The Perils of Angel Investing

You know I just had to read an article with the title Why I stopped angel investing (and you should never start). Tucker Max writes,

I can think of two portfolio companies specifically, both of which have raised major rounds from big name VC funds, where I have to actively refrain from punching founders in their stubborn, arrogant faces.

Actually, the sentences that I related to the most were these:

personally, I gotta be in the arena, competing, putting myself on the line. I can’t just watch. Once I understood this, the decision to stop angel investing was pretty clear.

I noticed this when someone put me in touch with the head of a firm that does early-stage investments. She showed me a few companies they were investing in, and I found that all I could think about was how I would position the companies differently and take different approaches in terms of staging their business. It does not matter whether I was right or wrong, but it showed me that I could not just sit back and watch someone else use my money to do things that I would not do if I were running the business myself. It would be way too stressful for me.

Finally, about successful angel investors, he writes,

they have the social clout to not get run over by VC’s and literally pushed out of an investment.

That’s the most frustrating part of angel investing. You manage to actually back a winner, and then a VC firm with clever lawyers just takes it away from you for nothing.

Which Economist Are You? The Game

I played (you can play here), and I got Steven Kaplan. His field is not one that interests me that much, he is not a familiar figure to me. But coincidentally, James Pethokoukis recently interviewed him. I agree with much of what Kaplan says in the interview, but I have my doubts about what he says near the end:

you have an increased regulatory burden on small businesses that everybody talks about – I think is real. And that would be my guess why you see fewer of the kind of mom-and-pop type startups. And you see – but you see no diminution on the high potential startups because they’re high potential enough that regulation doesn’t actually matter.

My guess is that the mom-and-pops are suffering more from competition than from regulation. I think of the challenge of opening up an independent retail store when there are so many advantages held by large chains and by Amazon and Wal-Mart. I think of the challenge of opening an “average” restaurant when there are now chains in every niche, where 30 years ago the only ones not in fast-food hamburgers were KFC, Taco Bell, and Pizza Hut. I think of individual medical practices giving way to large organizations–some of that is driven by health care policy, but I think that some of it is natural evolution, as the share of medical care that is produced by factors other than doctor-labor-time increases. I think of small retail financial firms (brokers, local banks) giving way to much larger institutions. There, too, regulatory influences are pervasive, and you have to attribute some of the concentration to Too Big to Fail. But on the other hand, big banks were over-regulated as of 1975, and I would attribute most of the consolidation that has taken place over the past 40 or 50 years to natural market forces operating in a regulatory environment that allowed more competition.

If you put it all together, I think that it takes a lot more brainpower to start a successful company of any type today than it did 50 years ago. Meanwhile, the large enterprises can afford to acquire lots of brainpower, so there is not a whole lot of it sitting around to start mom-and-pops.

Going back to the IGM survey, my most outlandish opinions relative to the IGM panel of experts were:

–I disagree that health insurance subsidies will produce benefits that exceeds the costs

–I strongly disagree that performance of a teacher’s students on standardized test scores can predict how well the teacher does at improving future outcomes of students.

I think the evidence on health spending is that at the margin it has no effect on outcomes.

I think that the studies that purport to show that teachers make a difference are a suspect molehill next to the mountain of evidence for the null hypothesis. And even if they do make a difference, test scores are too noisy an indicator to rely on.

Can Crowdfunding Work?

Robert Shiller is worried about crowdfunding.

But the SEC could do more than just avow its belief in “uncensored and transparent crowd discussions.” It should require that the intermediary sponsoring a platform install a surveillance system to guard against interference and shills offering phony comments.

Pointer from Mark Thoma.

My thoughts:

Amateur investing in start-ups is per se a really bad idea. I did it a few times as an “angel investor” and got screwed. Founders made promises to me about how they would handle finances, and they quickly broke those promises. And once, when the start-up managed to do well, the founder obtained follow-up funding that amounted to legal blackmail against those of us who were early investors, so we got nothing. I came out of that experience convinced that unless you have top-notch lawyers working with you, investing in start-ups is a no-win game. As a small investor, you would need to score a home run just to cover your legal bills.

I see two possibilities for crowdfunding.

1. Suppose that people are only asked to invest in companies where they want to buy the company’s offering. Then, it seems like an interesting way for start-ups to do early market testing.

2. Suppose that the crowdfunding platforms provide some of the legal protection that venture capitalists and other high rollers are able to give themselves against subsequent misbehavior by founders or follow-on financiers.

If one of these, or preferably both, are in place, then I think that crowdfunding could last. Otherwise, I expect it to produce very negative average long-term returns and die a natural death.

