Frothy Markets Are Like A Party With An Open Bar
There has been talk for sometime about a potential bubble in Silicon Valley. With China’s stock market cratering to an 8-year low and US equities pulling back, a possible downturn (and potential silver lining) seems like it could be on the horizon.
This got me thinking. If a bar metaphor can be used to articulate a Nash equilibrium in game theory, then maybe we can find a similar metaphor to describe markets with plentiful capital.
While not a perfect match, the qualities of an open bar seem to capture the spirit of a marketplace inundated with cheap capital. It goes something like this:
1) A frothy market is like a party with an open bar.
2) The bar (i.e., marketplace) is overcrowded by patrons (i.e., investors) because drinks are free (i.e., low interest rates).
3) Bartenders (i.e., entrepreneurs) can only handle so many patrons at a time (i.e., room on a cap table is limited). As a result, many serious patrons don’t get served (i.e., are unable to invest in a deal). Instead, they are pushed out of the way and drowned out by the noise.
4) Despite this, tips (i.e., high valuations/fundings) are plentiful because patrons have more cash to burn than ever; none of them are paying for their drinks anyway, and everyone is vying for the Bartender’s attention.
A few things happen as a result:
a) Bartenders don’t have an immediate need to differentiate between serious patrons and bandwagon patrons.
b) Bartenders recognize they are being tipped regardless of how well they do their job, and complacency sets in with some of them.
c) The tipping gold rush incentivizes bandwagon bartenders to enter the market, lowering the overall quality of bartenders, further increasing noise and decreasing signal.
5) This can’t go on forever. When the clock strikes twelve (i.e., market downturn/correction) and the bar starts charging for drinks again (i.e., higher interest rates), utility curves are traveled leaving only the truly committed patrons standing (at least for the time being ;-), while the bandwagon patrons run for the exit.
6) The bar becomes much less crowded and serious patrons have a much better chance of being served.
7) Bartenders who built relationships with bandwagon patrons will find their tip base (i.e. valuation/funding) erode, if not evaporate, whereas the tip base of bartenders who built relationships with serious patrons will be less affected.
8) Bartenders who remain complacent will no longer be tipped for their poor service.
9) The bar’s profit is no longer prepaid or seemingly guaranteed — Its profit is now a function of supply and demand for its services.
10) Incompetent bartenders will be fired as their performance is now more closely tied to the profits of the bar.
11) Experience improves all around; this party just got much better.
TL;DR: Free drinks have a price.
I’m curious to hear what you guys think!