If you built your Potemkin village entirely out of houses of cards

For a while now, we've been working toward a theory of how VC culture and practices can actually undermine innovation, perhaps even to the extent that it's a net drag on progress and real economic growth. This article by Peter Elstrom fills in a lot of the remaining questions in that theory.

A couple of points I want to underline in the following.

The growth fetish plays a major role in this story. We've been chipping away at this ages, but the quick version is that, while the right kind of growth is obviously desirable, it tends to be overvalued by 21st century investors. The fetish is particularly dangerous when it drives companies to make otherwise pointless acquisitions. I'm saving the best example of that (Oyo's real estate purchases) for another post.

I hadn't realized the extent that accounting tricks figured into SoftBank's strategy. I don't pretend to follow the subtleties but I am pretty sure this is bad.

[emphasis added]

In early 2018, the founders of Chinese artificial intelligence startup SenseTime Group Ltd. flew to Tokyo to see billionaire investor Masayoshi Son. As they entered the offices, Chief Executive Officer Xu Li was hoping to persuade the head of SoftBank Group to invest $200 million in his three-year-old startup.

A third of the way into the presentation, Son interrupted to say he wanted to put in $1 billion. A few minutes later, Son suggested $2 billion. Turning to the roomful of SoftBank managers, Son said this was the kind of AI company he’d been looking for. “Why are you only telling me about them now?” he asked, according to one person in the room.

In the end, SoftBank invested $1.2 billion, helping to transform SenseTime into the world’s most valuable AI startup. The young company’s valuation hit $7.5 billion this year.

That investment model is now under fire after Son, 62, boosted the equity in office-sharing startup WeWork only to see it plummet as investors balked at enormous losses and troublesome governance. Indeed, SoftBank has participated, along with other investors, in scores of fundraisings that have added a total of more than $150 billion to the value of private companies, according to Bloomberg calculations. Among its deals are the world’s top two startups—ByteDance Inc. valued at $75 billion and Didi Chuxing Inc. at about $56 billion. In some cases, SoftBank’s involvement in multiple funding rounds helped drive up valuations that resulted in paper profits for Son’s company.

The WeWork fiasco raises questions about such numbers. The co-working startup’s valuation crested at $47 billion this year with SoftBank’s investment, then plummeted to $7.8 billion in a bailout engineered by Son. WeWork is slashing jobs and scaling back operations.

“WeWork is not just a mistake, it is a signal of weakness in the whole model,” said Aswath Damodaran, a professor of finance at New York University’s Stern School of Business, who has written four books on valuing businesses. “If you screwed up that valuation so badly, what about all of the other companies in your portfolio?”

SoftBank said WeWork is an exception rather than a symptom of broader problems, and it has learned from the experience.

Since unveiling his $100 billion Vision Fund in 2016, Son has become the most active tech investor on the planet, pouring money into more than 80 companies. That helped create a bumper crop of unicorns, more than 300 startups priced at $1 billion or greater, according to the research firm CB Insights.

What’s not as well understood is the incentive Son has to keep valuations rising. When SoftBank buys shares in a startup and then invests again at a higher valuation, Son says he has made a profit. That is legal under accounting standards, but SoftBank receives no money. The only change is that SoftBank has boosted the value of its original stake from, say, $1 billion to $2 billion by raising the value of the startup. In SoftBank’s income statements and return calculations, at least some of the additional $1 billion can be counted as profit.

“They pump up valuations to get higher returns to look good to investors,” says Eric Schiffer, chief executive officer of Patriarch Organization, a Los Angeles-based private equity fund. “That kind of fundraising apparatus is essentially unicorn porn.”

SoftBank said its accounting complies with all standards and is consistent with widely accepted practices. As for startup valuations, it said it is not determining them on its own and invests with experienced firms such as Sequoia Capital and Temasek Holdings Pte. “Our valuations have been validated by more than 120 sophisticated investors who’ve invested alongside and after us,” Navneet Govil, chief financial officer of SB Investment Advisers, the entity that manages the Vision Fund, said in a statement.
...

But the profits SoftBank booked were mostly on paper. In the first fiscal year, unrealized gains on investment valuations accounted for essentially all the stated income for the Vision and Delta funds. In the most recent fiscal year, unrealized gains on valuations amounted to 1 trillion yen, while realized gains—like the sale of India e-commerce giant Flipkart to Walmart Inc.—totaled less than 300 billion yen.