The Venture Capital Market

There's a wonderful blog conversation ongoing between Paul Kedrosky and Fred Wilson on the optimal number of venture capital firms. To summarize, both advocate for a reduction in amount of capital and number of VC firms participating in the market.

Check out Kedrosky's post from this week - Fred Wilson and the Venture Capital (Non-)Cartel and Wilson's - The Venture Diet is Working.

I look at it from a market standpoint, driven by supply and demand. But like a good economic analyst, I've got more than two hands...

1. Good firms will survive and poor ones will exit. The challenge though is the slow speed of entry and exit in the VC market. Firms can take years to raise capital from investors, then need time to evaluate eventual investments, then ride them through to exit. Unsuccessful firms that enter the market take years to display their incompetence, so the market is stuck in the intermediate term with an over supply of VC firms and capital. Overall, you'd think that's a good thing for entrepreneurs - more investment money chasing fewer projects. But, VCs are not a commodity product - each have their advantages and strengths that abet entrepreneurs in their drive to successful exit. This means that entrepreneurs need to examine their options more closely - more money and more favorable terms doesn't always mean the best deal.

2. Maybe the challenge is not an over-supply of VC firms, but a dearth of investment targets. Are we out of good ideas? I'd say no way this is the case. There are always plenty of good ideas in today's global marketplace, with that number rising exponentially as countries like India and China gain increased access to technology and build a economic infrastructure that supports the development of new technologies to replace the old.

3. Market inefficiency could be an explanation - there isn't enough communication between aspiring entrepreneurs and VCs. I don't think this is the case either - VCs get hundreds of business plans submitted every week and "investable"start-ups only going to develop in markets with access to communication nodes and infrastructure that provides clear awareness and access to the existing VC firms.

4. Or maybe it's that the venture capital model is no longer relevant for a majority of emerging companies. Back in December 2008, I wrote that venture capital is moving "up the ladder." As deal size requirements get bigger and bigger, that means that the exit opportunities must be bigger and bigger. There's limited room for the mega-exits, so that means that more and more start-ups are seeking smaller investment amounts funded by angel investors, leaving the formal venture capital firms with fewer investment opportunities. Bigger exit requirements also mean smaller rewards for company founders and early-stage team members that accept venture capital. That makes the whole idea of funding with VC less attractive. Altos Research is bootstrapped, profitable, and quickly growing (gasp!). Our company founders never wanted to use VC as a vehicle for precisely this reason (and others...).

Profile of Angel Investors

Received an emailed list of the :most cited articles from Institutional Investor Journals. One of them caught my eye - "A Profile of Angel Investors" - published in the Journal of Private Equity. Haven't downloaded or read the article yet, but passing along in case you should care to...

Technology & Start-ups in the Sacramento Valley

I've been spending some time of late researching some of the organizations focused on technology and start-ups in the Sacramento Valley of late. Couple of interesting items to share:

UC-Davis Center for Entrepreneurship - Based at the University of California, Davis in a brand new facility, this center focuses on Green Technology and Food & Health (but technology stuff too!). I've chatted with a couple of people over here - very engaging and committed from what I can see - looking forward to getting involved with them in 2010.

The Sacramento Area Regional Technology Alliance (SARTA) is a tech-focused corporation that supports entrepreneurial programs, companies and technology investment throughout Butte, El Dorado, Nevada, Placer, Sacramento, Solano, Sutter, Yolo and Yuba counties. I'm planning to attend a couple of their events in the next month or so to learn more about them.

More to come on this. Now that I'm getting settled in the area, I'm excited to get more proactive helping out and contributing to the technology and start-up efforts out here. With the state government situated in Sacramento, the inherent industries (food, agriculture, energy), and a number of research and state colleges nearby, it's seems to be a natural extension of Silicon Valley to diversify the economic base locally.

Indulgences & Seigniorage

(Note: My thoughts on this aren't completely formed, but I felt it important to record as a start to the formalization process...)

Trolling through TED.com, I came across Jay Walker's presentation about his Library of Human Imagination. One of the artifacts he displayed during his talk was a Gutenberg Bible (about 90 seconds into the video) - the first substantial book to be mass produced using the printing press. Walker shared some insight about the reason behind the Catholic Church's reproduction of the bible - it wasn't so much for individuals to read the bible for themselves. Instead, the Gutenberg Bibles were reproduced so the Church could sell "indulgences" to the masses in order to raise money. The Church was struggling for cash, so in a sense, they financed their operations by issuing indulgences as currency, eventually printing millions of these and distributing them. In economic terms, this is known as "seignorage.")

It was this action by the Church that led to Martin Luther's 95 Theses, questioning the Catholic Church's operations and motivations beginning the eventual downfall of the Catholic Church in Europe during the Renaissance Period.

