A new way to invest in modern businesses
Before the advent of Venture Capital a new business would likely take a loan in order to be able to bootstrap and grow to profitability. Since 20% of new businesses in the US fail during the first two years of being open, 45% during the first five years, 65% during the first 10 years, and 75% during the first 15, a loan can only be made to relatively non risky businesses, which are either predictable and not particularly innovative or given at a later stage once a business is somewhat established and therefore de-risked. And since a loan is capped and doesn’t pay out more if a business ends up being really successful, a lender cannot effectively use a portfolio to pool the risk and subsidize its losses with its winners.
Many new businesses and particularly new businesses in a changing world with uncertain futures, like we have today, cannot be supported by loans.
Venture Capital solved this problem for new companies by taking equity, a percentage of the company itself, which meant that, in theory, ‘skin in the game’ through both more downside and more upside potential, aligned interests between business founders and investors.
To scale, Venture Capital required using other people’s money (Limited Partners) to invest in a fund, where the fund managers (General Partners) were paid salaries and operating costs out of the fund (2% a year) and a percentage of the profits (20%). The economics of managing an early stage investment fund only really worked for above $50M, and typically $100M
At the other end of the scale, early stage funds didn’t typically scale to very large funds and couldn’t use a more scientific analytical approach as there are so many unknowns in new companies, and so Venture Capital firms were relatively boutique, creative and hands on compared to investors in other asset classes and therefore couldn’t spread risk across large enough portfolios. As a result, performances vary (according to Pitchbook, of 3,981 VC funds below $2B in size, only 8.3% returned 3x or above) and aren’t known quickly (fund durations are 10 years) so the choice of VC firm itself is risky for an LP and the return from that choice is expected to be higher. A $100M early stage fund would invest typically invest in around 20 companies, to retain enough of a percentage and so that a partner could take a board seat in each one. The expected return is relatively high — currently 3x. So a $100M fund is expected to return at least $320M, but most don’t and a few return a lot more.
Further, since the returns of investment in new businesses also follow an 80/20 rule, sometimes called a Pareto distribution, where 80% of the returns come from 20% of companies invested in, 4 companies typically have to return more that $60M each, where the typical ownership at exit is around 10%. So that $60M represents a small share of the overall value of the company invested in.
This means that every company a VC fund invests in has to be potentially worth significantly more than half a billion dollars within ten years. Most companies are never going to be worth this, so most companies can’t be Venture Capital backed.
Venture Capital works where companies have the potential to be worth a fortune, even if 75% are worth almost nothing.
Venture Capital and its Rise Because of the Internet
Because the Internet is a fundamentally new type of communication network it creates very different market dynamics, where there are potential network effects (the value for each user is more, the more users there are) and potential viral distribution. These dynamics lead to natural monopolies for those companies that capture these effects (Google, Facebook etc.).
Distribution factors rather than technology are the primary success criteria influencing Internet investments and are often overlooked as we tend to talk about technology companies and technology investments. But Internet companies are very different from pre Internet, software ones and the rise of Venture Capital coincides with the rise of the Internet because of the way businesses grow not because of technology.
The companies that successfully leverage commoditized technology (many Internet platforms are built on open source software) using sophisticated sales and marketing techniques and the right go-to-market to eventually capture a much broader one, tend to be the ones that build or buy technologies later, when they need them, rather than the other way around. This is why the world’s cloud computing is a byproduct of an online bookshop, Amazon, that eventually became an online everything shop.
The Internet created business model rather than technology opportunities for lots of companies to be created that had the potential to go public or be acquired for more that $500M, within ten years, so it was a very good fit for the Venture Capital asset class.
Debt or Equity Financing Aren’t Working for Most New Companies
The Venture Capital model is not a good match, however, for most companies, since most companies don’t have the potential to be worth enough regardless of how likely they are to be worth something. This is because if there is an opportunity to be worth something and the Internet plays a role, a winner will possibly grab it all from you. It also isn’t a good fit for people who want to build a company that is sustainable indefinitely, without being acquired or going public, as Venture Capital requires an exit such as this, to be able to sell the equity and return cash to investors.
At the same time, because the Internet is changing the entire business landscape as we move from an industrial to information era, even non technology businesses sectors may be considered ripe for Internet businesses, as we have seen from Taxis (Uber) to Hotels (Airbnb). But many of these companies operating in non technology business sectors will never be the size of Uber or Airbnb, rarely be acquired and never go public so won’t raise Venture Capital. At the same time, they may still operate in a relatively new way using new technologies (e.g. a Shopify store) and marketing (e.g. Instagram influencers) which are difficult for a bank to assess the risk of and make a loan.
