Would you:

  1. Put $20m into a company that you’re valuing at $75m and has no proven mainstream appeal, scalability problems or business model?
  2. Invest $25m at a $200m valuation in a company that has already raised $12.5m, has reportedly generated about $1m in revenues since its launch in 2005 and was unable to develop acquisition interest at $250m?
  3. Give $50m and a $500m valuation to a profitless company that does $10-12m in annual revenues and whose CEO has said, “We’re like a teen in our clock cycle. Now, we have to figure out how do you get a job and work in the real world“?

If you answered yes to any of the above, you should consider a career as a VC as you clearly have blind, unconditional faith in the Greater Fool Theory, or GFT.

The GFT states:

“Someone who makes a questionable investment will usually be able to sell it later to a bigger fool.”

It is not new, nor is it a Web 2.0 “innovation” - many shrewd investors have used it to create vast wealth. As the saying goes, “A fool and his money are soon parted.

Of course, one must first find a fool and this is where the distinction between employing the GFT wisely and employing the GFT stupidly becomes apparent.

In my opinion, Web 2.0 has proven itself to be one of the best case studies of the stupid application of the GFT.

There are two primary requirements for leveraging the GFT successfully:

  • You must find one or more fools who have money to part with. The more the merrier and often, fooling a lot of fools a little is more rewarding than fooling one big fool a lot.
  • You must have an offer that looks credulous to the average fool. If your offer becomes too incredulous, the number of fools you can realistically “take to the cleaners” decreases.

Web 2.0 provides a less-than-compelling environment on both counts:

  • There are not enough fools to support all the Web 2.0 investments based on the GFT.

    In Bubble 1.0, the public markets were open to internet startups that, in retrospect, were not public market material.

    The public markets are the perfect platform for the GFT. On a daily basis, they are used by institutional investors to transfer wealth from the pockets of foolish retail investors into their own.

    In Web 2.0, the public markets have not been open and thus most Web 2.0 startups have been forced to look to an acquisition from the usual suspects (Google, Yahoo, Microsoft, News Corp., et al.) as their only hope of cashing out.

    With dozens of funded startups in the same categories (i.e. online video) all competing for the chance to turn the small number of usual suspects into fools, simple math and common sense dictates that most won’t.

  • The valuations that have been given to many Web 2.0 startups are simply so incredulous that it’s increasingly difficult to find fools. A transaction like AOL’s $850m acquisition of Bebo is the rare exception, not the rule.

    While the usual suspects have money to spend and have demonstrated a willingness to pay premiums, they by in large exercise reasonable judgment most of the time. Digg’s difficulty in finding a buyer highlights that.

    Unfortunately, the investors who are funding these Web 2.0 startups have pushed their valuations too high. Potential acquirers recognize that there is no way to justify making an acquisition at the ever-higher valuations the investors need to generate a satisfactory return.

    Thus, an already-limited market of fools for the vast majority of Web 2.0 startups shrinks even further.

Clearly, the VCs who have been trying to make the GFT work with their Web 2.0 holdings have demonstrated that they’re not good at playing the GFT game.

What amazes me most, however, is that despite the fact that the writing is now on the wall, many of these investors continue to throw good money after bad.

Take, for instance, Meebo. It’s the second company in the list above. Rumors have it closing a $25m round at a $200m valuation. Even dismissing the fact that it generates no revenue of note and has no clear path to a bright financial future, it’s hard to call investing in it at a $200m valuation anything but stupid when the company’s investment bankers found no buyers at $250m

For GFT investors with half a brain, this type of reaction from the market indicates one thing – you’re not fooling anybody and if you continue to invest, you’re only fooling yourself.

Unless Meebo’s backers buy into the highly-unlikely notion that Meebo is somehow going to become a ruthless machine for massive monetization within a reasonable timeframe, the odds that an interested prospective acquirer will eventually come to the table at an even higher valuation seem pretty damn low.

Ironically, perhaps, is the fact that some entrepreneurs play the GFT game better than their VC counterparts.

While the technology entrepreneur population is a lot like the general population – a few winners, a whole lot of losers (to quote George Carlin) – I have observed that there are a few entrepreneurs who appear to consciously fool investors.

Instead of hoping for a lottery ticket (i.e. a Google acquisition), they are content to jump from startup to startup raising money while living very comfortably off handsome VC-subsidized salaries.

This isn’t a bad deal, but it demonstrates why I think most Web 2.0 startups, in general, are bad vehicles for the GFT theory – the players are all fools:

  • Limited partners are fooled into believing that McKinsey-types (VCs) who couldn’t run a Starbucks if they were given a manual can invest their money in sexy startups to generate attractive returns.
  • Most entrepreneurs are fooled into believing that VCs are a crucial part of building successful businesses that either go public or get bought out.
  • VCs fool themselves into believing that they’ll be able to find fools willing to pay ungodly amounts for their significantly overvalued portfolio companies.
  • Some wiser entrepreneurs fool the VCs into funding startups that serve as little more than lifestyle subsidies.

In other words, the whole game is little more than an orgy of fools and given the fact that most of the time, an even bigger fool is never found, it’s a poor excuse for an orgy.