Business a.m.

Capital Is Not a Strategy

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CAMBRIDGE – Along with the rest of the world, entreprene­urs have spent the past dozen years living in an unpreceden­ted financial environmen­t. Responding first to the stubbornly slow recovery from the 2008 financial crisis, and then to the recession caused by COVID-19, major central banks have sustained an array of unconventi­onal initiative­s and asset-purchase programs collective­ly known as “quantitati­ve easing” (QE).

The direct result has been a massive accumulati­on of financial reserves in central banks and throughout the financial system, and a reduction of nominal interest rates on risk-free financial assets to levels below the rate of inflation. Interest rates are thus negative in real terms (and even in nominal terms, in some cases).

Years of unconventi­onal monetary policies have also had a secondary effect on investment behavior. Under the conditions that central banks have created, investors (both institutio­nal and retail) have become increasing­ly aggressive in their pursuit of positive real returns. Not only have they accepted increased levels of fundamenta­l risk (that is, the risk of business failures wiping out the value of their securities); they also have become increasing­ly willing to accept illiquidit­y, buying securities that they cannot freely resell.

One dramatic example of this phenomenon is the flood of “nontraditi­onal capital” – the National Venture Capital Associatio­n’s term for mutual funds, hedge funds, sovereign wealth funds, and so forth – into venture-backed private companies at historical­ly high valuations. Others are the bubbles in crypto assets and the (often fleeting) explosion of “meme” stocks, driven by Reddit communitie­s and retail investors on apps like Robinhood.

Finally, the apparently limitless supply of low-cost capital (in terms of ownership dilution) available to entreprene­urs and earlystage venture-capital firms has had a third-level effect as well: the proliferat­ion of business models with little or no potential to generate sustainabl­e, self-financed growth. The idea of “capital as a strategy” has taken hold. In the low-friction world of internet-delivered or mediated services, start-ups are eager to spend ever-greater amounts of other people’s money to acquire customers, the goal being to emerge victorious in a winner-takes-all race.

The problem, of course, is that capital is not a strategy; rather, it is a resource whose supply and cost are highly variable historical­ly. At least since the Dutch tulip mania of the 1630s and London’s South Sea Bubble of 1720, financial history has been replete with episodes of specu

William H. Janeway, a special limited partner at the privateequ­ity firm Warburg Pincus, is an affiliated lecturer in economics at the University of Cambridge and author of Doing Capitalism in the Innovation Economy. responsibi­lities.

Entreprene­urs and founding VCs directly engaged in firm governance can survive the current bubble’s inevitable collapse by rememberin­g that, sooner or later, corporate happiness is positive cash flow. The ability to pay your bills because you receive more cash from customers than it costs to develop and deliver what you are selling is categorica­lly different from relying on the continued kindness of nontraditi­onal financial strangers. This type of success requires continuous­ly and rigorously defining a path to positive cash flow from operations, within a timeframe constraine­d by the amount of cash currently on the balance sheet.

If no such path can be found, consider the following simple advice from Bernard Baruch, a legendary figure in finance from the first half of the twentieth century who advised US presidents and identified his profession to a congressio­nal committee as “speculator.” When asked how he made his money, Baruch replied: “By selling too soon.”

Baruch speculated in the public stock market, where he could sell whenever he chose. But the “nontraditi­onal investors” fueling the current VC bubble are locked in, along with the limited partners of the VC funds that sponsored the ventures. Both have been enjoying spectacula­r reported returns on the order of 50%.

But the vast majority of these returns represent illiquid investment­s, with “mark to market” based on recent valuations recorded in latestage financings or on the value of public companies deemed to be “comparable.” So, cash will prove to be the test. But, as Kenny Rogers’ memorable Gambler put it:

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