Tuesday, August 8, 2023

Predatory Pricing

Adam Rogers' The dirty little secret that could bring down Big Tech is based on work by Matt Wansley and Sam Weinstein of the Cardozo School of Law, who questioned why the investors in companies such as Uber, Lyft, or WeWork would sink:
billions of dollars of capital into a money-losing business where the path to profitability wasn't clear?
The answer is the remarkable effectiveness of predatory pricing at making money for VCs and founders. Rogers writes:
Wansley and Weinstein — who, not coincidentally, used to work in antitrust enforcement at the Justice Department — set out to change that. In a new paper titled "Venture Predation," the two lawyers make a compelling case that the classic model of venture capital — disrupt incumbents, build a scalable platform, move fast, break things — isn't the peak of modern capitalism that Silicon Valley says it is. According to this new thinking, it's anticapitalist. It's illegal. And it should be aggressively prosecuted, to promote free and fair competition in the marketplace.
Below the fold I discuss Wansley and Weinstein's paper and relate it to events in the cryptosphere.

January 2017's Yale Law Journal contained Lina M. Khan's influential Amazon’s Antitrust Paradox. In the abstract Khan wrote:
Although Amazon has clocked staggering growth, it generates meager profits, choosing to price below-cost and expand widely instead. Through this strategy, the company has positioned itself at the center of e-commerce and now serves as essential infrastructure for a host of other businesses that depend upon it.
We cannot cognize the potential harms to competition posed by Amazon’s dominance if we measure competition primarily through price and output. Specifically, current doctrine underappreciates the risk of predatory pricing and how integration across distinct business lines may prove anticompetitive. These concerns are heightened in the context of online platforms for two reasons. First, the economics of platform markets create incentives for a company to pursue growth over profits, a strategy that investors have rewarded. Under these conditions, predatory pricing becomes highly rational—even as existing doctrine treats it as irrational and therefore implausible. Second, because online platforms serve as critical intermediaries, integrating across business lines positions these platforms to control the essential infrastructure on which their rivals depend. This dual role also enables a platform to exploit information collected on companies using its services to undermine them as competitors.
Wansley and Weinstein's abstract reads:
Predatory pricing is a strategy firms use to suppress competition. The predator prices below its own costs to force its rivals out of the market. After they exit, the predator raises its prices to supracompetitive levels and recoups the cost of predation. The Supreme Court has described predatory pricing as “rarely tried” and “rarely successful” and has established a liability standard that is nearly impossible for plaintiffs to satisfy. We argue that one kind of company thinks predatory pricing is worth trying and at least potentially successful—venture-backed startups.

A venture predator is a startup that uses venture finance to price below its costs, chase its rivals out of the market, and grab market share. Venture capitalists (VCs) are motivated to fund predation—and startup founders are motivated to execute it—because it can fuel rapid, exponential growth. Critically, for VCs and founders, a predator does not need to recoup its losses for the strategy to succeed. The VCs and founders just need to create the impression that recoupment is possible, so they can sell their shares at an attractive price to later investors who anticipate years of monopoly pricing. In this Article, we argue that venture predation can harm consumers, distort market incentives, and misallocate capital away from genuine innovations. We consider reforms to antitrust law and securities regulation to deter it.
The idea of lavishly subsidizing a company's customers wouldn't be attractive to most investors, but Wansley and Weinstein explain the attraction for VCs:
VCs are motivated to fund predation because it can deliver the rapid, exponential growth that venture investing requires. Venture funds are invested in portfolios of startups. The distribution of returns from a successful venture portfolio follows a power law. Most of the startups will fail or generate only modest growth, but one or two will grow exponentially. The outsized returns from those outlier companies must offset the losses from the rest of the portfolio. The skewed distribution of venture returns makes VCs focused on upside potential and relatively insensitive to downside risk. They seek out startups with the potential for rapid, exponential growth and push them to take risks to realize that potential.
It is likely that VCs' focus on "venture predation" really started with Amazon. Jeff Bezos was clear from the start that Amazon's business model was not about generating profits, but instead about devoting free cash flow to "scaling". i.e. using predatory pricing to monopolize market segments. The graph shows how extraordinarily successful this strategy was in investing in growth.

