Tesla has a seemingly bottomless appetite for capital. The company raised $2 billion from bond investors in 2014, sold $738 million in stock in 2015, and sold $1.46 billion in stock in 2016. Now it’s planning to raise another $1.15 billion in the coming months.
Tesla needs so much cash because it has hundreds of thousands of preorders for the Model 3, Tesla’s relatively affordable electric vehicle that’s slated to begin production later this year. CEO Elon Musk has set a goal to produce 500,000 cars a year between 2018 and 2020. Achieving that goal will require billions of dollars of investments in new factories, warehouses, robots, and so forth.
Tesla is hardly the only Silicon Valley company raising big sums from investors. Airbnb announced just last week that it had raised $1 billion, for example, and Uber has raised more than $11 billion over the past few years. But there’s an important difference between Tesla’s fundraising and that of most other big Silicon Valley companies.
Tesla’s big problem is that it has too many customers chasing too little product. It needs to spend billions of dollars to build infrastructure that will allow it to meet surging demand for electric cars. Most other Silicon Valley companies have the opposite problem: They have plenty of spare capacity, but they’re essentially spending their millions (or billions) to buy customers.
That’s an ominous trend for Silicon Valley and the broader American economy. The kinds of investments Tesla is making expand the capacity of the American economy to produce useful goods and services. But a lot of the “investments” being made elsewhere in Silicon Valley don’t do that. Companies are spending millions in zero-sum battles for market share. And these battles ultimately do little to grow the economy as a whole.
The three waves of Silicon Valley innovation
In a recent book, AOL founder and venture capitalist Steve Case divided the history of the modern technology industry into three waves. The first happened from roughly 1985 to 2000. During the first wave, the basic infrastructure of the internet was still expensive. Like Tesla today, early internet companies often found themselves in a situation where demand outstripped supply, forcing them to raise millions of dollars to buy servers, rent bandwidth, and license software.
During the first wave, it was fashionable for companies to make big investments in tangible assets. A now-infamous startup called Webvan acquired a fleet of delivery trucks so it could offer on-demand grocery deliveries to internet customers. Many of these investments didn’t pan out, of course, but the successful companies built the basic online infrastructure that we still rely on today.
During Case’s second wave, from roughly 2000 to 2010, big investments became unfashionable. The poster child for this era is Facebook, a website started by a college kid in his dorm room in 2004. By that point, computer servers and bandwidth had become cheap enough that Mark Zuckerberg didn’t need very much money to grow his site. This allowed him to maintain total control over Facebook as it grew.
This trend toward cheaper technology has only accelerated over the past decade. Cloud services like Amazon Web Services have drastically reduced the cost of building a website or app that serves millions of users. Open source software has made it possible to build a website without paying a dime of licensing fees. Because cloud services can be rented by the minute and expanded at any time, they require hardly any capital to scale up and serve millions of users.
It has become a Silicon Valley ideal for companies to be essentially weightless: using other people’s infrastructure to build online platforms that allowed users to interact with each other, but not tying up the startup’s own capital in buildings, employees, or other tangible assets. Uber doesn’t own any cars. Airbnb doesn’t own any hotel rooms. And Silicon Valley orthodoxy says this is a good thing
When I wrote about Tesla’s last round of fundraising last year, I essentially ended the story there. Tesla, I noted, was bucking this trend by raising billions of dollars and using it to build tangible stuff like battery and car factories, while starting a tech company was getting less and less expensive.
But a year later, it’s clear this isn’t quite right. Internet infrastructure continues to cost less and less. But big tech companies continue to raise huge sums.
A lot of Silicon Valley “investments” aren’t really investments
Uber is the poster child for Silicon Valley’s third wave, in which the technology sector invades conventional industries like taxicabs. And in one sense, Uber is fully consistent with the weightless ideal of second-wave technology companies. Rather than owning cars or employing drivers, Uber provides a neutral platform that connects drivers with passengers. That has allowed Uber to become a global company with a fraction of the cash it would need if it had bought cars and hired drivers directly.
Despite this, Uber has raised $11 billion and is still a long way from turning a profit. And that’s not because it’s spending a ton of money on servers and bandwidth. Rather, Uber is using that $11 billion to wage a seemingly endless price war against Lyft and international rivals in an effort to boost its market share. Uber hopes that if it offers a customer a below-cost taxi ride now, it will develop a customer relationship that will produce a profit over the long run.
