World Economic Forum / Flickr)” width=”308″ height=”462″ />Bill Gates, Chairman, Microsoft Corporation, USA, captured during the session “The Impact of Web 2.0 and Emerging Social Network Models” at the Annual Meeting 2007 of the World Economic Forum in Davos, Switzerland, January 27, 2007. (Photo: World Economic Forum / Flickr)Imagine that we upped the prizes in state lotteries by a factor of 10 or even 100. Currently winners get tens of millions of dollars, or occasionally hundreds of millions of dollars. Suppose instead that winners got billions, or sometimes even tens of billions of dollars.
This would mean that winners of the lottery would immediately rank among the wealthiest people in the country. They would able to spend as much as they could ever want on their own consumption, buying houses, cars, islands, or whatever else they might like. Leading politicians would come visit them to get their wisdom, and their money. Lottery winners could set up foundations to support whatever charitable projects they considered worthwhile.
This is pretty much the story these days of Silicon Valley and the tech sector. That may upset some of the acolytes of Bill Gates, Jeff Bezos and the rest, but the economics of the sector are pretty clear. There are thousands of start-ups every year. The bulk of these burn out without their founders ever hitting the jackpot.
However in some cases there will be jackpots. Most of the time, it will prove fleeting, but our lucky Silicon Valley Powerball winners may still be able to walk away with hundreds of millions or even billions from their bet. In rare cases a company may survive, but even then, the market value after an initial flash may be just a fraction of its prior peak. This means that Silicon Valley lottery winners would have an opportunity to dump off their stock at grossly inflated prices before saner eyes bring the price back down to earth.
For example, take the case of Zynga, the maker of Farmville. It currently has a market value of $2.3 billion, but a bit over a year ago its market value was more than four times as high. This meant that if a Zynga Powerball winner had a 10 percent stake in the company, they could have cashed out with more than $1 billion. Groupon, which had the revolutionary idea of selling coupons on the web, saw its market value fall by almost $10 billion from the beginning of last year to the present. This disappearing market value could have made billionaires out of several of its founders.
This story is not new. In the stock bubble at the end of the 1990s there were plenty of millionaires and billionaires created by selling off businesses that were at least hugely over-valued, if not altogether hare-brained.
The best example in this category would of course be AOL and Steve Case, who is one of the richest people in the country. This is the result of his ability to get Time-Warner to sell itself for AOL stock back in 2000. At the time Time-Warner was a huge media conglomerate with a market value of $83 billion. The AOL stock it got for the sale would probably not be worth much more than 1 percent of this price today.
Even Bill Gates and Microsoft fit into this picture. At the peak of the stock bubble in 2000, Microsoft’s market value was almost 2.5 times its current level, adjusted for inflation. Even if we take the value from the trough following the collapse of the bubble, Microsoft’s stock price has been virtually flat over the last 11 years whereas the broader S&P500 has risen by more than 100 percent over this period. Holders of Microsoft stock effectively threw a lot of money in the garbage by buying the stock at vastly inflated prices and in the process made Bill Gates the richest person in the world.
The fact that the stock market and especially individual stock prices are volatile is not news. What is new is that so many new companies can quickly jump into the market and take advantage of the largest fluctuations. This has substantial implications for the distribution of income and wealth and the structure of incentives in the economy.
In terms of the distribution of income and wealth, because a start-up can quickly become worth billions of dollars we have a story where income and wealth is transferred from existing stockholders to the founders of the start-up as happened to the shareholders in Time-Warner to the benefit of Steve Case. Insofar as these shareholders were established wealthy people, the loss of money to the newly wealthy is hardly a cause for concern.
However when pension funds and mutual funds held in retirement accounts make bone-headed investments in trendy start-ups, we should be concerned. There does seem to be a problem of asymmetric incentives in some cases, where fund managers get far more credit for finding the next Google, than punishment for investing in the next Pets.com.
In terms of incentives, the biggest fortunes to be made are now in coming up with some scheme and going public before investors recognize the idea has little potential as a profit making enterprise. It’s great that many people enjoy playing Farmville, but it doesn’t look like they enjoy it enough to support a multi-billion dollar company. But this will not be the founders’ concern if they have been able to cash out their stock.
Just as Wall Street is now largely about ripping off suckers, the high tech world of Silicon Valley seems to have evolved into the West Coast version. And it ain’t pretty.
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