Who is funding the future? In order to answer that question, we have to understand the different moving pieces within our economic framework, recent financial markets history and how they all fit together. Money has to ultimately flow from investors at the source, all the way to the entrepreneurs who utilise the capital, to execute their large scale and bold society shaping visions. In the 21st century, internet based platforms have disrupted the traditional means of access to capital and specialised knowledge. This has helped foster the ability to bootstrap start-ups faster, easier and created the ability to impact bigger addressable markets than in previous generations. We will also explore the implication of this disruption within the context of the funding chain and the evolving attitudes of the different stakeholders on the innovation cycle itself.
After the credit crisis, the US corporate essentially de-levered. CEOs took a flight to cash (rightly so), as seen through their record net debt levels. This helped bolster their balance sheets and everything looked rosy. They were immune to any further deterioration in aggregate demand brought on by the recession. Companies optimised costs through the usual means. On the other side of the markets equation, the investors themselves had canned their positions, leaving the S&P500 below the 700 level (March 2009).
Over the following 5 years, the markets walked blindly into a bull territory. No one believed in it whilst it was happening. And even towards the start of 2014, there was a lot of coverage about how many funds had missed the rally from the lows of 2009 – as can be seen from hedge fund returns. Many were trailing the index itself, repeatedly.
The management of US corporations were doing a little better than the portfolio managers (PMs) at these funds. A large number of them were orchestrating a recovery all by themselves, independent from reality. This was no ordinary recovery. With the consumer also trying to de-leverage from the crisis, companies realised that there would be lacklustre aggregate demand. Some argue that technological innovations are part of this issue of consumers needing to spend less, creative destruction becoming creative devastation. Others say that in the developed world, even if you put cash in their hands, they have no desire to spend, citing Japan as an example. Anyway, the point is that corporations had to find a way to make things look good. And they did.
With record levels of cash on their balance sheets, companies started buying back their own shares – by the bucket load. The effect of this has been widely reported and analysed by many this year. Basically, buying your own stock means you reduce the number of shares available. This means that you artificially elevate your EPS. Not only did they use their cash to buy back their own shares but the management started issuing cheap debt. The additional cash raised was used predominantly to buy back even more shares. This multi-year iterative process pushed the S&P500 to record levels.
What is the point of giving you a brief history of the situation post the financial crisis? It is so you can understand the context of the next bit. During this era of earning seasons EPS beats, record margin highs, extraordinary cash levels and stocks reaching all time new highs – the US corporate didn’t spend on capex. Capex investment is of course required for future growth. Investors chasing yield are fully aware of this situation. Many understand that with what we have described above, yield chasing in the traditional markets will be very difficult over the foreseeable future (emerging markets is different story altogether for another day). The S&P500 corporate, in general, is going to find it difficult to create new value if they haven’t invested in the future. Presently, there is no incentive for the majority* of companies to spend on innovation and updating their infrastructure.
If corporates are not investing in the future, we believe that venture capitalists could play an even bigger role in allocating capital to drive innovation forward. If PMs don’t believe in the traditional markets delivering tangible growth in the developed markets and feel like they are chasing diminishing yields, then they will position their funds elsewhere. Institutional investors at entities like pension funds, endowments, private equity fund of funds and the like have a segment on their books called alternative assets. Within this fund sits their allocation for these sub-classes: VCs, private equity, real estate and other alternative investments.
At the moment 10% of alternative assets are allocated for venture capital. However VCs used to be up to 50% of the alternative asset class. VC as an asset class has fallen from grace. You could debate how much of this reduction is due to the dotcom fallout, pushing funds to shy away from this class of investment. In 2012, venture capital had a 12 year negative return. It is understood that this was one of the longer cycles of negative returns the investment class has had.
Markets participants seek to buy what is “cheap” or under-performing. You try to reason and understand from first principals and fundamentals why an asset is behaving in this manner. You can also look for something called “mean reversion”. Either way a case can be made for a VC allocation turnaround. We are beginning to see an increasing number of disclosures, of various funds increasing VC fund allocation. There are various sources showing that in addition to increasing flow from funds into venture capital, the returns for VCs are making a turn around.
If venture capital allocations get anywhere near the 50% levels within the alternative asset class over the coming years, you will see these investments come at a prime time, as the propensity for innovation hits a sweet spot. We are sitting on the cusp of technological breakthroughs which is enabling start-ups to implement low cost virtual reality, low cost sensors for smart devices (internet of things), low cost robotics, low cost 3d printing for prototyping, low cost on demand cloud computing and much more.
It is true that the size of allocation to venture capital in is small, percentage wise, in relation to the total fund sizes at these institutional funds. However, it can be argued that even a small increase in allocation will have tremendous impact on innovation. Say if VC funding doubles to 20%, within the allocation of the alterative asset class. This increase could be sufficient to help the industry capitalise, guide and assist the next generations revenue creating and market owning behemoths like Amazon, Google and Facebook. Remember when gold was trading at 300USD, and note the context that institutional funds typically only allocate a very small fraction of their money to the precious metal. When these funds increased their allocation to gold even by a small margin, it was sufficient to pull the commodity up by the shoe laces and reach all-time highs. A similar effect could be seen in the VC world. It would translate to more start-ups getting funded. This in turn, implies a better chance of funding the start-ups which define the next era.
