How Inflationary Environment Promote Startup & Exit Culture and Venture Capital: The story stocks don’t seem to have a happy ending in sight
If I look up the definition of a 'startup,' I first see a Wikipedia definition of it which reads as follows: A startup or start-up is a company or project undertaken by an entrepreneur to seek, develop, and validate a scalable economic model.
I don’t know if I have been living in some kind of time capsule but according to me, that just sounds like what a company really is. I don’t know what was the need for having coined a new term for a company but maybe the term ‘company’ is tainted with some kind of right wing connotation or maybe has some spirit of colonialism attached with it such that when you utter it a ghost of Queen Victoria of England presents itself and starts annexing territories to be colonised in a pending rage.
All companies are growth oriented for the simple reason that, being in a competitive environment, not growing will cost them in the long run by being rendered unprofitable against others who would outcompete(outprofit) them. With growth comes growth of surplus and that arms companies to make themselves more efficient over time with the quick adoption of new technology and various necessary methods needed to adapt with consumer demand and keep up with technology.
And all businesses are run by entrepreneurs. To put it simply, an entrepreneur is someone who runs a business. An entrepreneur could choose to service his business for the long run by reinvesting surpluses into the business to make it more competitive or could simply choose to pocket the surpluses and retire while the business, over time, fails to be competitive and thus, gets dissolved one way or another. So that definition of a startup seems disingenuous.
Here’s what ‘they’(the wrongly educated masses with the utmost crude understanding of the market) really mean when they say ‘startup’. A startup is simply a company made to make something that they call a ‘product’. Now, this could be anything from something that is physical(like a juice making machine) to something that is completely digital(like Netflix or accounting software).
That isn’t too far off what a company is but the key difference here lies in the fact that while generally business models of companies have to be profitable in realistic short terms, a startup has none of those strings attached. The whole philosophy behind startups is that someone else bankrolls the entire operation while they, the startups, figure out how to be profitable(theoretically, of course that this happens is whole another question).
Of course, not anything can be bankrolled you might say, so what is the criteria by which a startup can be distinguished from any Tom, Dick and Harry coming in wanting money for their business? The answer lies in revenue which simply means ‘sales’ in one way or another. Whether the product itself is profitable per ‘piece’(or sale) is of no concern. All that matters is whether the startup can somehow peddle these products at a rate of growth which somehow demonstrates scalability.
While a traditional company might seek to get profits per product sale and as it grows and becomes more efficient, they can increase those margins by utilising bulk purchasing, automation and various other methods that are far too unique and many to count. The startup does not have to abide by this method, it seeks to skip it entirely by making products that are financially impractical for the startup itself but good value for the consumer.
The way these otherwise unviable companies keep surviving is via venture capital. The cycle goes something like this: a) Make something that some people want(maybe) you think b) Acquire capital in various ‘stages’ c) Keep growing the sales d) Repeat b and c.
Of course, in the process of getting capital, they have to give up a certain percentage of the company but that is not a problem when the survival of the startup depends on these cash injections. Eventually, the startup gets bought or acquired and the founders can exit. The founders can exit whenever they like but they have to maximise the valuation and exit at a time that is comfortable for them. There might be conditions for exit of founders in contracts between the bankrollers and the founders, however.
The whole industry is kept afloat by these valuations over actual profits.Whoever is the startup dumped on is to make a profit or, as usually goes, acquire its customer base under its wing. Typically, a bigger company acquires a smaller company which presents some competition to it.
In that, the interests of all parties are aligned, the venture capital funds bankrolling the startup get a return based on the deal on their percentage stake and the founders and other shareholders get to exit while the bigger company gets to acquire a ready customer base or eliminate ‘competition’.
The startup can also go public via an IPO which may decide its fate moving forward and their business model after going public will decide whether they become profitable or not but in this period the option of acquisition is not out of the picture still.n At any point, the VCs funding the operation might decide to sell their share if they deem fit.
More and more of these story companies that were ‘startups’ have not returned a single dollar in surpluses ever since going public now more than the level that was seen on the peak at the dotcom bubble.
<img src="media/image1.png" style="width:5.97076in;height:4.17188in" />
Source: https://www.toptal.com/finance/venture-capital-consultants/state-of-venture-capital-industry-2019
As you can imagine, these companies require more and more injection of cash in bigger and bigger doses for a smaller and smaller piece of the pie as the time goes on. The valuations that they get also keep on increasing because it is in the best interest of evaluators to keep evaluating these higher and higher in order to get more and more work from others who are playing the same game. And there’s various amounts of trickery that can be done in order to get higher valuations.
