January 26, 2009

Too Small to Fail?

Innovative, upstart ventures have a crucial role to play in economic recovery, says Michael A. M. Keehner, who suggests it may be time to give entrepreneurs a stimulus package of their own.


Lately, the notion of getting a bailout has become embedded in American culture, intensified no doubt by unprecedented federal support for troubled companies like AIG. So far, the rationale has been that some firms are too big to let fail. I think there are some firms that are too small to let fail too — young enterprises that are the entrepreneurial backbone of our economy.

As Americans, we hold our tradition of entrepreneurship dear. Decades of economic growth have been fueled by innovators spawning new industries, high-value jobs and stock market gains. Lotus, Southwest Airlines and Google are but a few of the success stories. Yet one result of our credit and subprime crises is that the current wave of U.S. innovations is very likely to be slowed — or in some cases lost to us entirely — from lack of adequate investment sources. Many of these young entrepreneurial enterprises are facing serious cash shortages or even outright failure, not for lack of entrepreneurial promise, but for lack of dependable funding. And if they lose their momentum, we as consumers, investors and perhaps even employees will lose the benefits innovation usually bestows.

No stimulus plan under consideration addresses this critical sector’s vitality directly — not a surprise, since the companies are too small to lobby effectively. And, their venture capital (VC) sponsors have seen a degradation of their political clout over most of the last decade, overshadowed as they have been by the sponsors of investment vehicles that use leverage and financial engineering. I suggest that, rather than betting everything on outdated industries or new infrastructure, we place a few stimulus chips on the best of our young and soon to be cash-starved enterprises.

These budding enterprises are typically underwritten by VC funds which invest in young, high-potential companies and hope to see a return as the companies mature. Venture capital funds are in turn funded by institutional investors and high-net-worth individuals and managed by dedicated professionals.

The majority of new entrepreneurial companies do not use substantial leverage. Nevertheless, the damage from the subprime and credit crises is very meaningful to them. The lack of a viable IPO market is their first impediment. Public markets are a crucial capital source for these enterprises when they reach maturity as well as an exit where the venture capitalists can realize and recycle their investment gains. The IPO market has been nonexistent since last August save for one deal, Grand Canyon Education. The Nasdaq index was down as much as 33 percent last quarter and was extraordinarily volatile. An outright sale is an alternative for some young companies, but many that do not want a sale or cannot find one are being forced to seek unanticipated rounds of venture funding because there is no viable public-market access and none is likely soon.

At the same time, the VC funds that might meet this unanticipated funding gap are experiencing a capital drought of their own. Their principal investors, particularly pension funds and endowments, are reeling from losses and markdowns in subprime vehicles, hedge and private equity funds, and greatly diminished equity portfolios. As a result, some institutions are beginning to retrench on honoring capital calls and to rethink the portfolio proportions committed to the investment category that includes venture capital.

The venture capitalist, then, faces a difficult choice: Well-managed funds have a portfolio of promising enterprises that depend upon ongoing injections of growth capital. When that funding dries up, the manager must decide which companies will be given the needed capital — and thus the chance to survive — and which will be cut loose to slow their growth or perish.

It does not matter that capital may have been previously committed to a VC fund by a large investor. Frequently, VC funds are structured such that the money committed is delivered in stages, in response to calls for capital from the fund manager. But in difficult times like these, the commitments can be illusory — no venture fund manager can afford to ignore the institutional power of a major pension fund or endowment warning against receiving capital calls.

Compounding the issue, there are usually limits to the amount a VC fund can invest in any single promising enterprise. Typically, a VC sponsor will seek like-minded VC fund managers to participate in subsequent rounds of a venture’s financing or launch another fund. But today, additional venture investors are scarce, since they face the same issues with their own fledgling companies, and any new money can find deeply discounted positions from institutions seeking liquidity in the secondary market. That may be fine for the new investors, but no cash reaches entrepreneurial enterprises in these transactions.

As a result, many of these young enterprises are being told to slow down, conserve cash and stretch out development and marketing plans. No doubt, some perfectly viable enterprises will be abandoned in the hasty triage process. And many new ideas triggered by the current economic realities will be hard-pressed to find funding at all.

Some inappropriate ventures, conceived at a time of high leverage and unrestrained consumption, will fail. But the more typical entrepreneurial enterprise is aimed at providing efficiencies, improvements or new approaches to commonplace industrial processes and everyday life. Many of these can survive and prosper in the altered economic climate we now face.

New technologies, new products, and new efficiencies are all nice things to have sooner rather than later in a broad economic downturn. There is also job creation, economic activity and perhaps an exciting story or two to breathe some life back into the IPO markets in the near future. Further, with the right kind of protections, taxpayers may well get a decent return on their invested tax dollar.

So how about devising a channel for a few billion dollars of whatever stimulus package we decide upon to directly maintain an adequate level of capital availability for these emerging enterprises? There is some precedent for this with the U.S. Small Business Administration. It or another agency could be authorized to take over venture fund commitments from legitimately cash-constrained institutional investors. The agency could also invest directly in portfolios of promising enterprises, alongside VC sponsors that have poor prospects for near-term fundraising on their own. Procedures to institute meaningful taxpayer protections and to avoid unsuitable ventures or funds are not difficult to devise, and any such program would have the benefit of injecting some dependable financing into this important entrepreneurial component of our economy.

No entrepreneurs or venture capitalists are flying (or driving) to Washington, D.C., to make the case for this particular form of stimulus. But consider for a moment which would leave us better off in a few years: our tax dollars invested in Detroit or a bridge to nowhere — or in a few years’ vintages of U.S. entrepreneurs?

Michael A. M. Keehner is adjunct professor of finance and economics and a Bernstein faculty leader at the Sanford C. Bernstein & Co. Center for Leadership and Ethics at Columbia Business School.

A version of this piece was published December 16, 2008, on Public Offering, the Columbia Business School blog.

Have You Read Columbia Business?

Columbia Business School’s alumni magazine connects alumni with each other and the School; celebrates alumni milestones and accomplishments; and chronicles the impact of Columbia Business School alumni, faculty members, and students on the global business landscape.

Read Columbia Business>