Jaworski and Brennan on Markets in Everything

Peter Jaworski and Jason Brennan write,

put philosophers out of the business of talking about the moral limits of markets. The interesting questions about markets are not what we may buy and sell, but instead how we should buy and sell it. Certain ways of buying and selling things might be wrong, but that does not mean the thing in question must never be bought or sold. Perhaps buying sex from a desperate woman exploits her, but that does not imply buying sex is always wrong — you could buy it from someone who is not desperate.

The title of their piece is, “If you may do it for free, you may do it for money.”

In The Secret of Our Success, Joseph Henrich endorses the view that traditional customs surrounding marriage and sex served to tamp down violence. In the absence of other cultural norms, the natural propensity of men would be to compete to have many wives, and this competition would be violent.

A lot of the cultural tension concerns what you may do for free. Extramarital affairs are still frowned upon. Norms about premarital sex appeared to loosen for a while, but perhaps the “yes means yes” movement can be viewed as a sort of backlash.

Perhaps some of the fear about allowing markets in sex is that what people can do for money might affect how other people who are doing it for free. For example, there are those who suggest that pornography has adverse effects on the way people behave in relationships.

The Year I Beat Bill Gates

Shane Greenstein writes,

Gates misinterpreted the value of the Internet’s commercial prospects. This error would take three interrelated forms in its conventional assessment:

1. Underestimating the Internet’s value to users;
2. Underestimating the myriad and clever ways entrepreneurs and established firms would employ Internet and web technologies to provide that value for users;
3. Underestimating the ability of Internet firms to support applications that substituted for Microsoft’s in ther marketplace.

This is from How the Internet Became Commercial, Greenstein’s new book. I started my business on the Internet in April of 1994. Gates did not become a believer in the Internet until a year later.

Greenstein offers a well-judged analysis of the business strategy and Internet governance issues during the first decade of the Internet’s commercialization, starting in 1994. However, I think that there is still plenty of room for someone to write another book on this historical episode. I would like to see a book that makes the dynamics more vivid.

In the introduction, Greenstein sketches a few timelines on which he lists events. I am not clear whether he chooses the events for their significance or to try and help the reader understand the order in which certain developments occurred. In any case, his choices are mostly very different from what mine would have been.

I actually would include several timelines:

–the release date and processing speed of Intel’s chips. Another would show

–the amount of hard disk storage on a top-selling personal computer each year.

–the speed of the most commonly used Internet connection each year. I remember when 28.8 Kilobytes per second was an upgrade.

–the number of people with Web access each year. When I started my business, unbeknownst to me that figure was less than a million. I had read, correctly, that there were 20 million Internet users in the U.S., and I very naively figured that this was approximately the number of people with Web access. The Web did not become a mass-market phenomenon until the fall of 1995, when AOL began offering Web access and Microsoft released Windows 95.

–the total number of web sites and the top five web sites in terms of traffic each year.

–well-hyped businesses that failed, such as MecklerWeb, Web TV, and PointCast Network.

–buzzwords that no longer have meaning, such as portal and push technology.

–creation of important software and protocols, such as JavaScript, Java, Flash, MP3, JPEG, and Linux.

–appearance of iconic web sites, such as Yahoo, Amazon and Google

–fading of once-iconic web sites, such as AltaVista, the NCSA home page, and the Netscape home page.

–Internet IPOs, by year

My point is that the environment evolved very rapidly. Your business strategy could not be based on what was there at the time. It had to be based on a guess about what was coming.

I describe my business experience in those days as a sequence of miscalculations, because I got so many things wrong. But I made some fundamentally good guesses about what was coming, and that was sufficient.

Paging Daniel Klein

Don Boudreaux writes,

The bad news is that 74 percent of these surveyed economists either disagreed, were “uncertain,” or expressed no opinion that such a huge hike in the minimum wage would cause substantial shrinkage of low-skilled workers’ job prospects.

My stream-of-consciousness reaction was this:

1. These economists must be mood-affiliating with sociologists, or other left-wing academics.

2. I’ll bet that non-academic economists would think about this question in a more detached, business-informed way.

3. This sounds like a project for Daniel Klein. Conduct a large survey of economists affiliated with academia and economists affiliated with businesses, and find out questions on which they differ. Interesting questions would include the one on the minimum wage, whether Obamacare is lowering health care costs, whether more inflation would be lead to better economic growth, . . .

Clay Shirky’s Little Rice

The book is centered on Xiaomi, a Chinese cell phone firm. I found the writing rather jumpy, almost ADD. Here are some random excerpts (each of these is from different parts of the book):

This focus on a handful of individual product lines in turn allows the company to stay small. Employees who have been through Xiaomi’s hiring process are told that the company’s goal is to hire as few people as possible, by concentrating on attracting and retaining talented employees.

