Venture Funding Unrefined: An Inconvenient Truth

Venture Funding Unrefined: An Inconvenient Truth
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While most of us obsess over access to private capital to kickstart new ventures, a very sizable part of such capital is already quietly flowing in the form of federal funds.

Here's some data on that which makes for some most interesting reading. The analysis is brought to you by the letters W, T and F.

The Silent Partner

The fact is - the U.S. government spends more on small and medium enterprises (SME) than on education or healthcare - in the form of grants, tax credits, loan guarantees and more.

Each year, federal agencies spend almost half a trillion dollars in procuring goods and services from the private sector which is another way government supports business. By statute, it must ensure that 23% of that amount is spent with small businesses and 16% on so-called "socio-economic" SME - disadvantaged businesses, women owned businesses, veteran owned and the Historically Underutilized Businesses (HUBZone program).

In 2015, the money awarded on SME in total was $165 bn (including $91 bn on small businesses).

In the same year VCs invested $59 bn. And HBO renewed Silicon Valley for a third season.

The level of public interest to Silicon Valley as a hub where innovative miracles are happening has never been higher while the media has crowned venture capitalists as miracle-makers. But when I recently heard a talk from a highly respected VC who declared that "any innovative economy can make it without the government", I realized it is time to sharpen my pencil and write this piece.

Please repeat after me: Silicon Valley has been benefiting directly from government funding.

Just about every innovative poster-child company, including Intel, Compaq and Apple were advancing public funds such as SBIC or SBIR. These are companies that wouldn't even exist without government funding and support.

Look at your smart phone - the Internet, GPS and SIRI were all backed by the state.

Elon Musk, celebrated as a genius of our time, launched his companies with very sizable government loans.

He is saying there is no need for a hate speech.

So are a number of companies in biotech and healthcare sitting on the state life-support.

Who is financing venture capital funds?

History teaches us that the venture capital industry has been no stranger while benefiting from government policies - and funding. It got a handsome boost in 1958 with the passage of the Small Business Investment Act which furnished tax breaks to private investment companies and when the Small Business Administration (SBA) created a 2:1 fund-matching program to encourage long-term risk investment in new ventures - for every dollar invested, the SBA (read: government) would grant two.

But the real game changer was the year of 1979 - this is when pension fund managers got permission to invest up to 10% of their capital in venture funds (known as the Prudent Man Rule).

As a result, pension fund commitments increased their annual contributions to VC funds from $100-200 million during the 1970s, to billions by the end of the 1980s making the VC industry one of the most powerful forces in venture financing. Last year venture capital funds raised $47 bn and logged the highest one-year returns of 20.5% reaching a record level of $136 bn in total assets.

Who is the main financier of VC funds? Surprise! Pension funds are still the largest institutional investors (aka Limited Partners) which contributed 20% of the industry's overall haul in 2014 (Dow Jones' Private Equity Analyst).

What does it mean? If you thought the venture capital industry had been funded by high-net worth individuals taking unbearable risks you might want to reconsider once you realize that the major contributing force might have been actually your money.

To put things further into perspective - VCs are neither investors nor particularly job makers - they are matchmakers. Entrepreneur is creating value; LPs are extracting value and VCs are derivatives of the value focused on a quick and profitable exit, usually via a buyout to a large company (the percentage of VC-backed IPOs reached its highest of 59% only during the dot-com boom, but has been just over 18% in each of the last 20 years).

Innovative economy, interrupted

Now - any serious start-up - VC backed or not - will create more jobs pro rata than an established business, since the starting point is zero. The interesting question - could the VC backed companies make it without VC capital?

Most likely yes - if they would have access to any capital which simply is the most important factor for any new venture. Just ask South Korea, Germany, Sweden, Japan and Switzerland - the top five innovative economies in the 2016 Bloomberg Innovation Index.

As the U.S., the world's largest economy took No. 8 in the rankings, you might want to think: OK - well, with the state financing- or VC money - our companies eventually reinvest their profits into further innovations and human capital, which would mean moving from a surgical innovation into a cyclical one - something which would benefit a society as a whole in the long-term and will reap new jobs or taxation. I wish.

These days companies spend more on share buybacks which help raise the overall stock price by making the remaining ones more valuable (in other words, it helps earnings per share results) than on R&D, growth opportunities or employees.

Let me run some numbers. As Reuters reported, last year the total amount returned to shareholders was $885 billion, which was more than the companies' combined net income of $847 billion. Among the 1,900 companies that have repurchased their shares since 2010, buybacks and dividends amounted to 113% of their capital spending, compared with 60% in 2000 and 38% in 1990.

I will now recap - for innovation to flourish and make an actual inclusive impact, long-term "patient" finance wanted. But VCs are "exit-driven" while businesses are not investing in their own businesses. Who else is available?

I am glad you asked.

Public investment in innovations: let's get the discussion started

The truth is - the major risk taker and lead investor in innovative economy is the state (read: public money). But who gets rewards? I am not sure if this topic was discussed by the National Venture Capital Association (NVCA) that got recently invited to testify before the Senate Small Business Committee but I feel it is time to acknowledge public risk-taking, re-write the rules for
modern public-private partnerships and start building a new model of collaboration
that would be based on three quantitative measures - risk, return and impact.

The wide acceptance of the conventional wisdom among both policymakers and the public that SME should be supported is admirable but how is such funding benefiting a society as whole - do we know? Or why are cash positive companies such as Boeing or General Electric on the list for "being in the public interest" and are heavily subsidized as well - and since they are, how about paying royalties to the state - for public good?

On the other hand, the new businesses are increasingly divorced from the rest of the economy and are not engaged in resolving the actual societal problems. How many more mobile applications do we need? How about new energy? Clean air? Affordable housing? Education? Art projects?

What I want to see is a next generation level of partnership where the government is a co-investor and a platform that crowdsources and analyses proposals from the public so it could arrive with a list of prioritized problems on a macro-level which we, entrepreneurs need to resolve.

As you see, as long as we have problems to resolve - we are not running out of jobs.

And while it is certainly sexy for the likes of Elon Musk to launch the mission on Mars or run some other grand projects, someone actually has to do the "duty work".

Victoria Silchenko, Ph.D. is an educator, alternative funding expert, Founder & CEO of Metropole Capital Group, Creator and Producer of the Global Alternative Funding Forum which is set in Los Angeles on November 11th this year, Creator of and an Adjunct Professor on "Entrepreneurial Finance"at CLU.

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