Something similar explains two of Facebook’s biggest acquisitions. Facebook acquired Instagram for $1 billion in 2012 and WhatsApp for $19 billion in 2013. It didn’t cost anywhere close to $1 billion (to say nothing of $19 billion) to create these companies in the first place. Instagram was less than two years old and had 13 employees at the time Facebook bought it. What made these companies valuable is that they had millions of users and were on a trajectory to attract many more. Facebook was essentially buying itself a larger user base.
Another example: Over the past decade, we’ve seen a menagerie of food delivery startups. The market has been so crowded that none of the companies have managed to earn significant profits. But venture capitalists are betting that if they develop strong relationships with customers, then eventually the market will shake out and the biggest companies will be able to turn a profit.
Servers and bandwidth tended to get cheaper over time thanks to innovation and economies of scale, so there was room for everyone to profit from higher investment. But the supply of customers is basically fixed. So as more and more capital has flooded into the market, the cost of acquiring a customer has gone up and up, forcing companies to fight bitter, zero-sum battles that leave them all worse off.
And this may explain why a profitable, lightweight company like Airbnb is still raising money. Airbnb hasn’t explained exactly what it’s going to do with the $1 billion it finished raising last week. But it’s not hard to make an educated guess. Last week, the New York Times noted that Airbnb has acquired a payments startup called Tilt and a vacation home rental company called Vacation Retreats and was investing in a restaurant reservation app called Resy. Around the world, Airbnb has “invested to steal market share from traditional rental sites, like Expedia-owned HomeAway and VRBO,” as CNBC wrote last year.
In short, Airbnb is spending its millions in much the same way as other startups: on acquiring similar businesses and stealing market share from rivals. These are technology investments in a very loose sense, but they’re very different from Tesla spending billions on a car factory.
To be clear, there’s nothing wrong with companies trying to expand their market share. Almost every large company spends money to gain market share from rivals. That’s why Coke and Pepsi spend so much money on television ads. But nobody thinks of soft drink ads as investments in high-tech innovation. Increased ad spending isn’t going to drive faster economic growth.
A shortage of Teslas is a bad sign for the US economy
The point of having capital markets is to convert savings into productive investments. They are supposed to do this is by funneling money into companies — like Tesla — that use the money to build factories, perform research and development, invent new products, and so forth.
Tesla has a large appetite for capital, but it’s not infinite. A healthy economy would have a lot of companies like it. But in recent years, the supply of money people want to invest has started to outstrip companies’ demand for that cash.
In fact, money has mostly been going in the other direction. In 2015, companies paid out more than $1 trillion to shareholders. And shareholders have struggled to find anything productive to do with the money. If you add up all venture capital firms' investments in 2015 — including big investments in Uber and Airbnb and many smaller investments — the total was just $59 billion. Money raised in initial public offerings accounted for another $30 billion.
With nothing better to do with the money, a lot of investors have simply used their dividends to buy more stock in existing public companies. These payments go to the companies' previous shareholders — not the company itself — so they don't lead the companies to put the money to productive use.
Instead, share prices have been getting bid up. Right now, stocks in the Standard & Poor's 500 — an index of 500 large American stocks — are selling for almost 27 times their annual earnings. This is an unusually high value that signals that stocks are likely to produce below-average returns over the long run. At the same time, interest rates on government and corporate bonds are near their lowest point in decades.
What investors need is a lot more capital-hungry companies like Tesla: companies that need a ton of cash to grow quickly. Tesla is so capital-hungry because it sells physical products that take complex manufacturing facilities to build. Tesla is planning to spend $5 billion on just its "gigafactory" — a vast facility to produce batteries for its cars.
And if Tesla is successful, its appetite for capital will only increase. Even if the company achieves its goal of producing 500,000 cars per year by 2020, it will still be a very small player in the overall auto market. It's going to need to build many millions of cars a year to achieve Elon Musk's goal of making electric cars the industry standard. And that will require building many more facilities for creating batteries and building cars.
The problem for investors is that there just don't seem to be very many companies like this. There are too many investment dollars chasing too few investment opportunities. Increasingly desperate investors have poured money into companies like Uber and food delivery startups whose main strategy is to use lavish spending to lure customers away from rivals.
This helps to explain slowing growth of the US economy as a whole. Investments in new factories, equipment, and technologies are a major way that advanced economies grow. But this kind of investment has gotten less and less common, both in Silicon Valley and in the broader economy.