Capital is not a strategy by William H. Janeway



After years of central banks keeping interest rates low and injecting liquidity into financial markets, asset valuations have reached historic highs. While entrepreneurs and venture capitalists think “capital is a strategy,” the financial bubble is no substitute for a business plan that can generate positive cash flow.

CAMBRIDGE – Like the rest of the world, entrepreneurs have lived the past twelve years in an unprecedented financial environment. Responding first to the stubborn slow recovery from the 2008 financial crisis, and then to the recession caused by COVID-19, major central banks have supported a series of unconventional initiatives and asset purchase programs collectively known as “quantitative easing” (QE).

The direct result has been a massive build-up of financial reserves in central banks and throughout the financial system, and a reduction in nominal interest rates on risk-free financial assets to levels below the rate of inflation. Interest rates are therefore negative in real terms (and even in nominal terms, in some cases).

Years of unconventional monetary policies have also had a side effect on investment behavior. Under the conditions created by central banks, investors (both institutional and retail) have become increasingly aggressive in their quest for positive real returns. Not only have they accepted increased levels of fundamental risk (ie the risk of business failures destroying the value of their securities); they have also become more and more willing to accept illiquidity, buying securities that they cannot freely resell.

A dramatic example of this phenomenon is the influx of “non-traditional capital” – the term used by the National Venture Capital Association for mutual funds, hedge funds, sovereign wealth funds, etc. Others are the bubbles in crypto assets and the (often fleeting) explosion of “meme” stocks, driven by Reddit communities and retail investors on apps like Robinhood.

Finally, the seemingly limitless supply of low-cost (in terms of ownership dilution) capital available to early stage entrepreneurs and venture capitalists has also had a third-level effect: the proliferation of business models. with little or no potential to generate sustainable and self-financing growth. The idea of ​​”capital as a strategy” it’s imposed. In the low-friction world of internet-delivered or mediated services, start-ups are eager to spend ever-increasing sums of other people’s money on acquiring customers, the goal being to emerge victorious in a race where the winner takes it all.

The problem, of course, is that capital is not a strategy; rather, it is a resource whose supply and cost have historically been highly variable. At least since the Dutch tulipomania of the 1630s and the South Sea bubble in London in 1720, financial history has been filled with episodes of speculative excess (which is why I called a chapter of my book Making capitalism in the innovation economy: “The banality of bubbles”).

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Sometimes these outbursts of investor exuberance have funded the deployment of innovative technologies on a scale sufficient to transform the market economy, as has been the case with railways, electrification and the internet. The productivity of a bubble depends on what it leaves behind. But all the bubbles burst, so even investors in a productive episode’s vehicles will inevitably fall into one of two categories: the rapids or the dead.

Opportunism is a virtue in the world of VC. Taking virtually free capital from investors who have no interest in (or capacity for) corporate governance is compelling. As the old saying goes, “When they pass the cookies around, take whatever you can.” If non-traditional sources of capital are ready to liquidate the holdings of original investors at a multiple cost that is typically only available through an initial public offering or commercial sale, a partial seller should be extremely eager to decline the offer.

And yet, the extraordinary increase in the supply of capital has eliminated any perceived need to critically assess business models and business plans, thus undermining the golden rule of venture capital: that those who have the gold make the rules.

Instead, there has been a shift in the balance of power between entrepreneurs and VCs. This is evident in the growing number of start-ups whose founders are well in control, regardless of the amount of capital raised.

The managerial sagas of Uber, WeWork and Theranos represent the downstream consequences of the flood triggered by central banks. Theranos founder Elizabeth Holmes is perhaps the only one to date who has been caught crossing the line of criminal liability as she pumped and swelled her business. But the absence of further lawsuits is no excuse for investors and board members to abandon their fiduciary responsibilities.

Entrepreneurs and founding venture capitalists directly involved in corporate governance can survive the inevitable collapse of the current bubble by remembering that sooner or later business happiness is positive cash flow. The ability to pay your bills because you receive more money from customers than it costs to develop and deliver what you sell is distinctly different from relying on the continued kindness of non-traditional financial strangers. This type of success requires a continuous and rigorous definition of a trajectory towards positive operational cash flows, within a time limit constrained by the amount of cash currently on the balance sheet.

If no such path can be found, consider the following simple advice from Bernard Baruch, a legendary finance figure of the first half of the 20th century who advised US presidents and identified his profession to a congressional committee as “a speculator.” “. When asked how he makes his money, Baruch responded: “By selling too early.”

Baruch was speculating in the public stock market, where he could sell whenever he wanted. But the “non-traditional investors” who fuel the current venture capital bubble are stuck, along with the sponsors of the venture capital funds that have sponsored the companies. Both have enjoyed spectacular reported returns around 50%.

But the vast majority of these returns represent illiquid investments, with a “mark to market” based on recent valuations recorded in late stage financings or on the value of public companies deemed “comparable”. So, cash will turn out to be the test. But, as Kenny Rogers’ memorable player Put the:

“You never count your money
When you sit at the table
There will be enough time to count
When the case is over.

Not only is capital not a strategy, too much capital can eliminate the need for entrepreneurs and investors to have a strategy at all. For VCs and investors, this will work until suddenly there are no more cookies.


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