When the Music of the “Wealth Effect” Stops

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by Wolf Richter, Wolf Street:

The phenomenon has reached historically huge proportions in the Everything Bubble era. But it comes in cycles – with a big impact on the real economy.

OK, so here we have a phenomenon that has taken on historically huge proportions in the era of the Everything Bubble: More or less wealthy people with liquid assets are plowing their money into cash-burning companies, and not just startups, but big companies too, that have been around for many years with tens of thousands of employees and billions of dollars in revenues, that are still burning cash. And there are a lot of them.

Some of the most shining examples just this year are: Tesla, which received another $2.3 billion from investors in early March; Netflix, which received another $2.2 billion from investors in April; Uber which received another $8 billion from investors during its IPO in May. Tesla and Netflix will burn through this money in about a year. Uber might take a little longer.

Then there are a whole bunch of permanently cash-flow negative fracking operations that received all kinds of funds. But it also includes the many hundreds of startups that receive millions and billions from investors without even having a business model or revenues.

This is big money flowing into this companies, and these companies then go out and invest and spend this money until it’s gone, and investors are then asked to give them more money. This is so routine and it happens all the time now, and in every larger quantities. While there is a little bit of hand-wringing about it in some corners, included by yours truly, because it shows the excesses currently underway, it doesn’t appear to be slowing down. On the contrary.

Investors that chase yield and profit opportunities are eager to go out on a limb and hand over their money to these companies that then spend and invest this money.

So here is why this is great – for the real economy and the people that work in it, and why the big S is going to hit the fan if this ever slows down or stops as these investors are getting mangled.

Let’s use the example of a tiny startup. A couple of guys have an idea and got some angel funding, and with this funding they developed their idea. And so a year later, they get $2 million from VCs. And these two guys hire some people and pay their salaries with this money, and they rent an office and pay the lease, and they use this money to buy computer equipment and furniture and mood-lighting and some craft brews to put into the corporate fridge in case of an energy.

And after 10 months, they’ve spent most of the $2 million, and now they are able to raise $4 million from VCs, and they hire more people and put more craft brews into the corporate fridge and buy more computers and pay more salaries and payroll taxes, and the like. They spend every dime that investors give them. And before they run out, they get more money.

Then the service they’re working on is ready to go live, and they raise $50 million and hire more people, and buy more beer, and much of the new money they raised is dedicated to advertising to launch their product, and so they buy ads for $40 million, most of which goes to Facebook and Google.

Everything this company spends goes into the economy, and directly or indirectly ads to the economy as measured by GDP.  The office lease is a service, and is added. The computer equipment and the beer and the furniture the company buys are added to GDP. The salaries it pays are being spent by the employees on rent and restaurant meals and smartphones and Uber fares and furniture, etc., and in this way, their salaries are converted into economic activity that is added to GDP.

And the businesses that sell this beer and the furniture and the ads, they too pay their employees from those funds, and they buy stuff too. And so the investor-money that the startup received in multiple rounds of funding enters the real economy and is being constantly recycled to generate business activity elsewhere.

And everyone is happy. The investors are happy because the startup, which is burning a huge amount of cash, is getting some traction, and these investors hope that a few years down the road they get billions of dollars when this company has its IPO or is acquired by Apple or Alphabet.

And the executives of the startup are happy because their joint is going in the right direction and because their equity stakes are starting to have huge valuations though the company might not yet have made a dime in revenues.

And the employees are happy because they have a job and because they too see the equity event at the end of the tunnel that they hope will make them rich.

And all the companies that sell them stuff, from Facebook and Google to the craft brewer are happy because they sell them stuff and they’re getting paid, which allows them to pay their employees.

And the governments at all levels are happy because they’re collecting various kinds of taxes and fees from the company and its employees.

And if Microsoft comes along and outbids Apple to buy the company for $2 billion, then everyone is even happier, and the equity holders are getting paid off with money Microsoft extracted from its customers. And the recipients of Microsoft’s money then plow some of this money into new startups, and they spend some of it, and they put some of it in Treasury securities, just in case.

In the worst-case scenario, it doesn’t get this far. After raising $10 million, investors lose faith and decide not to fund it anymore. After the beer is gone, the company will lay off its people and break its lease and sell the furniture and shut down.

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