Venture capital isn’t the only source of raising funds for a budding entrepreneur these days. The new kid on the block, so to speak, is of course crowdfunding. The most talked about platform getting its lion share of success is Kickstarter. Crowdsourcing isn’t in competition with venture capital but augments the funding cycle for start-ups. The ability of the public to micro-finance, on first glance, a niche idea, enables a potential (future) start-up to engage the early adaptor. Crowdfunding asks the public to bear the initial small financial risk. This allows entrepreneurs to experiment, bring to market once dormant, dead, fringe or experimental ideas. These start-up ideas are still in the gestation stage and may not yet be mature enough to be on the radar of bigger venture capital funds. In some sense, the ability to crowd source funding for a project is a bit like angel investing.
Crowdfunding encourages the creative and technical people of different background to get into the start-up scene without necessarily committing mentally to it fully. In the sense their target is to ship a particular product to the public in limited size and not be overwhelmed by the pressure of building something grandiose, like say the next Facebook. The public in the modern age is fully cognisant of the risks involved with crowdfunded projects. Although public backers want to receive their product they funded, most more or less write down the stake mentally and understand the downside of their stake.
The risks involved in this new variation of funding the early stage, small scale and an un-tested idea is undertaken by the public. If the founders manage to implement the initial version of the product they sought to create, and demonstrates the viability of the project at this early stage, it opens up the scope for venture capital firms to step in and do what they do best. VC firms can enter the ring and capitalise the founders. VCs also guide the founders and help them avoid the common fit falls. Most arguably, and importantly, allow the start-up to tap into a network of expertise, which will allow them to scale their idea, ready for prime time. This is exactly what happened to the once dormant idea of virtual reality, with Palmer Luckey’s Oculus Rift.
So essentially the market research and field test is done already by the time a VC gets involved in a publicly backed crowdfunded project. The prototype also showed the VC that the product has the potential to gain traction with the public – as the idea was initially backed by them. The number of early adapters allows them to gauge some sort of early stage interest too. All of these factors combined make the investment for venture capital that little less risky. Noting traditionally larger size VCs only get involved in late stage start-ups as investments.
All VCs when going into an investment will certainly have in mind a possible exit strategy. After all a return is what the investor wants. IPOs are not the only way to make a successful exit nowadays, like a Facebook or Twitter public offering. A model that has grabbed the headlines recently is one of where a cash generating publically listed giant comes in to buy the start-up out. Again I refer to Mark Zuckerberg’s acquisition of Oculus Rift for 2 billion dollars.
The corporation which buys out the start-up then can allow the founders sufficient freedoms enabled by the capital backing them, and assist in scaling to create new verticals and potentially fresh new future revenue streams for the new owner. Tony Fadell’s Nest exited VC land through another S&P500 corporate exit. This time it was Larry Page’s 400 billion dollar, cash generating giant to the rescue. Beats by Dr Dre is also another example.
Earlier we talked about the US corporate using their balance sheet to buy their own stock. The other use of cash during more recent times has been to utilise their cash and their high stock price levels to buy new business segments, in order to make bold moves to bolster the potential to generate future revenue streams. Unfortunately this is not a common story for the majority of S&P500 index member. All too often we see stocks being rewarded for divesting business segments. Essentially they are being paid to cut innovation potential for instant cash gratification.
A quick side note: the dynamic between crowdfunding start-ups and venture capital firms could be further complicated in the coming years. The SEC is looking into methods of updating the legal frame work to enable the public to get an equity stake at the crowdfunding stage, which currently they do not. Whether in practise this can be implemented for the crowdfunding community remains to be seen. Once you start getting equity structures into place, it can become very complicated for the ordinary public to fully understand the risks.
Whilst discussing the notion of who funds the future with people, I’ve been asked about the possible implication for the future of innovation itself. As we have outlined in this piece, currently it doesn’t seem likely that immediate future innovations will come directly from existing publicly listed corporations. It may instead stem from the rise to quench the desire of public needs, wants and desires. Instead of a few fund managers sitting in a room deciding which ideas are worth funding, we seem to be moving into an era where any idea can be initially backed by the smaller public pocket. The way the markets have been operating by giving priority to shareholders, doing share buy backs, dividends and divesting – they have in some roundabout way forced innovation to find different mediums to fund itself.
The immediate visible impact that we are currently seeing materialise is that we get more start-ups, more innovation and more efficient futures. Virtual reality was largely ignored till recently. It was not seen the most appetisingly low hanging fruit. Nobody saw ways to bring it to market and monetize the vertical. Academia wasn’t interested. Corporations weren’t interested. Instead the people wanted virtual reality, and so they funded it.
Venture capital investing is not without its risks. VC investing is not liquid. VC investing exits can sometimes take up to a decade to see material monetary gains. Many investments can and do fail. However, with the way the early part of the 21st century has developed, the once really expensive and sophisticated technologies are now available at very low cost and in the hands of the better educated and creative public. This means that it is worth the risk for venture capital in getting a few dud investments, in exchange for the potential of discovering the few start-ups, which more than make up with materialising sufficient gains on the upside. At the same time, venture capital has a shot at funding innovations and technologies to make a better and more equal future for society.
*Of course there are exceptions like Amazon which plough almost every penny back into entering new verticals and trying to own the market in all segments. These players should fare better and effectively be the last man standing, so to speak.
How do we fund the people who create the future? (Image: A Syd Mead artwork)