Economics and Entrepreneurial Finance
posted by Darian Ibrahim
(I seem to have the blogging bug today, so I’ll take the advice on my last post and blog shamelessly about my new article!)
Economic theory holds that money is fungible: any unit of money is an adequate substitute for another. But my research on entrepreneurial finance, which analyzes and compares different sources of financial capital available to high-tech start-ups, suggests that this isn’t always the case. In my new article Financing the Next Silicon Valley, I show that differences in financing options may explain why we don’t have more Silicon Valley-like regions in the U.S. With our other economic engines (manufacturing, financial services) in rapid decline, a competitive economic strategy for our nation must include more tech-driven innovation. Entrepreneurial finance is a huge part of that (after all, what do start-ups lack: money!), and not all money is created equal.
My article compares three major financing sources for start-ups: private venture capital, state-sponsored venture capital, and angel investor groups. Private VC is smart money – the dollars also come with the VC’s expertise on start-up development and networking benefits. (Case in point: eBay went with the Silicon Valley VC Benchmark Capital primarily for the VC’s connections, which led to Meg Whitman taking on the CEO position.) But on the downside, private VC is heavily concentrated in existing tech regions like Silicon Valley, and also not available to the early-stage start-ups that need it most. In step the states, which set up their own VC funds with taxpayer dollars to try and fill the financing void for their neglected, home-grown start-ups. But the states, without any expertise in this area, just muck it up with their inability to pick the best start-ups ex ante or help them develop ex post. A new solution, the angel investor group, offers more hope for the future. Like private VC, angel groups are private actors who offer smart money; like state VC, that money is spread out to more regions and available to early-stage start-ups. It’s the best of both worlds.
In short, comparative entrepreneurial finance is important, both theoretically and practically. This sort of money, contrary to popular economic thinking, is not all fungible.
March 12, 2009 at 6:55 pm
Posted in: Bright Ideas
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Responses (15)
A.J. Sutter - March 12, 2009 at 9:07 pm
One reason venture money is not fungible is that it comes attached to people. Who gave you money is important for validation. E.g., if the lead in your last round was some small Asian VC fund, that often is not as persuasive to (i) subsequent investors or (ii) potential corporate partners (some of them, anyway) as if you got money from an A-list, Sand Hill Road VC. (Caveat: I’m speaking of a tendency, not an ironclad rule.) When I was at Sony and was scouting for possible investments and, more importantly, alliance partners, identifying who had funded the start-up was a very material factor for building confidence.
OTOH, one company in the clean energy area that I was looking at was an early favorite in its field, in part because an A-list fund did invest in it. Yet when I interviewed the partner who’d made the investment, it turned out he was entirely ignorant of a major regulatory roadblock to bringing the business plan to fruition. Nonetheless, that company remained in the news, and did an IPO (though in a reverse-triangular way — in my book, that kind of going public is a sure-fire de-validation ). To date, that application is not yet commercialized by anyone, including some big Asian electronics firms who’ve sunk years and millions into it.
In short, whether angel or early-round money is smart often may be less important for multiple round funding success than whether it is reputed to be smart. And not everyone with a good reputation for smartness deserves it.
JP - March 13, 2009 at 11:06 am
A.J. is right. Doesn’t your article show that: “just as popular economic thinking would suggest, money is fungible, but the people and strings attached to it are not.”?
Darian Ibrahim - March 13, 2009 at 11:30 am
A.J. & JP–
But doesn’t money always come attached to people? It just usually doesn’t matter who the people are. For example, when you get a mortgage, some bank is providing the funds. But which bank really doesn’t matter, it’s just the interest rate (the money) that matters. In fact, the mortgage is sold as soon as it’s entered into, and you as the borrower don’t care. So mortgage loans are fungible, whereas entrepreneurial finance is not.
c'mon Darian - March 13, 2009 at 11:34 am
Which serious scholar of venture capital suggested that funding by a VC is equal to funding by a random person from the street? C’mon. There are lots of papers showing that founders select not only VCs over non-VCs, but also some VCs over other VCs, on the basis of things other than money. It is well-known, and well-described in the literature, that VCs bring things other than money. I am not sure which “conventional economic thinking” you are debating.
c'mon Darian - March 13, 2009 at 11:34 am
Which serious scholar of venture capital suggested that funding by a VC is equal to funding by a random person from the street? C’mon. There are lots of papers showing that founders select not only VCs over non-VCs, but also some VCs over other VCs, on the basis of things other than money. It is well-known, and well-described in the literature, that VCs bring things other than money. I am not sure which “conventional economic thinking” you are debating.
JP - March 13, 2009 at 12:36 pm
“It just usually doesn’t matter who the people are.” I’m not sure this is true. (Maybe to an extent for transactions with liquid secondary markets, such as stock in public companies, or mortgages pre-2008.)
I might choose to borrow money from Vinny rather than Ivan (at the same interest rate) because Ivan is known to break arms when payments are late, whereas Vinny usually just goes for fingers. But I don’t think this says anything about the commonly understood fungibility of money (which might suggest that it doesn’t matter whether I spend the loan directly on food or gambling, so long as my gambling expenses increase by the same amount in either case).
