopoly plays succeed or not.
