How Venture Capital Changes the Laws of Economics Working Paper
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Exit How Venture Capital Changes the Laws of Economics Stefan Kühl ([email protected]) Working Paper 3/2005 Stefan Kuehl Exit English 1 17.02.06 ((U1))Contents The Contours of Exit-Capitalism I. The Exit Concept and the Logic of Venture Capital Financing 1. Thinking of an Investment in Terms of Its “Outcome” 2. From Risk Capitalism to Exit Capitalism 3. The “Democratization” of Venture Capital Financing II. Founders, Managers and Employees as Venture Capitalists 1. The Spread of Exit Logic 2. Worker-Capitalists: Beyond Dividends, Profit and Wages 3. Entry and Exit Cycles III. Capital Market-Orientation 1. The Venture Capital Spiral 2. Signal Politics, of Business Plans, Equity Stories and the Entrepreneur as a Hero 3. The Dominance of Capital Market Orientation IV. The Dual Reality of Capital Market-Oriented Companies 1. Business Plan Economy 2. Producing “Good Numbers” 3. Management by Potemkin Stefan Kuehl Exit English 2 17.02.06 V. Growing Pains: Organizational Problems in Venture Capital-Financed Companies 1. The Organizational Promise 2. Communal Living As an Organizational Principle 3. The Problematic Formation of Structure VI. Profit as Myth: The Threat of Collapsing Capital Markets 1. The Decline of a Company's Most Important Currency – Its Own 2. A Survival Strategy: Using Profitability to Send a Message VII. Of the Strengths and Weaknesses of Capital Market-Oriented Companies 1. Solvency, Not Profit 2. The Pressure on the Dinosaurs 3. The Question of Timing VIII. The Greatest Money Burning in History, or Normality in Exit Capitalism 1. Con-men, Crooks and Coke-Heads: Rash Explanations for the Failure of Growth Companies 2. The Lemming Mentality, or The Wave Form of Exit Capitalism 3. The Cycles of Exit Capitalism Appendix Methodological Considerations Stefan Kuehl Exit English 3 17.02.06 References Stefan Kuehl Exit English 4 17.02.06 ((U1))The Contours of Exit-Capitalism “There are two times in a man's life when he should not speculate: when he can't afford it and when he can.” Mark Twain The euphoric days of the stock market boom have vanished without a trace. Cleaning up the debris is a sobering task. Venture capitalists financed manifestly senseless business concepts, laments Gordon Moore, longstanding chairman of chip manufacturer Intel. Anything that moved received venture capital financing or headed straight for an initial public offering (IPO), criticizes Benjamin M. Rosen of venture capital firm Sevin Rosen Management. Summarizing the boom phase in retrospect, Rosen says that strictly speaking it was a horrible period. Don Valentine, one of the elder statesmen of the U.S. venture capital scene, observes that the crush of start-ups changed the venture capital business from the ground up. In earlier times, venture capitalists would finance one or two companies per business sector all told, and the companies’ only competitors were the larger, well-established corporations which were too sluggish to recognize the first signs of an emerging niche market. During the boom, however, each venture capitalist had one or two investments in every niche market. According to Valentine, these start-ups competed with each other so fiercely that even the best of them had difficulty turning a profit. Stefan Kuehl Exit English 5 17.02.06 The consequences of such “over-financing” became clear when the mood changed on the stock market, share prices plummeted and companies encountered increasing difficulties obtaining additional financing for their activities. One company after the other missed projected targets. Top executives from established, profitable companies who had switched to young, unprofitable start-ups during the boom days had no alternative but to declare their companies bankrupt several months later. Suddenly, journalist John W. Wilson reports, an industry which had “burned” vast amounts of money only a year or two before found itself struggling with liquidity problems. In the hope of recouping their market losses at least partially through litigation, outraged shareholders began filing suit against the companies and the banks that had underwritten their IPOs. Venture capitalists used the remaining resources in their funds to save the stagnant companies in their portfolios from bankruptcy. For new enterprises the prospects for obtaining financing were dismal, and, as Richard J. Matlack, president of consulting firm InfoCorp. tells it, anyone who was still intent on currying favor among venture capitalists had to promise a really fantastic deal. Retrospectives of the stock market’s intoxicating upswing and its appalling collapse could go on indefinitely. But one important point needs to be made. The comments mentioned above do not stem from