Capital Is Not a Strategy
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: