Government and Venture Capital: Discursive Essay

Is Government a Good Venture Capitalist?

Introduction

Venture capitalists rely heavily upon gaining stake in emerging firms in order to offset the risk associated with their investment. However, before venture capitalists even had a name, budding business ventures were mainly financed through credit rather than equity. Historically, there were several legitimate reasons as to why a prospective venture capitalist would seek to finance through loans rather than equity. Primarily, there was a large degree of asymmetry of information before the technological age of today. Pragmatically speaking, unless they lived within close proximity to the firm, or had a good personal relationship with the CEO, potential investors had next to no way of knowing if the money they invested was being used responsibly within the firm. In addition to this liability amongst shareholders was unlimited, meaning that debtors could recover funds from the executives of a defunct firm. Consequently, the coming of limited liability as a concept ushered in a new age for the United States economy and for their thousands of potential investors.

Since limited liability blew open the floodgates of VC, the industry has exploded to the unparalleled proportions we see today. It is not uncommon for VC firms to have billions of dollars raised and over a thousand firms within their portfolio. For example: Sequoia Capital is a profoundly large VC firm with over seven billion dollars raised for upstarts and they sport a portfolio with over 1,400 startups. All venture capitalists are hopeful that they might stumble upon the next Google or Uber, however, this isn’t to say that the industry isn’t without its issues. Many industries and disciplines are taught with winners and losers, however, it just so happens that the realm of venture capital has a lot more losers than winners. Even so, the winners win very big in this industry which is what makes it so appealing to aspiring capitalists. This includes the biggest capitalist of all, the government. The government engaging in venture capital raises a few valid questions. Most of all, can the government be a good venture capitalist? There are a few facts that must be taken into consideration before this question can be answered. Firstly, government is at a stark disadvantage when it comes to providing the same level of intimacy that venture capital firms can and as a result incurs more risk than these firms. Secondly, government attempts at supporting upstart firms for the betterment of society have been largely ineffective and resulted in the formation of inefficient governing bodies. Lastly, the government is under a microscope in the United States, meaning that their shortcomings are going to be met with far more criticism than a private venture capital firm would experience. Knowing all this to be true, it would be difficult to admit that government could, or, should compete with private venture capital firms.

Background Information: How Venture Capital Works

Contrary to popular belief, venture capital does not begin at the very beginning stages of a firm’s lifecycle. Before venture capitalists even get involved, upstart firms typically seek out funding based on personal relationships that their founders have. This is because no venture capitalist in their right mind would take the risk associated with backing a company that does not have any tangible receipts. The money that these firms seek out during this initial round of funding is called seed capital and is crucial to avoiding the valley of death. This is a stage in the lifecycle of all startups; aptly named because of its proclivity to claim the lives of new startups. Startups that survive this step generally go on to pitch their ideas to venture capitalists. Venture capital firms use money raised from a selection of limited partners that entrusted the executives of the firm to make good investments on their behalf. Venture capital firms are generally trying to go big with investments that have immense potential, typically looking for firms that could have a return in the billions in a very short period of time.

Following this fact, it is natural to wonder how much a venture capital firm can be expected to gain from these prospective firms. The whole of venture capitalists are paid in a combination of fees and interest charged, this combination in the venture capital industry is often called the two and twenty arrangement. The 2% in the two and twenty is known as the management fee; this paid to venture capitalists regardless of the performance of the firm. The second portion of this arrangement is tied to the performance of the startup and is a 20% tax on all profits above a certain predetermined rate; this is also called the hurdle rate. The two and twenty arrangement is largely a standard in the industry and has made many hedge fund managers and venture capitalists immensely wealthy. It is only natural that the federal government of the United States would want to get some piece of the action.

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Background Information: Government and Venture Capital

What many do not realize about the federal government is that they have engaged in some form of venture capital since the 1950’s when former President Eisenhower signed the Small Business Act of 1953. The mission statement of the SBA is as follows: ‘to maintain and strengthen the nation’s economy by enabling the establishment and viability of small businesses and by assisting in the economic recovery of communities after disasters.’ The SBA provides four main amenities to startup businesses. Firstly, the SBA facilitates access to capital by supplying loans that are partially backed by the federal government; ideally this would help businesses that could not achieve loans by other means. Secondly, the SBA facilitates entrepreneurial development by offering free training and guidance to entrepreneurs and startup owners. Unfortunately, this can never match the intimacy that venture capital firms can achieve but it is a step in the right direction for the government. Thirdly, the SBA brings the federal government and small firms together by connecting these firms with government contracts. The SBA strives for 23% of federal contracting to be given to small businesses. In addition to this they attempt to represent those who have been historically underrepresented throughout history. At least 5% of these federal contracts must be granted to small businesses owned by women and at least 3% of the federal contracts must be granted to disabled veteran-owned small businesses and other underrepresented classes. Lastly, the SBA is the voice of small businesses in the United States and the agency also does independent research on the small business environment. Additionally, in the SBA, the office of advocacy and office of the national ombudsman argues in stead of small business to congress and analyzes the ramifications of regulation on small business, respectively.