the aftermath of the Internet boom at the beginning of the 21st century, but rather from the mid-1980s. On the venture capital scene in those days the opinion gained sway that the PC-boom in the early part of the decade had led to uncontrolled hype.1 Although several hundred personal computer makers had been financed with venture capital 1 This information is taken from Wilson 1985, 189ff. For Rosen’s comments see Schilit 1991, 127. Stefan Kuehl Exit English 6 17.02.06 during that period, only a handful had survived. Several dozen venture capital-funded start- ups were active in the relatively limited hard drive market alone. Prior to the change in sentiment among financers, experts following the software sector actually counted over 3,000 companies. The similarity of analyses drawn from the earlier period and observations made after the Internet bubble had burst suggests that the venture capital business is remarkably cyclical. The goal of the present book is to discuss the principles underpinning this sector, beyond the commotion of its up and downswings. Only knowledge of the sector’s cyclicality will allow us to achieve one of the key insights; the venture capital business is based on “chain letter mechanisms.” The companies – and financers – who come out on top are the ones who understand how to optimally exploit the capital market’s hyperbolic flight. This book uses the concept of “exit-capitalism” to portray an economic process which has emerged with the gradual institutionalization of the venture capital business since the Second World War. Granted, speculating on short-term gains was always part of capitalist economies, but only with the launching of venture capital funds, the formation of venture capital firms and the professionalization “venture capitalism” did the dynamics develop which make it necessary to view an exit orientation as a central element of economic life. The term “exit-capitalism” applies because growth company founders, the venture capitalists who back them and small stock holders on the exchange are not interested primarily in receiving regular dividends on a capital investment. Rather, their main goal consists of selling the shares they hold for a high exit profit. The logic is not based on an investment made for the long haul, but is dictated by the orientation of venture capital investors whose earnings depend on the difference between the purchase price and the sale Stefan Kuehl Exit English 7 17.02.06 price of their shares. Since offering stock for sale implies selling a piece of the company itself, interest therefore focuses on a product behind the actual product. Regardless of what is sold, be it a software package, a potency-enhancing pharmaceutical with astronomical development costs, the delivery of packages in downtown New York or company shares, the short-term effect is always the same; the sale puts money in the till. The strategies employed in sales, however, are subject to wide and sundry range of principles. In order to outline the contours of exit-capitalism clearly, the present book will elaborate those principles which are geared to the capital market and illustrate the relationships between capital market and product market orientation. The term exit-capitalism is not limited to the business dealings of company founders, venture capital firms and investors in growth stock markets. The current book will also demonstrate how the logic of venture capitalism can influence wide segments of the economy. During hype phases venture capital-financed companies are cast as models in every respect, ranging from their strategic orientation to their capacity for innovation and their management techniques. The rise and fall of the major traditional corporations which compete with venture capital-funded enterprises can frequently be traced to the corporations adopting the capital market orientation of their venture capital-funded competitors. This book is based on interviews with venture capitalists, entrepreneurs, managers and employees of venture capital-financed companies as well as on an examination of the research literature. Overstatements of the principles of exit-capitalism are intentional. The book’s main objective is to describe the new economic development lines that have emerged since the Second World War, using as examples the exit orientation of venture capitalists, the spread of this logic to entrepreneurs, managers and employees, the capital market orientation of venture Stefan Kuehl Exit English 8 17.02.06 capital-financed companies and their presumed exemplary nature, their creative accounting practices, and finally the failure and survival of the startups themselves. The occasional reader might find some of the differentiations lacking in detail. Clearly, the differences between various types of venture capitalists