A few days ago I read a story about Survey Monkey’s recent venture financing. The article pointed out, with a somewhat surprised tone, that Hedge funds were financing expansion stage startups as an alternative to venture funds when a tech startup was seeking an expansion round. The article reminded me of the many that have been written about the “Series A funding void,” where the decline in the number of venture capital funds is creating a severe mismatch between entrepreneurial startups that are seeking to scale and places to get patient longer term growth capital. And, it also made me think about the various folks I have heard tell me that crowd equity (when the SEC finally issues regulations) will solve the Series A funding crunch, and bring large amounts of needed capital to entrepreneurs around the US.
What all of these articles, conversations and musings have in common is an implicit assumption: financing startups is a unique and distinctive activity that exists somehow independently from other markets and uses of capital. For these observers, the only thing that matters for understanding the ability to access startup capital is to understand the identified sources for startup capital. Unfortunately, this approach is like trying to understand the universe by only discussing what is visible, and forgetting about dark matter. To truly understand what is occurring in the world of startup financing, and what is likely to occur, you must appreciate the dark matter of the financial markets.
The financial markets are highly complex, and extremely efficient at allocating capital to opportunities for perceived returns. Efficiency in this context is not a normative term, but is used to describe the ease and rapidity at which a market (for example, the market for milk, or the market for financial assets) adjusts to changes in supply and demand. Believe it or not the best example of efficiency in the financial markets is the crisis of 2008 and its aftermath. The markets worked efficiently – pushing capital into a market sector that had high return potential with small perceived risk (mortgage backed securities). What happened thereafter was the market learned that the risk of holding mortgage related assets was much higher than expected, and market participants rapidly reevaluated the price at which they would purchase these financial assets. The phrase “not at any price” became the market price for many of these assets, and the cascade of repricing resulted in a near collapse of the financial system. Forget about your political leanings for the moment which cause you to apportion blame (it was the fault of greedy buyers of houses, Fannie Mae, greedy bankers, blah, blah). The financial market did what it always does when left to its own devices – it moves capital to where investors think that they can get the best returns with the least corresponding risk.
“Ah, ha,” you say, “but markets aren’t about people looking for returns without risk! How do you explain Angel and venture capital investments? There’s lots of risk there.” You are absolutely correct. But, here is the key point – investors do not look for investments without risk: they look for investments where the risk that they take is compensated for with an appropriate level of return. Simply put, investors demand more return on their investments the riskier an investment opportunity. And, in fact, they look for investments where they are overcompensated for the risk with a higher comparative return. In other words, they try to find investments where for some reason their perceptions of actual risk are less than the market generally, so that they can get an investment with a higher return potential than they otherwise should. It is the constant push/pull of investors trying to get higher comparative returns, and the sellers of investments wishing to offer the lowest possible return potential, that makes financial markets work. When agreements as to the correct level of price and risk occur, a sale of an investment takes place.
This matching of buyers and sellers, and the allocation of risk versus return happens throughout our financial markets on a constant basis. Business people often think of these market allocations as occurring in a continuum, where each investment opportunity is evaluated on the same criteria (return versus risk). They describe this continuum as the Capital Market Line. The CML looks like this:
Because of the highly efficient characteristics of the world financial markets, most financial investment opportunities around the world exist on the CML. Certainly, because the US financial markets are the most efficient financial market in the world, each US investment opportunity, whether it is a Series A investment in a startup or the purchase of US Treasury Bonds exists on the same market continuum. Which brings us to the reason for the foregoing explanation – if you want to understand the world of financing of startups, you need to understand the CML and the factors currently affecting it. So, with that, here are few big ones:
- The financial markets are presently dominated by a desire for short term, highly liquid investments. Liquidity is a term that is used by financial market participants to describe how quickly they can turn an investment into cash. There are a number of salient reasons for this focus on short term investments with high liquidity, including the financial crisis of 2008/2009, geopolitical challenges (i.e., Iran and the atom bomb or China and Japan fighting over a small island) and the continual drum beat of political risk (i.e., strikes in Greece, Elections in Italy and Sequestration in the US). Investors are highly motivated to have liquidity to get their capital back and “run for cover” from the next to occur market panic.
- Financial markets reward the people who can generate high returns while maintaining liquidity. A Hedge fund manager can legally take 20 to 50% of his investors’ profits for himself. A banking proprietary desk manager can make $20 million a year doing his job well (which, by the way looks a lot like managing a Hedge fund). As a general matter, the highest compensated investment professionals can make $1bn or more a year managing a Hedge fund. In an industry where “keeping up with the Joneses” means how are you compensated vis-à-vis your friends, the compensation of Hedge fund managers drives behavior in the financial markets in a few ways. Firstly, it drives up compensation requirements for all finance professionals. Secondly, because, the highest compensation opportunities come from taking a percentage of profits trading opportunities that create immediate high profit potential are favored.
