Why Startups Have An Access To Capital Problem
In our most recent white-paper resource, we dive deep into tackling the subject of alternatives to equity for small businesses and entrepreneurs. The following is an excerpt from that white-paper. If you would like to learn more about alternatives to equity then please consider downloading our free resource here.
Evolution of Capital
The widest category of today’s business community does not fit the sensationalized Silicon Valley model of zero to exponential value in a short timeline. It’s a model that, while viable for some, has created an unintended gap in access to capital for the majority. Furthermore, traditional lending has proven exclusionary to many start-ups for a variety of reasons. Investors and entrepreneurs alike are requiring new and more diverse approaches to financing.
The process that led to the current environment of homogeneous start-ups and start-up investors is the work of many forces over many, many years. Like most complex things, it’s easiest to dig into within the framework of a story. In this case, the story is about three characters whose narratives converge in Silicon Valley: The Entrepreneur, The Investor, and The Firm. This is a story about where these characters came from, and how they came to be at times deeply disconnected from the reality of entrepreneurship in America.
The term ‘Silicon Valley’ was first published in the early 1970s, just before the explosion of the area as a hub of innovation, capital and entrepreneurship (Laws). Forty-eight years after Don Hoefler published the phrase in Electronic News, Silicon Valley has accrued a mythical status for entrepreneurs everywhere. The myth goes something like this:
– Great idea
– Tons of capital
– Maximize valuation
But entrepreneurship hasn’t always looked like this, nor does it typically look like this today. Some core aspects have remained the same. For example, entrepreneurship has often been about facing a great risk for the possibility of great reward. Marco Polo setting out on the Silk Road into unknown China comes to mind, or Dutch sailors plotting shipping routes across wide, rough seas. In fact, the word ‘entrepreneur’ was interchangeable with ‘adventurer’ when it first entered the English lexicon. While adventurers still exist, our ideal ‘entrepreneur’ has evolved in massive ways.
To clarify, things have evolved to become both better and worse for entrepreneurs. Skilled professions in agriculture and craftsmanship gave way to Industrial Age manufacturing and then Internet Age highly-educated careers. Valued trade skills were lost, and the education to learn new ones became increasingly expensive. All along the way, the barriers to entry for starting a business became lower, while the barriers to owning an enterprise became larger and larger. On one hand, the Internet has democratized entrepreneurship in many sectors and created a platform that’s revolutionizing education, making it easier than ever to start a company. On the other hand, growing a company to enterprise-scale is more difficult than ever as the economy grows more centralized and multinational firms grow more powerful. Throughout centuries, core elements like networking and supply chains have remained a challenge for entrepreneurs of all stripes and eras.
The infrastructure to support what we now understand as ‘investment’ was first established by the Code of Hammurabi in 1700 BCE, which laid out laws describing the pledging of land as collateral. Our modern image of a Wall Street investor has evolved dramatically since then, coming to encompass not just those willing to exchange capital for collateral, but also those who leverage advanced capital structures in a variety of ways, many of them confined to the realm of wealth creation. Throughout history, investing was a unique privilege reserved for the wealthiest classes. The introduction of the stock exchange (which emerged out of the Dutch East India Company’s need for more complex funding and risk-sharing structures), led to democratized access to investment vehicles.
As the global economy advanced rapidly through the Industrial Era and into the modern-day, investment infrastructure has evolved along with it. Stock indexes and investment banking represent two of the most influential innovations, both of which transformed during and after the New Deal. The ensuing emergence of new equity options expanded the landscape, bringing more financial opportunity to a wider set of business owners and investors. Today, most people are ‘investors’ in some way, usually via a third-party-managed 401(k) or index fund.
But the investor as a true venture capitalist remains the domain of the elite. The investor accreditation process intensifies this issue by erecting significant barriers around who can invest in venture capital or high-risk enterprises. Some of the standards for receiving accreditation from the SEC include an annual income of $200,000, a net worth of $1 million, or an executive position in an existing unregistered securities issuing organization. In conjunction with the escalation of risk and reward expectations, accreditation works to create a negative cycle of gatekeeping and ever-higher barriers to entry in venture capital.
One reason that entrepreneurs continue to need capital and can’t simply start on their own stems from the concept of ‘the firm’. As Nobel-winning Professor Coase described in his famous The Nature of the Firm, there are transaction costs inherent in the very fabric of buying and selling goods and services, particularly as those transactions scale. Firms emerged and grew to provide a more efficient way to absorb those costs.
As the internet developed, these transaction costs lowered dramatically. Yet firms are not only not disappearing, but they’re also actually becoming larger and more entrenched (cc: Amazon). As it turns out, the complexity presented by today’s economic and sociological climate requires an increasingly deft managerial and strategic touch that’s most effective in the environment of a firm (“Rise of the Superstars”). In other words, when entrepreneurs access capital, it’s not just about financial capital—it’s also about accessing knowledge capital and human capital to increase the capacity of their organization.
While the entrepreneur, investor, and firm have all evolved significantly throughout modern history, they remain the three core contributing factors to the creation of an enterprise. In contrast, venture capital is a relative newcomer in the entrepreneurial space. That’s perhaps surprising, given how closely associated it is with our modern ideal of the entrepreneur. But private equity didn’t exist until after World War II, and venture capital didn’t emerge as a dominant form of private equity until the 1970s. After being a successful source of funding for companies like Apple, venture capital investments slowed during the 1980s recession before once again booming along with the internet bubble.
The very nature of venture capital makes it a particularly difficult type of capital for entrepreneurs to access, and for investors to leverage. Venture capital requires that some portion of ownership in business be handed over to its investors, making it a highly illiquid investment that requires long time periods to realize returns. Venture capitalists typically perform extensive due diligence and, on average, provide financing to just 1 company out of every 100 that apply. Typical expectations on the startup itself require excellence not just in the venture’s potential, but also in its expertise, management team, addressable market and growth potential.
It’s worth asking why such a stringent form of financing is expected to be the first choice of capital for so many entrepreneurs. Victoria Fram of Village Capital notes that “…the narrative around equity and the mythologized startup path is very, very strong. It leads to a lot of skepticism around alternative [funding] structures.” She goes on to explain that the ‘ideal’ startup journey that’s so ingrained in the modern consciousness by Silicon Valley tends to lead entrepreneurs towards more glamorous but less realistic approaches to funding and company building.
All these different factors intersect to create a massive, ever-widening gap between startups and the capital they need. It’s a gap that’s composed of unintended consequences and fueled by flamboyant cultural narratives about what it means to be a successful startup.
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