Arguments

Argument 1: The SBA is flawed by Design

The very structure of the lend itself to losing large amounts of money, while at the same time not efficiently serving the very companies they sought to embolden. Under the current requirements, for a firm to be considered for a guaranteed loan they must: be for-profit, appear that they can repay the loan, and be considered a small business. Under the current stipulations, around 99.7 of all U.S. businesses are considered small businesses. One of the chief tenants of the SBA is to supply loans to small businesses that could not get loans from more conventional means; however, with the requirements for being considered a small business being so broad, many businesses that do not need these loans are getting them at the expense of those who do. Moreover, much like venture capital companies, the SBA is meant to charge fees that would cover the cost of investing activities without the aid of congress. Unfortunately, the fact of the matter is that the SBA has not done this to any extent and as a result the program is almost entirely dependent on taxpayer backing. The 2008 financial recession naturally lead to an increase in the number of loan defaults which in turn required the SBA to buy approximately $4.8 billion in guaranteed loans in 2010.

Additionally, the SBA engages in policies that do not make much logical sense from a utilitarian perspective. As previously stated, one of the main goals of the SBA is to provide loans to firms that cannot get them in a traditional manner. In order to stay in line with this thinking, the SBA will not supply loans to those who display that their ability to repay these loans is great. Their thinking behind this policy is that firms that are too much of a guarantee should already have access to a conventionally sourced loan. Therefore, unlike venture capitalists, the SBA only is able to guarantee high-risk loans. Next, the SBA requires that all loans given out are low interest rate, this is good for the startup but bad for the SBA and the American taxpayers. Considering this, the SBA is putting the taxpayer money into investments that are intentionally high-risk and low-reward. This begs the question; if the SBA is inherently flawed and only serves as a money pit, then why is it still around? Unfortunately, the answer is politically motivated. The SBA is an easy way for law-makers to espouse their support of small business, a pollical position that holds a lot of bi-partisan favor. This is at the detriment of the American people however, because the SBA actually doesn’t provide a huge benefit to society, often times this is the contrary. The United States emerged as one of the greatest nations on earth by encouraging free-markets and leaving businesses to develop amongst themselves. Rather than providing hand-outs to businesses that most likely do not need them, the federal government should spend taxpayer money on reducing barriers to entry, and creating a fair game for all players

Argument 2: The Government Cannot Offer the Intimate Services that VC Firms do

One of the most overlooked advantages that a venture capital firm has over the government is the ability for the venture capital firm to provide services other than money for a startup to succeed. A venture capital firm can help an aspiring firm in several ways, firstly, they can help startups connect with potential customers. Corporations and venture capital firms often work together in order to facilitate networking, and for a new startup, finding a venture capital firm that hosts many of these events could mean the difference between becoming profitable or phasing out. Secondly, venture capitalists naturally have a large phone book at their disposal due to the sheer amount of companies they likely have worked with in the past. This is incredibly valuable for upstarts because venture capitalists can help them set up a skilled task-force, or even connect them with high ranking individuals in other organizations that may be able to bring their firm to the next step in development. Thirdly, most startups are founded by newer entrepreneurs, and as a result these new CEOs may have issues with making certain business decisions relating to the firm. A good venture capital firm in this situation can help new entrepreneurs make better business decisions as most venture capital firms have employees that have been in the industry for decades. Moreover, depending on how much the venture capital firm has invested within the firm, venture capitalists will likely take a more personal approach to helping the startup succeed because of the larger monetary incentive. Finally, venture capital firms often work synergistically with each other by making deals across industries. This is important for upstart firms because it exposes startups to new possible investors that may be interested in their product. Additionally, for startups, having access to many different venture capital firms means that they do not have to look far in order to acquire funding for new rounds of growth. Conversely, other than backing SBA loans and subsidizing certain industries, the federal government doesn’t supply the same level of involvement that a venture capital firm can.

Argument 3: The Government VC Failures are Under far More Scrutiny

Venture capital is one of the riskiest businesses that a person or entity can engage in today. Depending on your definition of failure, the amount of upstart firms venture capitalists invest in that fail is rather startling. Assuming a venture capitalist has a portfolio of ten companies, it is generally accepted that about three or four will completely go feet up. Next, only about another three or four will actually return the initial investment that the capitalist put into the firm. Moreover, venture capitalists would be lucky see even one company boom out of the original ten; and an even smaller percentage has even a shot at becoming the next Google or Uber. These numbers are generous depending on who is asked.