- The central banking system is at present much more concerned with combating deflationary pressures and counterbalancing governmental austerity, than inflation. Therefore, they are pushing unprecedented amounts of money into the financial system. At the moment much of this money is being captured on bank balance sheets (which drives down their need to pay interest to depositors to attract more lending capital). Concerns that at some point this money will result in higher inflation (which would cause investors to seek higher returns in compensation for the same amount of risk) have so far been unfounded. But, the niggling fear of inflation shapes market perceptions and reinforces investors’ preference for liquid investments.
- Corporate management of publicly traded companies is shaped by investor preferences. For most public companies compensation has become more and more tied to stock performance, so this interdependency has become more pronounced. Therefore, as management of corporate objectives has become more shaped by financial market attitudes, how companies are managed has to comply with general investor attitudes, rather than other factors that might be more relevant to longer term strategic considerations.
- Investments by individuals in startups are also affected by the same desires for short term and liquidity. This is why startups that are perceived as having a short time to exit are much more likely to obtain Angel capital. The clustering of Angel capital around Silicon Valley (and elsewhere) light software startups is an example of this.
- Where capital is invested in private pools (i.e., venture capital, LBO private equity or Hedge funds), in any given recent period the amount allocated by investors to Hedge funds dwarfs investments in all other types of private pools, by a large factor (in some cases more than 20 times). Hedge funds are categorically driven to seek short term, high profit potential investments.
- Investible assets are largely held by the very wealthy (investible assets of more than $10 million) and institutional investors that are investing to satisfy retirement obligations, educational or charitable purposes. Such investors tend to be conservative in investment appetite (either because they are interested more in wealth preservation than wealth creation, or because they are represented by professional money managers who have a legal duty to be careful in how they manage their client’s capital). Conversely, very little investible capital is held by middle class or less fortunate individuals. For example, most individuals currently facing near term retirement in the US have zero (as in no) savings at all. Only 10% of these people have savings in excess of $250,000 (including their houses). It could be that as more and more investible capital is in the hands of the top tenth of a percent of households, risky illiquid investments are just not that attractive.
With these facts in mind, and the immutable realities of the CML, what is going on in the world of startup finance is easier to understand. For example:
Why is there less Series A financing available?
There is less Series A financing available because the institutions that invest in venture capital funds see other opportunities to achieve required returns with less perceived risk. Moreover, because a Series A investment has a likely 5 to 8 year term before it ripens (and hopefully generates the expected return), it is less attractive in a world where investors are concerned with short term liquidity.
Will the JOBs Act free up lots of new investment capital?
Probably not from middle class investors (otherwise known as “non accredited investors” since they do not have $1 million in assets or make more than $200,000 a year), since they just don’t have that much savings. It might make it easier for wealthy individual investors to find new investments, but it’s not going to produce large pools of new capital. Investments in startups will still have to compete on the CML against prevailing investor requirements for liquidity, less risk and shorter time frame.
Why are Hedge funds, private equity funds and venture capital funds competing more and more for late stage technology companies?
Because the investors in these different pools of capital are fundamentally interested in the same thing: high return, lower risk and greater liquidity. Investing in a pre-IPO/exit startup can be very lucrative without a high level of perceived risk. Look at the folks who bought Facebook a year before it went public for example.
Why would a great technology company like Apple Have $137 billion on its balance sheet as cash, rather than investing it in research and development or basic science?
As a public company Apple’s management is motivated to make short term decisions that affect its stock price and perceived expectations of momentum, rather than making long term spending and strategic decisions.
I could go on, but I think that I have made my point. The realities of the financial markets pervade all aspects of financing of startups. An entrepreneur’s ability to obtain financing is very much tied to how her investment opportunity compares to others on the CML. Unless it provides sufficient return to compensate for perceived riskiness, an investment opportunity will fail to attract sufficient capital. Indeed this is where most entrepreneurs fail to achieve funding – they do not understand clearly the true nature of the risk/return tradeoff for their investment, and either price the opportunity incorrectly (too little upside (return) for the investor) or do not appreciate that there are some startups that are just not attractive investments whatever the price (they cannot offer sufficient upside to justify the risk).
The broader market factors which affect how investors look at all financial assets also will come into play. This means that an entrepreneur must at all times be watching the broader financial markets and political and economic events.
It also means that if entrepreneurs are concerned about the availability of risk capital for their businesses, they should be. Market demands are not at this moment consistent with a long term investment horizon. Over time, the market may adjust, through a combination of changes in perceptions of market risk, or a willingness to accept less liquidity for higher return potential. It’s also possible that governments may intervene to encourage changes in investor behavior. However, these changes occur, if at all, is something that will happen broadly as part of the overall financial markets, and not narrowly. My best advice to entrepreneurs is to get to know the dark matter of the financial markets, and to appreciate those factors which while not always reported in Tech Crunch or Venture Beat may as important to the entrepreneur’s financing plans as the next release of iOS or Android.