Is Venture Capital a Giffen Good?
During the Victorian era in the United Kingdom, Scottish economist Sir Robert Giffen stumbled on a curious trend: Demand for certain inferior goods would rise as their prices rose, which violated the law of demand. Such goods have become known as Giffen goods. Some economists suggest that potatoes were a Giffen good during Ireland’s Great Famine in the 19th century. Potatoes were a large part of people’s diets, so when potato prices rose, it had a large income effect. People responded by cutting back on the luxury of meat to buy more potatoes. The higher price of potatoes actually raised the quantity demanded.
This works in the other direction as well. Low-quality goods experience rapidly falling prices and a lack of demand when people become better off. Imagine the example of gruel (cereal boiled in water or milk) suggested by Hal Varian, chief economist at Google. If the price for gruel decreased, a consumer may decide to buy more milk and reduce the consumption of gruel. The reduction in the price of gruel frees up some extra money to be spent on other foods of higher quality. A change in the price of a good changes purchasing power and thereby changes demand. In this light, Giffen goods are inferior goods that are pushed out of the market when consumers get richer. The low quality of a Giffen good, which the newly affluent are no longer willing to accept, is to blame. Just look around: Who is still eating gruel today?
This sets the stage for the following discussion: entrepreneurs less interested in venture capital today than they were back in the first dot-com boom, even though there is more of venture capital available? After all, entrepreneur “wealth” has increased a great deal in recent years, so entrepreneurs may be losing interest in venture capital, despite the fact that it comes “cheaper.” Reasons for this are lower barriers to entry in almost every domain, globalization, and the network effects of the digitization of nearly everything. At the same time, capital is fungible. Per definition, it has no particular quality. Is more venture capital competing for fewer deals, or is it the other way around? It is indeed possible that conventional venture capital is becoming rather marginal for certain sectors — namely, small consumer internet ventures and software developers. Let’s examine why, and let’s see if venture capital is a Giffen good.
Decreasing Capital Needs vs. the Conventional Venture Capital Business Model
“Ramen profitability” describes the stage in which a start-up can cover the founders’ expenses on a minimal level. It is amazing how little time and capital are necessary to test and carry out an initial idea, especially those with technology at their core. So do ramen-profitable founders need venture capital? If founders can validate their idea and get traction in the market, they often produce revenue before they even begin discussions with venture capital firms. Social networking as a distribution channel and easy-to-implement payment solutions make this possible. If business founders contend themselves with building market share gradually, they may just as well scale the business with the sales they are already generating. Nimble start-ups may even suffer from a large influx of venture capital because they would need to abandon their validated business model to accommodate it.
At the same time, profitable start-ups are in high demand among investors. The CEOs of such start-ups are in a great position. Instead of locking up their businesses in long-term investment deals, such CEOs may negotiate multiple rounds of financing under terms advantageous to their companies. Becoming ramen profitable is far easier for a start-up today than it was 10 years ago. In my experience, most profitable start-ups only consider venture capital when it comes with extremely favorable terms. This may be a subtle sign that even though venture investors are trying to make themselves attractive to profitable entrepreneurs (by lowering the “price” of investment), they still may not get any bites. This fits Varian’s interpretation of a Giffen good.
Conventional venture capital is a “hits” business: A portfolio manager allocates capital across several projects, expecting that at least some of them will hit it off and succeed. Even though smaller, more profitable start-ups are less in need of venture capital, capital-intensive projects, such as those depending on economies of scale and mass production, still require massive funding. However, unless entrepreneurs have an extremely compelling story and track record (think Tesla Motors), going head-to-head with established players by trying to outspend them is an avenue that few investors have the stomach for. Highly capital-intensive start-ups are rarely a great investment. So, this time, it is the venture capitalists who pass. Both of these developments make the case for venture capital losing ground. Regardless, this is where things get interesting.
Capital Is Abundant, Entrepreneurship Less So
There are digital businesses sprouting up every day with lean overhead and the potential for explosive growth. They are anything but short of funding options. Capital is easy to come by in a world awash with liquidity. When money is the only value a venture capital firm or angel investor can bring to the table, most start-up entrepreneurs will be better off without it. They may just as well tap into crowdfunding, which is slowly replacing old-school venture investors. As a result, both the number of conventional venture funds (size: US$100 million–US$500 million) and their capital raised, as a percentage of the total, have been on a downward trend since 2006.
Source: Q3 2014 PitchBook US Venture Industry data sheet.
Things look slightly different for firms that bring entrepreneurial networks and experience to the table — namely, seed-stage venture funds (size: up to US$50 million). As a percentage of all venture funds created per year, the number of those smaller funds has doubled in the last eight years. Even though smaller funds represent only about 6% of the total capital of the venture capital industry, this is a meaningful shift in structure.
Source: Q3 2014 PitchBook US Venture Industry data sheet.
What start-ups lack today is not capital but expertise in business building and scalability. These skills only come with experience that first-time entrepreneurs gain through trial and error. Instead of early funding, entrepreneurs need strong mentors to accelerate their evolution. Even though founders need less financial capital, they can still take advantage of the human capital in experienced venture capital firms. When founders bring into the partnership a strong entrepreneurial track record, connections to successful entrepreneurs, and a long-term vision, start-ups benefit from these venture capital funds. In a time of abundant capital and minimal costs to entry, start-ups run a far smaller risk of disappearing any time soon.
Entrepreneurs Need Entrepreneurial Investors
This is where the door opens for a different kind of investor, who sees entrepreneurs’ contribution not in capital alone but also in hands-on support, advice, and network building. Investors can help entrepreneurs make the right decisions and speed up their learning curve, which is a great advantage in fast-changing markets. A new breed of venture capital firm has been emerging for a while now. While such firms invest only modest sums in new companies, they are strong at guiding entrepreneurs with their experience. An example is the seed accelerator Y Combinator. The first of its kind, Y Combinator started in Cambridge, Massachusetts, and moved to Silicon Valley in 2005. The accelerator model caught on, and Techstars, located in Boulder, Colorado, followed in 2007. Seedcamp, located in London, opened in 2008. Nearly every start-up hub around the world now boasts accelerator programs, some with billions of dollars of funding. The business model works for the accelerators themselves and for start-up entrepreneurs. Famous examples coming out of Y Combinator include Dropbox and Airbnb. The firm is in high demand: Y Combinator had an acceptance rate of around 2% in 2012.
The traditional route to external funding is less and less interesting for most entrepreneurs. When investment is about capital alone, entrepreneurs have better alternatives today in the form of choosing nimble business models or crowdfunding. The same is true for venture capitalists. With more capital chasing fewer deals, it is becoming harder to achieve competitive returns with little effort. Conventional, money-only venture capital could indeed be considered a Giffen good. Those venture capital firms with a more integrated perspective are far better off. By contributing intellectual firepower and entrepreneurial networks, they can accelerate the growth of start-ups better than capital alone. Such firms are in high demand and by no means inferior, or even Giffen, goods.
Although start-ups have a great deal to learn on their journey to becoming profitable, venture capital firms need to upgrade their entrepreneurial skills as well. When venture capital firms focus first on capital-efficient business building, qualitative assessment, and support networks for entrepreneurs instead of comparable sales, internal rate of return, and net present value, both sides of the table will be better off.
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Image Credit: Print by Sydney Prior Hall.