Bezos convinced investors that eventually the company would be able to extract monopoly rents and thus profits from the markets it monopolized and, despite these profits continuing to remain in the future, investors bid up the stock. The result is a company with a market cap of $1.3T and a P/E of 313. This P/E indicates that the stock market still believes that eventually Amazon will switch from scaling to generating profits, a triumph of hope over experience.

Amazon's business model is viable; it could generate profits, the company just decides not to. The success of Amazon inspired "venture predators" to try the same "Lucy and the football" strategy with the stock market without needing a viable underlying business model. Uber is the canonical example of this. Hubert Horan has routinely analyzed Uber's financials and each time demonstrated the use of misleading and manipulated figures to create the false impression of profitability. For example, his most recent post, Can Uber Ever Deliver? Part Thirty-Two: Losses Top $33 Billion But Uber Has Avoided The Equity Collapse Most “Tech” Startups Experienced, analyzes Uber's 2022 results which showed:
a GAAP loss of $9.1 billion for full year 2022 (a negative 29% net margin) ... GAAP Net Income from ongoing operations was negative $2.1 billion, producing a net margin of negative 7.4% and bringing a legitimate calculation of its cumulative GAAP losses to $33.3 billion.
Despite this, Uber claimed to be profitable. Horan documented the basis for this claim:
But earnings inflation returned in the fourth quarter as Uber claimed that its Didi stock appreciated by $773 million. Uber made no effort to explain exactly how a company that had been delisted from exchanges, been blocked from adding new customers and abandoned by investors in the US could be confidently judged to generated this much corporate value since September. More importantly Uber made no effort to explain why speculative numbers of this magnitude should be included in the headline numbers provided to investors about Uber’s current profitability.
Uber has "invested" $33.3B in destroying the taxi business, but has never been profitable on a GAAP basis and has no realistic path to profitability on that basis, which is the definition of "venture predation". Only the VCs and insiders made money; the stock spent most of its history below the IPO price and, after 4 years, is just 12% up.

And now Uber is running out of money to subsidize rides, and riders are discovering that the un-subsidized price is astonishing. Steven Levy discovered this on his way to interview Dara Khosrowshahi:
Fifty-one dollars and 69 cents. That was the charge, including tip, for the 2.95-mile trip I took last May from my downtown New York City apartment to the West Side facility where Uber was holding its annual product event, called Go-Get. The ride-hailing company’s charges have been higher in recent years, and fluctuate in any case, but that was nuts.

As Uber CEO Dara Khosrowshahi knows, high rates are one consequence of trying to run his company as an actual business, as opposed to a scorched-earth feral growth machine.
For years, Uber juiced growth by subsidizing prices. It lured riders and devastated the taxi business. You’ve now stopped the subsidies, and people are reporting sticker shock. We certainly feel it in New York City. I traveled 2.95 miles in an Uber to get here today, what do you think it cost?

Twenty bucks.

Fifty dollars.

Oh my God. Wow.

And that was my second try. Five minutes earlier, the price was $20 higher.

Yeah, surge pricing.

A surge makes no sense. It’s 10 am on a sunny weekday, and it’s not like the president’s in town. I do agree that this is higher than I normally see, but in general, an Uber now costs more. Do you worry that those who adopted the service because of attractive pricing might be rethinking their ridership?
Wansley and Weinstein write:
Will Uber ever recoup the losses from its sustained predation? We do not know. Our point is that, from the perspective of the VCs who funded the predation, it does not matter. All that matters is that investors were willing to buy the VCs’ shares at a high price. The VC firm Benchmark, which led Uber’s Series A round, generated a return of about $5.8 billion on its investment. To Benchmark, Uber was a smashing success.
In other words, "venture predation" is a strategy of creating hype about the inevitable progress moonwards of the stock of a budding monopolist then dumping the stock on retail before it becomes clear that the business model doesn't actually work.

