21 November 2014

The Silicon Valley startup as Ponzi scheme

Scientific American’s June issue included an article talking about Ponzi schemes, and how our economy is rife with them. One example they gave was the Silicon Valley startup:

A simplified example illustrates how this process works—and how it can take on the attributes of a Ponzi. A start-up offers workers a low wage, less, in fact, than the dollar value of what a worker produces. Hence, with each worker, the firm generates some profit. What makes people want to work for this firm, despite low wages, is the allure of stock options that the firm gives to its employees. Thus, in the first quarter of the start-up’s operations, the company employs one worker and offers options equivalent to one half of all profits for that period on. In the next quarter, the firm doubles the size of the workforce by employing one new worker—and offers the new hire options that total one fourth of the profit from that period on. In the third period, the company again doubles its staff complement by hiring two new employees, furnishing an options package equal to one eighth of all profits for that period on, which means that each new hire is offered one sixteenth of all profits. And so on in every future quarter.

This plan will ensure that a company’s profits will double each quarter. Because employees get a fixed share of profits, earnings from their options will also double each period. And the entrepreneur’s income comes from the difference in the value of the goods produced by the workers and the low wages because the entrepreneur gets to keep a part of this difference while giving away the rest to employees as returns on their stock options.

The exponential growth of the value of the stock options makes a job at this company alluring even though these highly trained professionals would not have found the job attractive otherwise, given the low pay. Ultimately, however, a camouflaged Ponzi will crash and will drive the firm into bankruptcy because growing a business in this fashion requires an inexorable expansion of the workforce, an impossibility in a world with a finite population.

Deciding which current startups are Ponzi schemes is left as an exercise for the reader.

The Made Off Dollar
Zachary Veach via Compfight

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