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    Money For Startups: Endangered Specie?
    By Fred Phillips | February 12th 2012 11:22 PM | 6 comments | Print | E-mail | Track Comments
    About Fred

    After a dozen years as a market research executive, Fred Phillips was professor, dean, and vice provost at a variety of universities in the US, Europe...

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    For innovative and high-tech startups that need financing, a worldwide drought is in the offing.

    Coming shortage of equity investment

    The Global Entrepreneurship Monitor reports a surge in early-stage entrepreneurial activity worldwide in 2011. Over 12 percent of US adults started a business in that year, compared to less than 8 percent in 2010. Entrepreneurship increased in three fourths of the developed countries GEM studied. Even in China and other countries where entrepreneurship was already high, entrepreneurial participation jumped 25% in 2011 [Klein].

    Some reports show US venture capital funding 22 percent above 2010 levels [Bigelow]. Other news stories paint the Austin VC market as hot. And yet...

    PricewaterhouseCoopers’ MoneyTree™ reported that VC investments in San Diego in 2011 were at an eight-year low. VC funding dropped 5 percent relative to 2010 with the number of deals in this formerly hot market declining 17 percent.

    GEM counts in its startup numbers new restaurants, grocery stores, and dry cleaning outlets, i.e., not just high-growth high-tech ventures. Furthermore, GEM numbers include forced entrepreneurs, those compelled to start small businesses because they were laid off from corporate jobs. This is, to be sure, the early stage of the fabled Schumpeterian creative destruction, but that theory only holds out the possibility of a happy ending in the long run. The short run may be grimmer.

    The GEM study showed entrepreneurial failures in the developed countries stemmed equally from unprofitability and from difficulty obtaining financing.

    “In 2007, venture capital firms raised more than $31 billion to invest, according to data from Thomson Reuters and the National Venture Capital Association. But they raised only slightly more than $18 billion” in 2011 [Clifford].

    “In Europe and America, companies have been retiring equities through share buy-backs, while the volume of initial public offerings has dropped considerably from the peak years of 2000 and 2007” [Economist 2011d].

    Why are we seeing signs of drought?

    Some of the reasons are:

    •    Commodity prices are up due to the diversion of agricultural output for energy. (Generally speaking, commodities go up when shares go down.) As a result of higher food prices, consumers divert savings into food expenditure, meaning that banks have less to lend and to invest.

    •    Rich people invest to preserve their capital, not to risk it. Their savings do not find their way into high-tech startups.

    •    In the US, the problem of unrepatriated earnings. “US companies are sitting on over a trillion dollars in foreign earnings that are subject to a 35% total tax rate if they are returned and put to use in the US” [CONNECT].

    •    In an age of ever more catastrophic climate change, investment is (often justifiably) siphoned off for disaster prevention, relief, and recovery, and to rebuild transportation infrastructure that will “withstand extreme conditions” [Caldwell 2011].

    •    In the aging countries, diversion of government expenditure to social pension payments and national debt service [Kozemetsky 1996]. In more statist countries, diversion of funds from deserving companies into state-owned enterprises (SOEs) [Economist 2011c].

    •    Pension funds are maturing, with the result that money is pouring into bonds rather than stocks. 

    •    “New US and European cash reserve requirements are causing insurance companies to divest their shares” [McKinsey].

    There seems no reason to expect these trends to reverse themselves any time soon.

    In the less-developed and emerging economies

    Few in the newly developed world own stocks. According to McKinsey, Only 8% of Indians’ wealth is in equities, as compared to 42% in the US. This is not likely to change quickly: “Companies in emerging markets are often not as transparent as those in the developed world, nor do they have a record of treating minority shareholders well.” Those companies will thus be slow to attract small investors.

    The natural resource curse. China’s huge appetite for natural resources has been a financial boon for nations in South America and Africa. Even if all the new wealth were channeled efficiently, which I do not expect, a psychological preoccupation with nonrenewable resource extraction as the prime source of wealth will slow innovation in those countries.

