Spending Other People's Money. Venture Capital Past, Present and Future Role

Updated: Jan 28

The IPHONE and its APPs are a cornerstone of the 4th Industrial Revolution enabling innovative start-ups, and Venture Capitalists.

The New Yorker January 27, 2020 reports in Annals of Enterprise “Big Spenders” Venture capital shaped the past decade. Will it destroy the next? By Nathan Heller

Like investing in a whaling expedition in the times of “Moby Dick, venture capital (VC), as we have come to know them, are mostly unsuccessful but if the “big one” hits the returns are very great. This according to Tom Nicholas author of “V.C.: An American History”.

VC draw investments from very-wealthy private investors, foundations, pension funds and university endowments. In common, unlike the small guy on the street, these investors can absorb a loss of that seed money. So, it is mostly Other People’s Money (OPM) with VC chipping in a little. The entrepreneur, or founder of a start-up group, "negotiates" to keep as much ownership and control as possible in exchange for funding. Far from a sure thing, getting funds does not guarentee that a helpful and sustainable company will emerge. Fully, only one in five VC-funded start-ups survive but from those efforts we celebrate the big successes. Since the 1970s, VC has indeed helped transform American business by supporting runaway successes the likes of Apple, Intel, Google, Amazon and Facebook, Genentech and Uber. In common, all these organizations needed significant money for research and development or for operations enabling benefits from economies of scale.

More recently, VC has been pursuing and supporting simpler, less complex businesses in the arenas of “direct-to-consumer, delivery services, financial services, car companies, shoe companies, office real estate, leisure real estate, coffee brewers, beer brewers, smoothies, razors, trousers, speakers, scooters, mattresses, toothbrushes, socks and underwear.” Having said simple, most of these start-ups speak with unusual gravitas about being industry "game-changers"-often just based on creating an online entity. The last decade also began for VC “A marriage between social enlightenment and manic growth"

On an individual basis, like a divorce, a falling-out with VC happens when a start-up fails developmental timelines or worse, for good reason, becomes media fodder. Notable examples Theranos, WeWork, Juicero and Zume. With $56B added to VC funds in 2018, this type of failure, is said to, help ensure better candidate-selection in what is defined as a “VC financing-boom". With these types of simpler business models-not requiring extensive R&D, the VC calculus is push hard for the quickest payout. Sadly, rather than creating value, being pushy may be counterproductive for nascent organizations working hard to innovate.

Besides a quick payout, VC work the storyline for the highest possible payday but in-the-end substance matters in the public marketplace. As examples, Facebook and Uber shares “wilted” after their IPO hurting investors. By contrast, when you have many M&A suitors prices are bid up and after sale revelations are almost always irrelevant. Instagram and YouTube are examples of start-ups that benefited from being acquired by the much-larger Facebook and Google organizations respectively. So, while start-ups are creating innovation, the rewards often accumulate to powerful companies at the top.

Surprisingly, favorable government incentives and taxing policies facilitated the development of VC over the decades. Today, VC argue against government intervention favoring instead what they call “market meritocracy” and professing the need for rewarding their risk-taking. They suggest that risk-taking is required for achieving innovative “moonshots” and that risky investments won't happen without the potential of substantial rewards. Others, using Microsoft and Craigslist as non-VC funded examples, suggest VC is not needed to create significant innovation.

So how good are VC in terms of generating returns to their investors. In reality, VC have not outperformed public markets. Most “had scarcely broken even” [in the last 20 years] according to a study of the Ewing Marion Kauffman Foundation but their efforts have yielded valuable unicorns. Luckily, in recent times, VC pursuing these simpler business models have uniquely benefited from the truly seismic innovation of the IPHONE and App Store, noted Mike Isaac the author of “Super Pumped: The Battle for Uber”. How did that happen? With APPs, distribution costs were largely eliminated and consumers suddenly began having access and functionality wherever they go. This allowed for enormous scaling of a platform like Uber and others.

Will VC destroy the next decade? The arguments are as follows. VC are becoming too large recording $200B in proceeds from last year’s "harvest". Being bigger equates to being more conservative. So, VC find themselves “moving outside their traditional province”. Doing so, in part, by allocating funds targeted at landing less risky companies that are closer to exit. This positions these large-VC closer to being a private equity than real venture capital. Another warning sign, is that start-up funding is declining. This trend of larger firms avoiding riskier start-ups may hurt the creation of the next meaningful company like Apple, Inc.. Lastly, using OPM, founder sweat and being buffered by mandatory management fees, VC firms may not be properly aligned for creating companies that are helpful and sustainable. VC are helpful, at least temporarily, by providing consumers with free stuff like getting a below standard fare cab ride-Uber. But for every winner there is a loser. Firms like Uber hurt workers and small companies by lowering total compensation and by creating unfair competition for small local business. All on the backs of OPM.

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