Viewing "venture predation" as a precursor, you can see why VCs were so attracted to cryptocurrency List And Dump Schemes. They didn't need to be funded with billions of dollars, they didn't need the time and people to, for example, flood the streets with gig workers and their cars, they didn't even need manipulated financials to create the hype. All that was needed was a white paper that could persuade Coinbase to list the coin. One VC in particular found it easy to persuade Coinbase. Andreessen Horowitz (A16Z) was an early investor in Coinbase.

Chia price
Crypto-bros were pre-conditioned to throw money at new listings, especially those on Coinbase backed by marquee VCs. The graph shows that Chia Network, backed by A16Z, is a typical example; I wrote about it 5 years ago, and Helium is a more recent example. Fais Khan diagnosed the strategy in "You Don't Own Web3": A Coinbase Curse and How VCs Sell Crypto to Retail:
If coins, especially VC-backed coins, consistently underperformed Bitcoin/Ethereum after listing on Coinbase, that says to me that insiders were waiting for a big, dollar-based exchange to list so they could sell - VCs taking profits at the expense of retail. Those insiders include venture capital firms like a16z and, incredibly, Coinbase’s own venture arm, which has a number of investments listed on Coinbase. Other exchanges like Kraken, FTX, and Gemini are also all active in venture, and have listed their own investments.
And in fact, Khan showed that:
A16z’s returns are much worse than Coinbase’s listings overall! This to me smells of insider selling. These should be the best coins there are, given a16z’s access, but instead 100% of those older than 12 months and 90% older than 6 months lag Ethereum.
He concluded:
I think this is a microcosm of how bad the incentives are in crypto - VCs and private investors that used to have to wait ten years for liquidity can now get it within one. The last time that happened was 1999, and we know how that ended. It’s a recipe for risk taking that is then quickly passed on to the public.
Yes, the rewards are smaller than Wansley and Weinstein-type "venture predation" but there are lots of them and waiting less than a year to turn the investment around means that the lots of smaller returns multiply quickly. And the risk is much lower; the returns are essentially guaranteed by the addiction of crypto-bros to buying VC-funded coins listed on Coinbase.


Geoff said...

Private equity and VCs share a core belief: "We have no interest in the long term consequences of our actions."

Tex said...

Uber is now more expensive than a black cab in London. Sad really - years demonising self employed cabbies, putting them out of business, for VC gain, and now there's one less piece of public infrastructure. Try getting a wheelchair friendly uber cab, good luck.

David. said...

Ellen Huet reports that WeWork’s ‘Substantial Doubt’ About Its Future Marks a Stunning Fall:

"The New York-based company is bleeding cash, and customers of its office rentals are canceling their memberships in droves, WeWork said in a statement Tuesday. Its shares fell 26% in the first minutes of trading Wednesday morning.

WeWork’s stock has plunged 98% since the company went public in October 2021, wiping out nearly $9 billion in market value. The stock was trading at 16 cents early Wednesday. Its bonds are also at deeply distressed levels. The company’s 7.875% unsecured notes due in 2025 last changed hands for 33.5 cents on the dollar, according to data from Trace."

And Hubert Horan continues with Can Uber Ever Deliver? Part Thirty-Three: Uber Isn’t Really Profitable Yet But is Getting Closer; The Antitrust Case Against Uber:

"Uber claimed its first ever quarterly GAAP profit when it released its second quarter and first half financial results on August 1. [1] The claim was a bit of stretch as the reported $394 million second quarter profit ($237 million for the first half) was entirely explained by an alleged $386 million second quarter gain ($707 million in the first half) in the value of untradable securities they hold in companies like Didi, Grab, and Aurora that have nothing to do with their ongoing operations.
starting in early 2022, Uber began keeping a larger share of gross customer payments and giving a smaller share to drivers. Until the 2020 pandemic demand collapse Uber took roughly 22% of gross customer payments. It restored that rate in the second half of 2021 but then increased its take rate to 28-29%. This was not because Uber was providing an increasing portion of what customers valued. Uber simply figured out how to transfer over $1 billion in revenue per quarter from drivers to Uber shareholders.
the delinking of passenger fares and driver compensation was a major driver of this labor to capital wealth transfer. Prior to 2022, driver payments were a function of what passengers paid, with adjustments for incentive programs and peak period demand. Uber has developed algorithms for tailoring customer prices based on what they believe individual customers would be willing to pay and tailoring payments to individual drivers so they are as low as possible to get them to accept trips."