<img src="files.pitchbook.com/website/images/content/Chart_4_gGs.jpg" style="width:6.5in;height:4.43056in" />
Source : https://pitchbook.com/news/articles/18-charts-to-illustrate-us-vc-in-2018
It is also in the interest of these Venture Capital firms to keep on acquiring more and more startups in order to increase their assets when the sale finally happens on these astronomical evaluations so a big investment early on can net them a larger share for the endgame and thus a net higher income when the startup company is sold(in addition to higher funding required due to higher cost of operation due to inflation).
<img src="media/image3.png" style="width:5.72917in;height:5.03125in" />
Source : https://pitchbook.com/news/articles/21-charts-showing-current-trends-in-us-venture-capital
According to this CNBC article, companies that are well funded survive more than those that are not. Well, I’d say that’s common sense. Of course they would survive for longer if they are getting money for being inefficient. Without the cushion of VC money to fall on, they’d meet the same fate as most private companies do.
Now, how does inflation have an impact on the rise of venture capital and this whole startup and exit culture?
We are aware of how much inflation has an effect on business operations. The cost of raw materials increases over time which forces businesses to adapt with these cost increases with technological deflation and other methods like simply delivering an inferior product for the same price. This makes it harder to survive and adapt in the market, especially when other companies do not have to abide by profit and loss in the short term swaying customers to where they would not be, had the rules been the same in the short term.
Suppose A is making a product at $7 with an overall $2 margin so at the overall cost of $5. B can come out in the market with a similar product at $4 with no margins and all losses funded by venture capital, this kind of undercutting would wipe out A in the short term. This sets the stage for an environment where if you have to survive, you have to take losses until the competition is taken out. It really is like a race to the bottom.
Naturally, not every entrepreneur can stomach sticking with their company through all of this especially when not only do they have to beat contenders like B but when they finally do, they have to make up for all the losses they took while also beating the competition coming after B goes down, which maybe even would be ‘honest’ competition but they would not have the baggage that A does now as a result of fighting it out with B and this increases the likelihood that even A not survive.
This makes it so your best strategy ends up being to start these businesses and dump them on someone else while you sell your stake and retire. However, in the current environment where the government injects inflation that ends up at stocks, these companies are held up as zombies that not only are completely unyielding but stop genuine business from taking place.
The entire thing would collapse if the government stopped increasing the money supply thus returning the market back to normal but the asset inflation keeps ensuring that VC funds that have a lot of assets tied up in stocks can increase in value so they can bankroll even more companies while also reaping from the sales of these startups by high value deals in the forms of company sale or mergers and acquisitions. At the same time, inflation makes it so savings are more and more unreliable as seed funding or initial capital to start a business.
The higher costs of operation, such as wages, rent, equipment etc. make it so the money required to start a business also increases and renders savings more useless over time which have already been inflated away to some extent. Small businesses usually take out a loan but going the venture capital route is enticing because it does not come with the risk of bankruptcy and offers some benefits in the form of non-monetary capital by the venture capital firms like aiding in talent hiring and providing access to business requirements from other firms that might be connected to the venture capital firm.
For now, it seems like this activity is limited in the high tax areas, staying where it gives an edge to the startups in the form of competition not being able to survive the ultra high costs and taxes(which may be a topic for another day).
<img src="media/image5.png" style="width:6.5in;height:3.75in" />
Source : https://en.wikipedia.org/wiki/File:Venture_capital_by_state.png
This does not mean that the effects are limited to these areas, however. We do not know how much it affects all the other things in the economy but any inefficiency is a loss for everyone. Under a free market, the inefficiencies are constantly being ironed out instead of bankrolled but since we are not under a free market, these things are bound to happen.
As a result of the inflationary and regulatory environment where the big corporations can get special privileges by the government and are more efficient with their capital situation having multiple assets under its belt, the chances of a small business surviving against big corporations is getting slimmer and slimmer.
<img src="media/image2.png" style="width:6.5in;height:5.41667in" />
In a non-interventionist environment, the big company would always be threatened by the small competition because large companies may be efficient but only until someone else comes along with an even more efficient product or process and better margins as a result of having less running costs in wages, rent, legal costs, etc.
However, with government involvement, the special privileges granted to the already big corporations ensures that the small competition is essentially wiped out and this is not helped by the patent system either, which is perhaps a topic for another day but I’d recommend ‘Against Intellectual Property’ by N. Stephan Kinsella on something related which may be of interest to you.
Some interesting things, worldwide seed investing via venture capital is on the, there are more VC funds than, is the life expectancy of companies really shrinking?, 83% of companies IPO’ed in 2018 were,75% of startups don’t return cash to investors.
Logic is superior to any empirical study or measurement but I have provided these just for some perspective on this.
Ohranje Gallante (OhranjeGallante@protonmail.com)