When the Music of the “Wealth Effect” Stops

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.

This is the transcript from my podcast, THE WOLF STREET REPORT:

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 dollars 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.

In this worst-case scenario, investors are out $10 million, that the company spent. But this $10 million entered the economy and was recycled, and boosted GDP likely by more than the $10 million through the multiplier effect.

In this worst-case scenario, these investors used their money to provide a stimulus to the real economy. It worked like a wealth tax, where some percentage of their wealth is removed from their wealth for the benefit of the economy. Investors call it a capital loss, but that’s what it does: it boosted the economy at investors’ expense.

So let’s use a big example that involves real money. Tesla. Since its IPO in 2010, Tesla has raised $21 billion from investors via debt and equity offerings. This doesn’t even count the funds it raised before its IPO. And it has burned through most of this $21 billion by now.

Tesla has real revenues, and they’re growing in leaps and bounds. But it spends a heck of a lot more than it takes in. Hence the negative cash flow. So the total amount Tesla spends is the combination of its revenues and the money from its investors.

Some of the money it spends is invested in manufacturing facilities and equipment. Some of this equipment is purchased from German companies, so these are imports, and they do not benefit the US economy. They benefit the German economy. But other sums are spent on equipment and materials made in the US, and it’s spent on vehicle components that are purchased all over the world, and a big part of the funds are spent on salaries of its 40,000 or so employees, most of them in the US.

In other words, every dime that investors ever handed to Tesla is getting spent in the real economy in the US and other countries and boosts those economies.

In the worst-case scenario that Tesla goes bankrupt and these investors experience this dreaded capital loss, they should be proud: they have boosted the US economy with their funds. This includes a lot of foreign investors, such as sovereign wealth funds.

Even if it doesn’t come to the worst-case scenario, those investors have boosted the US economy, and it will take new investors to step in with fresh money and bail out the old investors to keep the chain going, thus prolonging the cycle.

In the US fracking industry, the cumulative negative cash flow just from the publicly traded companies is well over $200 billion, funded entirely by investors. There are many oil and gas drillers that are not publicly traded, and their negative cash flow adds to that amount.

This money got spent on high-paying jobs in the industry, including tech jobs. It got spent on equipment and supplies manufactured in the US. It got spent on transportation, provided by trucking companies. While some of it got spent on products that were imported, such as steel products, much of it was spent in the real US economy and was then recycled by the people and businesses that received it, thus adding more the US GDP.

This is the principle of investors funding cash-flow negative businesses: These companies put more into the economy than they take out. And investors will only get paid if new investors bail them out, and take over the burden of the negative cash flow.

When Lyft and Uber went public the old investors got bailed by new investors recruited from the public. These companies are still cash-flow negative, and are still burning investor funds – meaning that they continue to spend these investor funds in the real economy.

This too is part of the “Wealth Effect.” The wealthy or not so wealthy asset holders invest some of their funds in cash-burn companies that then use these funds to stimulate the US economy.

Funding cash-flow negative companies is a great thing, while it lasts. It is like a voluntary tax on investor assets that is not perceived as a tax but as an investment because new money keeps bailing out the old money, and so the moment when this investment is converted into a capital loss gets moved out.

At big companies such as Apple and Microsoft, the capital losses they constantly experience when they shut down or write down the acquired operations get plowed into their “non-cash charges” that investors ignore, though they lower the profit of those companies, just like a tax would. For smaller investors, the outcome is more obvious.

But these things come in cycles. And when the cycle turns, that’s the moment when new money no longer wants to bail out the old money, and cash-flow negative companies begin to topple.

The money investors had put into these companies was spent long ago, and is gone. This is when the pain of the capital loss comes to the foreground. It tends to involve trillions of dollars; and if it gets messy, tens of trillions of dollars globally. But these losses, that suddenly show up, had been spent in prior years to boost the US and global economy, and this money was recycled but is now gone, and investors get to grapple with what really happened.

This is how financial crashes that happen far from the real economy can trigger deep recessions in the real economy, because all this investor-funded stimulus spending suddenly stops, and these people that got paid with this money are being laid off, and the offices become vacant, and the tax revenues slow down, and with these people getting laid off, they stop spending money, and the whole recycling processes reverses.

But looking at this phenomenon today, I have to say, so far, so good.

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