China, remarkably, has managed to create an alternate path, building a country where information moves like people,, in highly identified and constrained ways

the usual modes of censorship and surveillance are no longer enough to keep control of public opinion, and the government is expanding its online propaganda efforts. The people who flood online conversations with pro-Beijing sentiment are . . .paid half a yuan for every post.

the People’s Liberation Army paper published one saying, “The Internet has grown into an ideological battlefield, and whoever controls the tool will win the war.”

Of course, the idea of trying to operate a firm with a relatively small cadre of talented employees sounds very reasonable to someone in the tech business. But note that it is quite different from old-fashioned economic models, in which you hire “labor” until marginal revenue equals marginal cost.

But the issue that I am still mulling is the role of social media in affecting the evolution of beliefs and behavior. My sense is that people’s dislike of “the other” has gone up quite a bit during the relatively short period in which social media went from a small niche phenomenon to a mass-market phenomenon.

Heterogeneity of Firms and Workers, Scarcity of Management Talent

Jason Furman and Peter Orszag write,

Longstanding evidence (e.g. Krueger and Summers 1988) has documented substantial inter-industry differentials in pay—a mid-level analyst may have the same marginal product wherever he or she works but is paid more at a high-return company than at a low-return company. Newer evidence (Barth et al. 2014 and Song et al. 2015) suggests that much of the rise in earnings inequality represents the increased dispersion of earnings between firms rather than within firms. This is consistent with the combination of a rising dispersion of returns at the firm level and the inter-industry pay differential model, as well as with the notion that firms are wage setters rather than wage takers in a less-than-perfectly-competitive marketplace.

Pointer from Tyler Cowen.

I bristle at the phrase “same marginal product.” Modern workers are not widget-makers, and their value inside an organization is not visible to people outside the organization. Indeed, even within the organization, the value contributed by individual workers cannot be calculated with any precision.

I know someone, call him A, who works in information technology at a firm in a buggy-whip industry. One of his friends, call him B, just took a job at Google. Assume, probably correctly, that the difference between their two compensation packages is a lot wider than the difference in their skills. Some possibilities:

1. This is a disequilibrium situation. Information technology workers currently produce more value at Google than in the buggy-whip industry. In equilibrium, A will move out of the buggy-whip industry and go to work for Google.

2. This is an “efficiency-wage” equilibrium, in which Google pays B slightly more than B’s opportunity cost. This enables Google to be highly selective in who it hires and also to give B an incentive to provide top performance.

I am inclined toward (2). But in either case, the value of B’s work is high relative to B’s wage, which raises the question of why Google does not hire more engineers. Perhaps the value of the next engineer would be lower, because of management limitations at Google.

I think that the key factor here is that the collective management talent assembled at Google is scarce. It generates more value that the collective management talent at the firm in the buggy-whip industry.

What I am suggesting is that the value of a firm depends a great deal on collective management talent. This includes the skills of individual key executives as well as the team chemistry among them.

One of the challenges of maintaining a high-functioning management team is that the “tournament” to get to the top can become corrupt. That is, managers can start to get ahead by undermining other managers rather than by exercising better judgment. As this sort of corruption becomes widespread, a firm can rapidly deteriorate. For me, this is one of the most interesting phenomena in the sociology of organizations.

Schumpeter 1, Galbraith 0

Mark Perry writes,

In other words, only 12.2% of the Fortune 500 companies in 1955 were still on the list 60 years later in 2015, and nearly 88% of the companies from 1955 have either gone bankrupt, merged with (or were acquired by) another firm, or they still exist but have fallen from the top Fortune 500 companies (ranked by total revenues). Most of the companies on the list in 1955 are unrecognizable, forgotten companies today (e.g. Armstrong Rubber, Cone Mills, Hines Lumber, Pacific Vegetable Oil, and Riegel Textile).

Patterns of sustainable specialization and trade are in constant flux.

Getting Capital Out of the Buggy-Whip Industry

A commenter writes,

My favorite pet story is the economy is awash in “buggy whip profits”. Many businesses that currently generate free cash flow will be either outsourced or computerized in the future, but it is clear that investment in such firms is not profitable.

This is consistent with the productivity dispersion recently discussed on MRU and also with the large share buybacks made by mature firms.

Because our financial system cannot intermediate these funds towards the really innovative firms, the result is high asset prices and low interest rates.

My thoughts:

1. I love the phrase “buggy whip profits.”

2. There are those who say that the corporate raiding of the 1980s helped move capital out of lazily-managed firms and into better uses.

3. There are those who say that Michael Milken’s junk bonds helped move capital into forward-looking industries, such as the early cell phone networks.

4. As economists, we really do not know much about how financial intermediation works. As you know, I think of households as wanting to hold short-term, riskless assets and firms as wanting to issue long-term, risky liabilities, with intermediaries doing the opposite. But how can we tell if and when there is variation in the ability of the financial system to “intermediate these funds toward really innovative firms”?