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.

Bruce V. Bigelow (2012) “San Diego VC Activity at Ebb Tide in 2011.” Xconomy (January 20),

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,

CONNECT(2012) “Seven Innovation Policy Ideas to Spark an American Recovery.”

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.

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.