    Undeveloped financial institutional infrastructure in the developing world – plus recent proofs of the inadequacy of financial institutions in the US and Europe – will cause restructuring of financial channels before loans and equity investments can again flow freely.

    Increased volatility in private capital flows. Quite aside from Chinese SOE investments in the developing world, “net private capital inflows to emerging and developing economies... suffered a strong setback with the sharp deterioration in global financial markets in the third quarter” of 2011 [United Nations]. “The current level of inflows remains well below the pre-crisis peak registered in 2007. As a share of GDP of developing countries, net capital inflows are about half of their peak levels.” The UN believes volatility – and hence conservatism in investment behavior – will continue because of “deepening sovereign debt distress in developed economies [leading] to more capital being pulled back for deleveraging of financial institutions in developed countries or in a search for safe havens...”

    McKinsey predicts that by 2020 a $12.3 trillion gap will develop between the amount of equity available and the amount demanded by businesses that need to grow. “Global investors are losing their appetite for shares.” Just as it has become widely understood that innovation is the key to increased national wealth and a better life for all, funding for innovation is drying up.
    __________________________
    References

    Bruce V. Bigelow (2012) “San Diego VC Activity at Ebb Tide in 2011.” Xconomy (January 20), http://www.xconomy.com/san-diego/2012/01/20/san-diego-vc-activity-at-ebb-tide-in-2011-and-top-10-local-deals/

    Kathy Caldwell (2011) “The Cost of Doing Nothing.” Science Vol. 334, 21 October, p.289.

    Catherine Clifford (2012) Six Mistakes Entrepreneurs MakeWhen Seeking Venture Capital. January 17,http://www.entrepreneur.com/article/222652

    CONNECT(2012) “Seven Innovation Policy Ideas to Spark an American Recovery.” www.connect.org/programs/policy

    The Economist (2011c) “State Capitalism in China.”November 12, p.71-72.

    TheEconomist (2011d) “Buttonwood: Not sharing.” December 10,2, p.81.

    Karen E. Klein (2012) “Startup Rates Surge in the U.S.and Abroad.” Business Week online, January 20.http://www.businessweek.com/small-business/startup-rates-surge-in-the-us-and-abroad-01202012.html

    McKinseyGlobal Institute (2011) The Emerging Equity Gap: Growth and stability in the newinvestor landscape. December.

    ToddWyche (2012) “Shopping for Financing ‘At the Market.’” Genetic Engineeringand Biotechnology News,January 15, p.10-12.

    UnitedNations (2011, PRE-RELEASE) World Economic Situation and Prospects 2012: Globaleconomic outlook. New York.

    Comments

    Hank
    innovation is the key to increased national wealth and a better life for all, funding for innovation is drying up.
    The rewards for venture capital are less and less and the risks remain.  Biotech is one of few areas in America that has not been annexed by the government funding machine, so they have regulated it into oblivion.  If you can get a drug to market, and you don't get sued, you get to keep it for 7 years and you are treated like the world is doing you a favor.   Poor people need food but any company that tries to make food that grows in difficult areas is reviled by groups that claim to care about...poor people. If you don't give it away for free, you are an evil capitalist.

    And then we have the government trying to mandate winners and losers, like wasting billions on solar power companies making products that really aren't very good.

    My gosh, Fred, this article should be read by every policy maker in America.  You make the answers look so obvious even they would get it.
    Gerhard Adam
    As usual you have an interesting spin on some of these things.

    In my view the first problem is that corporations don't want free markets, so many of the problems you're describing is because that's what corporations have fought to obtain.
    If you can get a drug to market, and you don't get sued, you get to keep it for 7 years and you are treated like the world is doing you a favor.
    Well, let's consider that the drug companies think it's wise to advertise to consumers, despite the reality that the consumer isn't a doctor and not qualified to acquire the prescription.  As a result, the pharmaceuticals are hoping the consumers bully the doctors into prescribing it.  As for keeping it for 7 years ... well, they should count themselves lucky.  I can think of no industries where a product is provided that kind of protection from competitors.  If there is a patent or copyright, then it's a different matter, but otherwise, what's the problem?  So, in that respect, the world is doing them a favor. 