We now have the perfect storm where a large percentage of businesses can’t be funded either by debt or by equity, and at a time when the cost of capital (what they should in theory have to give up to receive funding) is at an historic low.
We are Damaging the Business Environment
Overall, this is creating an ecosystem that favors large monopolistic platforms and disadvantages small, evergreen businesses. Our business environment, like our natural one is becoming imbalanced at both the individual and overall ecosystem level, just as our natural environment is with damaged ecosystems and mass extinctions. This isn’t healthy or sustainable in the long term. If you just have apex predators like Amazon Inc., you don’t have a healthy ecosystem like the Amazon rainforest.
The Pandemic has Made Things Worse
Against all this is the backdrop of a global pandemic that is doing two things to make the situation worse: (1) unlike in 2008 where the economic system froze from the top down via large financial services institutions, this time, it is mostly small businesses (shops, restaurants or bars, B&Bs) or individuals (freelancers) that have been impacted most immediately and severely (2) the pandemic is accelerating changes that are shifting the business environment as a whole to the Internet era with its accompanying business models that require new types of funding (e.g. ecommerce has grown while offline retail has shrunk).
A New Business Model For Small Businesses
While the Internet has created natural monopolies in many areas, including those that used to be served by lots of smaller businesses (such as Uber vs minicabs, in London) there is also some early evidence that for some types of products it may do the opposite.
In the past, to sell burgers, beers or coffee globally, you needed consistency and a single brand. A Big Mac, a Heineken or a Nespresso taste the same wherever you are, and this is because marketing and distribution have traditionally happened through a limited number of channels that requires a consolidated approach. A TV ad would typically hire a celebrity to endorse a product so that a recognizable face was associated with it — such as George Clooney, who is the face of Nespresso coffee in many parts of the world. In many ways both the product and the marketing would be fake — MacDonalds would suck the flavor out of meat and then re-inject it chemically in order that its taste was recognizable and George Clooney may or may not like Nespresso, but he is paid to say that he does and his picture on billboards is because he is famous for something else than being a coffee aficionado.
Neither the endorsement nor the product are of the best authenticity and quality, they are just recognizable and reliable.
The Internet has changed the dynamics of marketing and distribution because there are now an infinite number of channels and a meritocratic form of self emergent celebrity has emerged through influencers on social media. Not all of these influencers are authentic, but some are, and there is usually an influencer for anything and in any geography. New physical brands such as Gymshark have build billion dollar companies using only social media influencers on platforms like Instagram.
For many types of products this means that multiple different artisanal ones can be effectively marketed and distributed through highly influential people in multiple different local markets so that they compete with the global brands that were traditionally reliant on broadcast media such as TV. By 2015 the number of US breweries was close to its peak of 1873, having declined by more than 95% by the 1970s.
Because these artisanal brands can now compete for awareness with global ones in local markets, via genuine fans and with a product that doesn’t need to scale beyond the limits that would sacrifice quality, customers get a better product from a small business pitched more authentically.
A New Sustainable Investment Model
These new types of business aren’t limited to artisanal products but anything where, given the right tools to market and distribute a product, a level playing field can be created relative to the large brands. You could imagine that the Fast Moving Consumer Goods model of Procter & Gamble or Unilever, where multiple global brands are marketed and distributed under one umbrella, could be completely replaced by one where many more small businesses’ products were marketed via a newly emergent marketing platform, with distribution being handled by companies like Shopify. Given the right investment model, a healthy balance could be returned to the business ecosystem by being able to support almost any type of small business.
What would the characteristics of this new investment model look like? It would neither be debt nor pure equity, but something in between where the investor shared both upside and downside risk, but sustainably where businesses did not need to ‘exit’. It would also possibly have a value added service to manage the marketing platform so that, say, a family that made a great pesto sauce would not need to become Internet software experts and where the data from that platform would allow the investors to leverage commonalities across their investments to help the businesses scale and optimize.
This investment would need to be for a share of future profits, a form of dividend but unlike a dividend with mutually agreed terms set by the investor rather than the company invested in. These terms would need to make sure a business could invest potential profits into itself rather than distribute dividends but where cash flows that would rationally be taken as profit could be distributed.
On the investor side, the potential for recurring revenue, continuously distributed rather than at sparse and distant, fixed points in time would allow for a flywheel of continuously investing in more small businesses. In addition, the types of risk/return, size of investment, number of companies invested in and type of relationship (shared visibility into SaaS accounting say, rather than a board seat) would mean that returns would have very different distributions and dynamics which would favor the ability to invest in a much wider range of sustainable businesses than traditional Venture Capital.
To do this would restore balance to the business environment, make it more humane and sustainable, and offer help to a wider range of people at a time when people need it most over both the short and longer term.