An oft-cited definition of seigniorage - "The amount of real purchasing power that [a] government can extract from the public by printing money" - presented by Alex Cukierman, Sebastian Edwards and Guido Tabellini in their 1992 paper published in the American Economic Review - "Seigniorage and Political Instability." The abstract of his paper explains more:

The importance of seigniorage relative to other sources of government revenue differs markedly across countries. This paper tries to explain this regularity by studying a political model of tax reform. The model implies that countries with a more unstable and polarized political system will have more inefficient tax structures and, thus, will rely more heavily on seigniorage. This prediction of the model is tested on cross-sectional data for seventy countries. The authors find that, after controlling for other variables, political instability is positively associated with seigniorage. (my emphasis added)

Christopher Adam, Benno Ndulu, and Nii Kwaku Sowa also study effects of government seignorage in their 1996 article - "Liberalisation and Seigniorage revenue in Kenya, Ghana and Tanzania" - published in the Journal of Development Studies.

The revenue consists of two parts, the first flowing from the willingness of the private sector to hold government financial liabilities (which we shall refer to as the real balance effect) and the second part from the taxation through inflation of the outstanding stock of real balances (the inflation tax effect.) Seigniorage is particularly attractive in economies where the traditional tax base is narrow and the costs of other forms of revenue collection are high. Moreover, in economies where the policy regime limits the portfolio of domestic financial assets available to the private sector, for example where there are limited possibilities for currency substitution, the potential for raising seigniorage revenue may be expected to be high. In addition, by exploiting the high adjustment costs faced by the private sector in such economies, revenue can be increased in the short-run as holders of money are temporarily forced off their equilibrium money demand functions and obliged to hold higher than desired money balances. The higher the costs of adjustment, the greater the short run value of the 'surprise' revenue.

Breaking this down in parts:

• "the willingness of the private sector to hold government financial liabilities" - This refers to the issuance of US Treasury bills and bonds, in the current case, to finance deficit spending and debt.
• "taxation through inflation of the outstanding stock of real balances" - This refers to the decreased value of current debt due to inflationary effects from issuing new currency via seigniorage.
• "Seigniorage is particularly attractive in economies where the traditional tax base is narrow" - The United States faces the primary problem of a shrinking tax base. As this CBS News article from April 15, 2009 notes that an "astonishing 43.4 percent of Americans now pay zero or negative federal income taxes. The number of single or jointly-filing 'taxpayers' - the word must be applied sparingly - who pay no taxes or receive government handouts has reached 65.6 million, out of a total of 151 million.
• "the costs of other forms of revenue collection are high" - Other forms of revenue refers to income taxes or VATS. Certainly the US qualifies here.
• "economies where the policy regime limits the portfolio of domestic financial assets available to the private sector" - Congress (and the administration) is placing restrictions on securitization and considering other financial regulations under consideration. Using the housing market as example, it's the GSE's and the Federal reserve buying mortgage securities and loan portfolios, not the private sector as would be more efficient and economically sound.
• "revenue can be increased in the short-run ... The higher the costs of adjustment, the greater the short run value of the 'surprise' revenue." - The net result is a short-term bump in GDP to the long term detriment of the economy. That's what we saw in Q3, 2009.

As described in the Abstract of the Adam, Ndulu, Sowo article, the "implication is that countries that have relied on seigniorage revenue need to undertake deeper-than-anticipated fiscal adjustment in order to maintain macroeconomic balance following liberalisation programmes."

This is often why prominent economists and thought leaders (including Steve Forbes) advocate the United States returning to the gold standard - so that the US Dollar is backed by an intrinsically valuable item. Additionally, Forbes backs the "flat tax" to make revenue collection by the government simpler versus the current income tax system or proposed VAT included in tax proposals of the 111th Congress.

I don't know what the answer to all of this is. I do know that rigorous academic work clearly shows that a government's use of seigniorage leads to long term pain for an economy and that current policies under pursuit work in strong opposition to these economic findings - financing government programs such as the American Recovery and Reinvestment Act, the proposed health care reform legislation, TARP, TALF, and others.

The questions that persists in my mind - is the government selling indulgences to get us out of economic purgatory only to cause a future collapse of our financial system? Watching Walker's presentation on TED.com sparked an immediate parallel in my mind that I can only hope is a result of my background as a history major and Catholic, and not founded on real economic principles. I sure hope I'm wrong on the one.

Sixth Sense Computing - Pranav Mistry on TED.com

Working from the in-laws basement this week and took a little retreat time to watch a few TED.com videos. If you want to get blown away by things like dialing cell phone by touching your fingers or seeing if you flight is on time by looking at your boarding pass, this is for you. (And I am really not doing this justice...) It's interesting that Mistry talks about bring the computing world into the objects world. His concept, to me at least, is bridging the gap between reality and the virtual world.