David. said...

Hubert Horan comments on Matthew Wamsley and Samuel Weinstein's paper in his part #33, Uber Isn’t Really Profitable Yet But is Getting Closer; The Antitrust Case Against Uber:

"Benchmark Capital invested $9 million in Uber’s Series A. After Uber’s IPO its return on this investment was $5. 8 billion. Travis Kalanick cashed in $1.4 billion in shares after the IPO while still holding shares worth an additional $5.3 billion. Thus the Matsushita test of rationality has clearly been met, even though neither Benchmark (the largest initial investor) nor Kalanick (the CEO) had done anything to establish a company that had any hope of strong sustainable profits. Benchmark and Kalanick had not only met the Brooke test of clearly recouping the initial losses from predation but had achieved returns from predation that John D. Rockefeller and the Standard Oil Company could have only dreamed of."

Horan notes some omissions:

"They included very little of the available P&L data that demonstrates the magnitude of the predation, and that none of the predation-fueled growth was part of a plausible plan to generate sustainable profits. They did not seem to be aware of magnitude and power of Uber’s PR/propaganda efforts which would be key to demonstrating that Uber’s early investors had a highly rational plan to create the investor perceptions that allowed them to recoup the costs of their predation after the IPO. [15] Their point that the early-stage investor funding financed the predation would have been stronger if they had quoted numbers showing the massive size of that war chest, or if they had pointed out that Uber’s investors provided 2300 time the pre-IPO funding of Amazon, whose growth strategy was not based on predation."

David. said...

David Gerard links to a paper Prof. Hilary Allen posted last month entitled Interest Rates, Venture Capital, and Financial Stability that is highly relevant to this topic. From her abstract:

"This Article illuminates one path through which the prolonged period of low interest rates from 2009-2021 has impacted financial stability: it traces how yield-seeking behavior in the wake of the Global Financial Crisis and Covid pandemic led to a bubble in the venture capital industry, which in turn spawned a crypto bubble as well as a run on the VC-favored Silicon Valley Bank.
It argues for increased monitoring of the venture capital industry by financial stability regulators, given that venture capital is well-positioned to generate asset bubbles now and in the future. More specifically, it argues for more aggressive enforcement of the securities laws to tamp down on the present crypto bubble, as well as for structural separation between crypto and the traditional financial system."

I need to study it and write a post on it ASAP.

David. said...

In How Bad Has Ride-Hailing Been for Cities? David Zipper reviews Disrupting D.C.: The Rise of Uber and the Fall of the City by Katie J. Wells, Kafui Attoh, and Declan Cullen, who write:

"Uber’s greatest achievement in D.C. has been not only to lower expectations of what urban life should look like, but also to codify those expectations into a new common sense in which the answer to all problems is, alarmingly, just let Uber do it. The low expectations that have made Uber and the broader gig economy seem like commonsense solutions to urban problems suggest a bleak future defined by social atomization, consolidated corporate power, persistent racial inequalities, inaccessible data sets, weak worker rights, and unmet promises related to automation."

David. said...

Wyatte Grantham-Philips' WeWork sounds the alarm, prompting speculation around the company’s future recounts another predator's fall:

"Last week, WeWork warned there was “substantial doubt” about the New York-based company’s “ability to continue as a going concern” — which is accounting-speak for having the resources needed to operate and stay in business. WeWork pointed to increased member churn, financial losses and the company’s need for cash, among other factors, over the next year."