Can a Business Model Be Unethical?

the case of venture capital...

Photo by Vladislav Reshetnyak: https://www.pexels.com/photo/full-frame-shot-of-eye-251287/

The collapse of SVB is as good a time as any to step back and examine the venture capital business model (which brought Silicon Valley Bank into being more or less). And to ask one fundamental question: is the VC business model fundamentally unethical?

A business model is a mathematical formula to create profit. Can a formula be unethical? This strange question differs from the idea of unethical individuals misusing a business for their own selfish ends. Not the same thing.

For a business model to be unethical, it has to have a perverse social logic embedded within it, one that ethical restraint can rarely contain and one that encourages extreme misleading of at least one stakeholder group required to make the business model operate.

It's a math formula for profit that requires unethical manipulation of other stakeholders to function correctly.

A Warm-Up: The Case of Supermarkets

My local grocery store marks up manufactured goods by about 100% to get the price I see on the shelf. This markup may seem egregious until you fully understand a supermarket's enormous, per square foot, operating costs. Grocery product markups alone no longer make your local grocery store profitable. Yes, you read that right, almost all supermarkets lose money because you shop there.

So, over the decades since the 1980s, selling access to shelf space and display space is what makes most of the money in a supermarket. While this B2B pay-to-play competition is not transparent to shoppers, it's evident to branded suppliers of your local supermarket.

Slotting fees do prevent small startups, in some cases, from getting access to meaningful, i.e. visible, shelf space (initially). This is unfair to small businesses, yes, but I can't say it's unethical, let alone deceptive. In part because neither retailers nor distributors hide this knowledge from grocery suppliers. And, I have yet to meet buyers (outside Whole Foods, perhaps) who blow smoke up a sexy startup's P&L to get them onboard. Suppliers need retailers to breathe. Retailers do not develop an operating culture of deceiving suppliers because they’re that essential. Most supermarket merchandisers are pretty dubious about any given startup's prospects to their face. It’s a land of curb-your-enthusiasm types. Retail merchants don’t feed blind hope.

Where ethics slip in retail is when retail merchants knowingly onboard a startup to collect a fee without vetting their ability to supply the stores and then, when Brand A fails, sell the slot again to pad the annual profits on their merchant desk. Some East Coast retail chains are notorious for this unethical twisting of the slotting fee model. Otherwise, it is a typical application of service fees in a high-demand area where more companies than shelf slots are available.

The Twisted VC Model

But venture capital's business model is fundamentally different from the grocery store.

Venture capital funds structure their investments on a cynical 90/10 ROIC(return-on-invested-capital) business model. Each fund is raised with a thesis and a time clock to deliver returns. Only 10% of portfolio companies in a fund will scale to generate a return that pays back the investment into the other 90% and returns a profit to the fund. And the VC fund’s General Partners never really know which ones will be among the 10%.

This requires VC firms to inhale a lot of companies; far more than is listed on their website. A whole hell of a lot in many cases. They have to place hundreds of bets to generate a return. This, in turn, involves courting even more companies. It can also involve seducing some that the VC is quietly dubious of. Venture capital is notorious for bullying companies onto the fund roster near the end of a fund's time clock. The GPs must deploy this time-bounded capital, or they lose it. This repeatedly leads to stupid, hasty, disingenuous deals in glaringly obvious ways.

VCs tend to be very careful, diligent, and ‘imaginative’ early in a fund's time clock. They are relaxed. They can say no to most companies who approach them. They can stroke and massage their investment "thesis" and still believe in it.

As the fund's time clock approaches its end, it's like a schizoid personality flip occurs. And this is when the business model of spreading your high-risk bets goes off the rails, in my opinion.

Let me explain.

I have yet to meet a single entrepreneur interested in venture capital investment who doesn't think their business will scale and crush it. They all think this. Delusions of grandeur come with this self-selected tribe, not just with Elizabeth Holmes or Sam Friedman.

So, the venture capitalist is constantly feeding and reinforcing this delusion on behalf of the founder to pad its portfolio with more ‘great’ bets. It gets so typical to encounter delusional founders that you adapt quickly to mirroring this when you want to. When you want a company on your roster, for any reason, venture capital GPs play to that delusion aggressively (unlike a supermarket buyer, who almost invariably couldn't care less about your company's future beyond 1-2 years, in part because desk rotation is frequent to prevent supplier corruption).

All along, though, the VC knows its long-term win rate internally. They have detailed records of capital deployed and ROIC for each fund. They, therefore, approach each potential company knowing the odds of success are less than 10%, when their 'partners' on the terms sheets see the odds as 90-100% (especially with a large check). This is true, even when they blow smoke up someone's P&L to get them on their roster to deploy capital before the fund's time clock runs out!

But, the SVB collapse revealed something even more deeply unethical about the Silicon Valley ecosystem.

The lead VC firms in the Valley essentially collaborated to fund a bank offering preferred, low-interest loans to early startups with no actual vetted business model. These were companies no other bank would ever loan money to. Why? Because most early-stage companies are losing money, not making it. This is assured in my industry of consumer-packaged goods.

Why would Valley VCs do this? They need a massive funnel of artificially propped-up startups to choose from to make their 90/10 ROIC business model function. In other words, SVB was an extreme, institutional version of the disingenuous interactions between VCs and delusional founders. SVB was like an industrial factory of delusion designed only to maximize the odds of the investor community, not the average founder (whose odds would go down by the sheer amount of other companies competing for limited funds).

A business model which requires the deliberate stroking of a business owner's delusion when the business in question is not solvent, not profitable, and dependent on super-cheap debt (that was always going to end at some point) is not illegal.

But the losers of this mutual deception society known as venture capital are naive founders and owners of small businesses who put their whole identity (and sometimes life savings) on the line. And who are not ultra-high-net-worth individuals either in most cases.

[an unethical business model] is a math formula for profit that requires unethical manipulation of other stakeholders to function correctly.

The behavior at the end of the fund’s time clock meets my standard of an unethical business model. As for the rest of their behavior and the industrial inducement of delusion at SVB, I may be alone in seeing this as an unethical manipulation of founders.

But there’s another layer of ethical dubiousness. I've never met a venture capitalist who puts their entire career on the line with any one portfolio investment. Ever. They are not that brave. They have no personal financial downside if they mislead a company through hyperbole or B.S. and the company blows up.

This seems beyond unethical to me. And it should require vastly more federal regulation to ensure disclosure of risks to founders. Especially when we have the 0.1% dangling large sums of money in front of the mere upper-middle-class founder.