By now it's old news that today's gyrating Nasdaq reflects a speculative bubble that seemed destined to burst. What's less well understood is that the process by which high-tech firms get their early funding helps fuel this fragility in public markets down the line.
To be sure, America's nimble venture-capital sector is a source of competitive advantage. Only in the United States are billions funneled to start-up firms with no asset beyond a promising idea. European or Japanese entrepreneurs, dependent on more traditional (and conservative) forms of bank financing, can only envy the process.
But there's a catch: The whole thing works because it's a rich man's game.
Venture funds are rich people's way of pooling money for bets on risky investments. Top funds often require minimum investments of $1 million to $5 million; this is not for the guy with a company 401(k). Once assembled, these funds can have $100 million or $200 million or even a billion dollars that they then seek, indeed need, to invest in new firms.
The vital thing to understand is that folks who have this much cash to invest in high-risk situations can afford to lose the money without affecting their lifestyle. The number of people in this happy circumstance has soared thanks to the long bull market and the record-long economic expansion. More rich people have more discretionary millions to bet on high-risk ventures than ever before.
They're also motivated to roll the dice. For the last five years every rich person in America has seen friends or acquaintances make genuine killings on high-tech start-ups. They see little downside to getting a piece of this action, especially when it won't change their family's standard of living if the worst happens and they lose the cash.
When you take these fresh billions on the "supply-side" of venture capital and toss in the Internet revolution, you have a combustible mix. Too much money is chasing too few good ideas. That's not to express skepticism about the way the Internet is transforming the economy. It's simply a statement about the quality of businesses being funded. In the early days of a new technology called the automobile, after all, there were 3,000 companies building cars. Only a handful survived.
In the meantime, this surplus venture cash turns old relationships upside down. Instead of begging for money, entrepreneurs thought to have good ideas are in the catbird seat, able to pick and choose among potential funders for the strategic advantages they bring (like prestige, contacts or industry expertise). Venture firms compete furiously to get into "hot" deals, often making snap decisions in a matter of days or even hours with little scrutiny. For most of us this might seem crazy, but for people investing rich people's money it isn't: If just one in 20 bets pays off big, it more than covers the outright loss of all the others.
This need to strike oil fuels the macho culture of venture capitalists who lust after fabled "10-X" returns -- that is, 10 times your investment, or 1,000 percent, within a few years. Apparently it's just the little people who now rest content with, say, the 20 percent annual return produced by broader market indexes these last few years.
The last piece of the puzzle comes in the drive by venture firms to reach their "liquidity event" -- the initial public offering (or IPO). Too many companies are going public too early (i.e., with utterly unproven business models) so that venture funders can cash in while the getting seems good. The hype surrounding these firms fuels unsustainable valuations that are bound to fall to earth, as we're starting to see.
The fact that rich people deploy their wealth in this way is, for the most part, socially constructive. It gives us today's eBays and Amazons. But it also gives us the 98 percent of high-tech firms that will fail, many not until after they've gone public. Ironically, thanks to the democratization of investment made possible by online trading, it's average investors who jump in to buy these sexy stocks that get left holding the bag -- and outsized losses they can't afford.
© Copyright 2000 Star Tribune