Should we worry about AI’s circular deals?

The yet once again on target Noah Smith reports:

As far as I can tell, there are two main fears about this sort of deal. The first is that the deals will artificially inflate companies’ revenue, tricking investors into overvaluing their stock or lending them too much money. The second is that the deals increase systemic risk by tying all of the AI companies’ fortunes to each other.

Let’s start with the first of these risks. The question here is whether AI’s circular deals are an example of round-tripping or vendor financing.

Suppose two startups — let’s call them Aegnor and Beleg2 — secretly agree to inflate each other’s revenue. Aegnor buys ad space on Beleg’s website, and Beleg buys ad space on Aegnor’s website. Both companies’ revenues go up. They’re not making any profits, and they’re not generating any cash flows, because the money is just changing hands back and forth. But if investors are looking for companies with “traction”, they might see Aegnor and Beleg’s topline revenue numbers go up. If they fail to dig any deeper, they might give both companies a bunch of investment money that they didn’t earn. This is called “round-tripping”, and it happened occasionally during the dotcom boom.

Now what I just described is completely illegal, because the companies colluded in secret. But you can also have something a little similar happen by accident, in a perfectly legal way. If there are a bunch of startups whose business model is selling to other startups, you can get some of the “round-tripping” effect without any collusion.

On the other hand, it’s perfectly normal and healthy for, say, General Motors to lend its customers the money they use to buy GM cars. In fact, GM has a financing arm specifically to do this. This is called vendor finance. It’s perfectly legal and commonplace, and most people think there’s nothing wrong with it. The transaction being financed — a customer buying a car — is something we know has value. People really do want cars; GM Financial helps them get those cars.

So the question is: Are the AI industry’s circular deals more like round-tripping, or are they more like vendor finance? I’m inclined to say it’s the latter.

Noah stresses that the specifics of these deals are widely reported, and no serious investors are being fooled.  I would note a parallel with horizontal or vertical integration, which also can have a financing element.  Except that here corporate control is not being exchanged as part of the deal.  “I give him some of my company, he gives me some of his — my goodness that is circular must be some kind of problem there!”…just does not make any sense.