How Venture Capital Changes the Economy
According to the ‘classic strategy’ for starting a company, one gets the business off the ground by taking out a loan or investing savings and, after some initial losses, one then seeks to make it profitable as quickly as possible, in order, finally, to expand into different regional markets or even market segments.
The ‘typical’ family business originates in the retail sector, expands only slowly (if at all), and is content with making relatively small profits. But even service businesses and manufacturers, which are often founded by people with management experience who are seeking to achieve a strong position within a niche market, grow mostly by reinvesting their profits.
Since the end of the Second World War, the emergence and expansion of the venture capital market has encouraged the creation of businesses based on exploiting growth markets and quickly gaining competitive advantages. These so-called ‘growth businesses’ or ‘high-growth businesses’ are backed by venture capital from business angels, venture capital firms, or investors who operate in high-tech stock markets. The business uses this capital to grow quickly, without regard for short-term profitability, so that it can achieve a dominant position within an emerging growth market.
The gap in the market that venture capitalists have seen here is obvious. Companies in growth markets rarely have access to bank loans; they do not have any significant assets that they could offer as collateral. And they can rarely point to sustained periods of profitability they have had in the past. These companies often operate in markets that are difficult to predict because they develop only slowly. The technology involved is often so complex that it would be laborious and expensive for banks to try to assess the soundness of the proposed investment.
Venture capitalists come to the rescue of these young entrepreneurs. They accept the risk of the business failing and their loans being written off, but if the enterprise is successful they stand to receive a very high rate of return. Unlike banks, which make their money from the interest on the loans, venture capitalists make their money from the difference between the purchase and sale price of the companies in which they have shares.
Venture capital is not a long-term investment. The goal of the business angel, venture capital firm, or investor in a stock market for growth businesses is to invest in a new start-up and sell the shares once the company has become sufficiently large and credible. The ‘exit’ of a venture capitalist takes place when the business is floated on the stock market, or when the venture capitalists sell their shares to another company or to the founders of the business. In short, venture capitalists buy shares in an entrepreneur’s idea, nourish the business for a number of years with money, advice, and support, and then sell their shares for the greatest possible profit.
From the very beginning, then, venture capitalists look at their involvement in companies ‘in retrospect’, from the perspective of the end of their involvement. When planning an investment, they are already thinking about their various exit options, for their profits derive not from dividends from the company but from the difference between the price of the shares when they invested and the price of the shares when they sell.
Venture capitalists employ a strategy of diversification. As a rule, a venture capital firm assumes that it will only make large profits on 10% to 20% of the companies in which it invests. Shares in other companies are either treated as total write-offs or sold on very cheaply. The sale of shares from one or two ‘top companies’, however, is usually enough for a venture capital firm to make 25% or 30% interest on its total investments.
Venture capital firms make no secret of the fact that their strategy is determined by the prospect of their eventual exit. The businesses which sell shares to venture capitalists are told that their backers are not interested in long-term investments but will sell their shares as soon as a lucrative opportunity to do so arises. In the contracts they sign with the businesses they are financing, venture capitalists will often insist on the right to float the business on the stock market or to put the company up for sale even against the will of the founders.
The primary focus of venture capitalists is the market for equities. The core competence of venture capital firms is therefore equity trading, not the product markets in which the businesses they finance are operating. Although the product or service market in which the business is active is an important indicator of the future development of the business, the success or failure of a venture capital firm ultimately depends on one question: can it sell its shares for a decent profit?
The result is that venture capitalists introduce what we might characterize as a ‘capital-market-based’ logic into start-ups. The central questions become: which segments of the industry offer good exit options? Which company is easy to float on the stock market? What kind of enterprise can easily be sold for a high price to other – and, most importantly, bigger – corporations in a few years’ time? How much of a loss is a purchaser of shares prepared to tolerate? Which expansion strategies will the capital markets look kindly upon?
The capital market logic that rules businesses financed by venture capital enters the heads of the founders, senior managers, and employees by a kind of osmosis. The entrepreneurs seek to increase the value of their shares in the business. The senior managers of growth businesses accept lower salaries on the understanding that the shares they have been given will rocket in value. Employees use their monthly salary to pay the bills but believe the shares they acquire through their stock option plans will provide the really rich pickings.
The classic entrepreneurial strategy (‘I invest capital, get people to work for me, and profit from the surplus value produced’), the usual calculation of a manager (‘I receive a monthly salary for advancing the business’), and the well-known rationale of an employee (‘I sell my labour power for a pay cheque’) play relatively minor roles in businesses financed by venture capital. All these rationales are increasingly replaced by the methodology employed in the speculations of the venture capitalist. The employee wants large parts of his labour to be paid in shares in the company, which may make him rich quickly but can also quickly become worth next to nothing.
The ‘classic’ rationale of the ‘labour for wages’ model, or the ‘starting a business and reaping the dividends later’ model, differ in several ways from the rationale of an ‘investor’ who acquires shares in a business in return for his labour, readiness to lead, or start-up initiative.
The ‘capital investor’ in a fast-growing company has an interest in seeing the business develop in a way that leads to a rise in its intrinsic value on the capital markets. As a result, it is not only capital investors (investment companies, venture capitalists, small-time shareholders) who make sure that the business pays attention to the vagaries of the capital markets. It is also the members of the organization themselves. In steering the business, they take their bearings from the chances of making short- or medium-term profits on the capital markets. The interests of ‘stakeholders’ and ‘shareholders’ increasingly coincide.
Because of this orientation towards the capital markets, there is little reason for founders, managers, or employees to show restraint when investing their labour. Businesses which take their bearings from the capital markets have the idea that the company will grow tremendously within a few years and that the value of shares will thereby multiply, meaning the sale of the shares will enable shareholders to lead a good life.
This is of course a risky game for the actors involved. Should the business fail, the shares will inevitably lose their value, and employees will find their regular pay cheque does not materialize. In sum, founders, senior managers, and employees all develop the mindset and rationale of the venture capitalist – with the only difference being that they cannot distribute their risk across multiple businesses.