Your article seems interesting, and I don’t know anything about the prior literature, but it seems confusing to portray your argument as a refutation of conventional wisdom re: the fungibility of money.
Jeff Lipshaw - March 13, 2009 at 1:04 pm
Darian, it seems like we have three concepts mixed up in here. First, “money is fungible,” in my experience relates to the idea of commingling and tracing, not finance. Second, there’s Modigliani-Miller, which says that in a perfect world (like a Coaseian perfect world) the type of financing, whether debt, lease, equity, doesn’t make a difference. That’s more what I thought you were suggesting. Finally, the services provided by the VC, which happen to be bundled with a particular form of financing, but are really something separate. In theory, you ought to be able to buy that expertise unbundled as well.
Jeff Lipshaw - March 13, 2009 at 1:14 pm
By the way, I do agree with your comment about government botching up the investments. If you don’t cite in your article (which I haven’t read yet), there’s a Josh Lerner piece out there somewhere on that point. The idea is to create critical mass – say, in Indianapolis, but Evansville, Fort Wayne, Kokomo, and Gary all want piece of it.
My intuition is that industrial centers spring up organically and hit a critical mass, like Detroit in the 1920s, or Silicon Valley in the 1980s. The reason you can identify some areas, Austin, Boston, Dulles, is because they went critical. It’s a big deal for drawing human capital, because if you go to work for a startup, there’s a good chance you are going to be looking for a new job in two years, and you don’t want to be stranded in, well, wherever.
Darian Ibrahim - March 13, 2009 at 4:41 pm
Jeff (and A.J. & JP)–
You all may have a point that the “money is fungible” idea is not the best hook for my paper, and in fact I don’t use it in the paper. (Although while Jeff argues against the point by noting that the VC’s value-added services could theoretically be delinked from its financial capital, I don’t know that this ever happens in practice.) I do find it interesting to think through to what extent my comparative entrepreneurial finance analysis gels with established economic theory, and appreciate all of your help in doing so.
Also, I don’t invoke Modigliani & Miller or other capital structure theories in the present paper, which only discusses equity, but will discuss all that in my next paper titled “Debt as Venture Capital,” which highlights the financing of start-ups through loans despite the conventional wisdom that debt and start-ups don’t mix.
c'mon again - March 13, 2009 at 5:50 pm
Darian, once again: name one respectable modern finance/economics scholar who wrote that VCs supply only money, not money attached to services. There is a large literature, both theoretical and empirical, showing why VCs normally (though not always) supply both.
My point is not that you are wrong, but that you are not saying anything new. But perhaps I am wrong — please give us a few links to top finance/econ journals arguing otherwise.
c'mon again - March 13, 2009 at 5:50 pm
Darian, once again: name one respectable modern finance/economics scholar who wrote that VCs supply only money, not money attached to services. There is a large literature, both theoretical and empirical, showing why VCs normally (though not always) supply both.
My point is not that you are wrong, but that you are not saying anything new. But perhaps I am wrong — please give us a few links to top finance/econ journals arguing otherwise.
Darian Ibrahim - March 14, 2009 at 1:23 am
“C’mon” — of course it’s not new to say that VCs offer value-added services in addition to money. I cite multiple sources for this proposition in both my current piece and my last one (on angel investment contracts). Never meant to imply otherwise, & don’t think that I did.
What’s new about my work is adding angel investors, and to a lesser extent state-sponsored venture capital, to the mix to see how that money, and those value-added services, compare to private VC.
A.J. Sutter - March 14, 2009 at 7:27 am
Thanks for your reply. My point was that who the people are does matter, though I think you eventually recognized that during the evolution of the thread. BTW, here in Japan VC financing used to be (~10 years ago and more) mainly debt financing — though without great success. One obstacle may have been that many VC financiers were bank employees, so maybe the model can be improved.
cosmas sikahala - January 6, 2011 at 6:55 am
I somewhat concur with Darians Statement on VCs fungibility.Recent trends have questioned the viability of VCs as a source of start-up funding. Has anyone noticed that the funding of venture capital has decreased since the financial crisis began in 2008 making it harder for VCs to invest or advance loans, and therefore, threatening their future operations? For the record the financial crisis that started in 2008 is associated with at least 20% decrease in the average amount of funds raised per funding round in the venture capital market. Although this effect can only be found in later funding rounds, firms needing capital to survive cannot avoid a deduction induced by the financial crisis, whereas firms that seek initial funding postpone their funding and expansion plans until the capital markets have stabilized. Furthermore, firms in later phases of the venture cycle are more likely to be negatively affected by the weak initial public offering (IPO) market than firms seeking initial funding. Will VC capitalists be able to fund or sustain venture capital? Or is VC destined for RIP?
Randy Sullivan - November 21, 2011 at 9:42 pm
Sikahala,
Great insight. [VCs are destined for "RIP"]…i like that. Is it accurate to state that fungibility of any trade instrument will depend on the criteria of assessment at that time or its sorrounding circumstances? Thoughts?
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