    I don't know where corporations got the sense of entitlement that they were justified in gaining government and market protections so that they could recover their costs and turns a profit.  While that's certainly an outcome that every business desires, it is only the largest corporations that have the means of ensuring that the government helps them achieve that end.  The economy is littered with thousands of bankrupt small businesses that were never granted comparable protections.  [Note: I'm not saying that small businesses should be protected, but instead I'm saying that large corporations need to stop complaining about how "tough" things are for them, when they've bought themselves the best government money can buy].
    If you don't give it away for free, you are an evil capitalist.
    I don't think anyone is saying that, although you have to wonder what's going on when the claimed objective is to help poor people [defined as those that have no money].  As I've expressed before, my skepticism comes from recognizing the profit motive and wondering what shell game is being played to generate revenue while helping "poor people".

    You don't become a charity to make a profit.  So, if a corporation is claiming altruistic motives, then they need to be transparent about how they intend to achieve that objective.  Most people recognize that the most common approach is to try and gain revenue from the taxpayers, by getting government to pay them what the poor people can't.

    This isn't the first time we've been round this block.  We all see banks routinely do it with ATM fees that we know are little more than a "license to steal" all the while listening to the lie about how expensive the computing infrastructure is that allows such transactions.  We have seen how the airlines and other service industries continue to charge more for less [i.e. luggage fees] while treating their customers worse than ever.  Basically we've seen how corporations over the past few decades don't even bother to pretend that they care about their customers any more.  Most recognize that you have few choices, and you won't complain unless you don't mind waiting a few hours on a phone operator in some foreign call center.

    While I'm obviously painting with a broad brush and there are notable exceptions to these things, I suspect that most people would recognize the essence of what I'm saying.

    It isn't that venture capital has significantly high risk with fewer rewards.  Instead we've created an economic class of individuals that simply doesn't even need to assess it any more.  They pay less in taxes than almost anyone, including the poor, while they are able to make money from nearly anything for a pittance in tax liability.  It's little wonder there is no incentive to take any kind of risks to make money. 
    Mundus vult decipi
    MikeCrow
    As usual you have an interesting spin on some of these things.

    As do you.
    Never is a long time.
    MikeCrow
    Fred, I'd be inclined to think a lot of the money dried up as VC wait to see what happens with the tax code.
    Never is a long time.
    Fred Phillips
    In this article (http://smallbiztrends.com/2012/02/solving-the-small-business-credit-mess.html) a
    business consultant gives the numbers on bank reserves and says part of the solution for increasing lending to small businesses would be new rules for FDIC. Of course that doesn't help the equity investment picture.

    The first time I posted this article, "endangered specie" somehow got changed to "endangered species." I was making a pun:
    specie |ˈspē sh ē; -sē|
    noun
    money in the form of coins rather than notes.
    Mi Cro, you might be right. You'd think VCs would want to do all they can while they are still unregulated. However, much of their funding has traditionally come from pension funds, and aging boomers are cashing out the pension funds. VCs (like hedge funds) might fear their future profits will be taxed as income rather than as capital gains, but I (without much evidence, really) doubt it.
    MikeCrow
    new rules for FDIC

    I'm not a finance guy, so I'm not 100% sure this is correct, but I think there was a big change in liquidity requirements because the banks melted down when the were leveraged to the hilt in mortgage derivatives when the housing bubble popped. So now they don't want to lend, and maybe use the liquidity rules as an excuse.

    You'd think VCs would want to do all they can while they are still unregulated.
    But tax rules apply when you cash out, doesn't matter the rules when you buy in, only when you sell.
    I forget about all of those other source of VC money. One of my bosses ended up as a partner at MDV, I laugh(with other co-workers) and say it's about the only job that you have to pay to get.
    Never is a long time.