- I start a company to sell e-widgets over the internet.
- I produce e-widgets and sell them for $10.
- I pay my buddy $10 million to buy a million e-widgets from me.
- My buddy pays me $10 million for a million e-widgets. We do it again next month, but for $20 million and 2 million e-widgets.
- I go to investors and say "look I have gone from nothing to $20 million of revenue per month; at 8 times annual revenue that justifies a valuation of $2 billion."
- I sell 5 percent of the company to investors for $100 million and spend it on yachts.
- E-widget sales dry up (once I stop paying my buddy to buy them), the company shuts down, the investors lose all their money, and we all shrug and say "what can you do, most startups fail." [...]
In fact, markets are now kind of used to the idea of investing large sums of money into companies based on multiples of active users -- not even revenue -- meaning that you can run this fraud by paying your buddy money just to look at your website a lot. [...]
Perhaps it is wrong, and the venture capitalists are confused, seduced by a few examples of success but underestimating the difficulties. Or perhaps it is a charitable redistribution of wealth in which rich venture capitalists effectively donate their money to the middle class in the form of underpriced Uber rides or free movie tickets.
But perhaps the analysis is even simpler: Pay someone a dollar in customer-acquisition costs, have him pay you back a dollar in revenue, sell that dollar of revenue to investors for $8, and you're rich.
The internet age has allowed the perfection of this particular fraud: