The siren song of venture capital

The idea of investing in a promising but risky venture in hopes of making a substantial return in the future is nothing new. This was the business model that funded Christopher Columbus, Venetian spice traders, 19^th-century whalers, and the early days of the Hudson’s Bay company. This model provides a big incentive for investors to channel capital to promising new areas of activity that could benefit society, projects that would otherwise go unfunded.

Venture capitalists today inherit that tradition, and their activities are celebrated in media accounts, detailing the praise of elected officials and champions of economic development. In Canada such investors have put some $40 billion into promising early stage companies over the last decade, according to the Canadian Venture Capital and Private Equity Association. Globally, VC investment in 2021 was $US613 billion, according to the Business Development Bank of Canada. That represents a significant rise from $US60 billion ten years ago, an increase driven by very high returns — reportedly 20 percent from 2017-2021.

The business model

VC’s assemble a pool of capital from individuals and companies, who are passive investors, or more specifically, Limited Partners. In contrast, General Partners screen companies and decide which ones to pursue. After investing in a firm, the General Partner usually has a seat on the Board and provides the CEO with intensive coaching, mentoring, and access to networks.

After a certain number of years, and several rounds of investing, these investors make their exit. This can take the form of an Initial Public Offering or, more likely nowadays, the sale of the company to another company. This cycle will be just one of many parallel investments within a larger portfolio, a strategy driven by the high level of risk associated with these early stage companies. Such a large proportion of these firms will fail, that VCs rely on the small number — perhaps 1 in 10 — that will yield a large return, thereby covering the losses with the others.

Although VC-backed companies represent less than 0.5 percent of American companies created every year, they make up nearly 76 percent of the total public-market capitalization of companies started since 1995.

The community impact

There is no doubt that the VC model is a very effective way of advancing innovation. Seven out of ten of the world’s largest companies, including Apple and Amazon, were venture capital-backed. However, what is good for the economy as a whole may not always be good for the individual communities that nurture these enterprises.

In fact, the goals of the VC and economic developers do not align at all. A VC’s sole purpose is to make money; local economic developers intend to create good jobs and build their community. For that community, there are a number of downsides to hosting a VC-backed firm.

The company often moves away after the exit. If the acquiring company is based in the US or Europe, the company’s assets will simply move to a new location. According to Dan Breznitz, Munk Chair of Innovation Studies at the University of Toronto, there are relatively few big companies in Canada capable of acquiring VC backed companies.

The profits also move away. By way of example, over the last few years, Calgary has given rise to five unicorns, companies with a market capitalization of $1 billion. All five were funded by VCs (or private equity) from the US or UK, which means when investors make their exist, those countries are where the profits will go.

These firms do not build a local innovation ecosystem. Since company management receives intensive support from the VC, there is no need for them engage in a similar way with any local counterparts.

Entrepreneur gives up some ownership. This is in common with all forms of equity investing.

Social inequities arise. In his book, Innovation in Real Places, Breznitz describes Israel, whose economy has grown substantially due to VC investing. At the same time, Israel has now one of the most economically unequal societies in the world, as a small group of entrepreneurs has become very wealthy but their gain has not penetrated to the rest of the economy, where 20 percent live below the poverty line.

Local economies receive few spin-offs. The Israeli experience demonstrates how the “VC economy” can coexist with the “other economy”, yet with very little interaction between them.

Alternative outcomes

The contrasting goals of VC investment and community economic development can be reconciled, if successful founders play a key role in community-building, by staying and acting as mentors and investors for others. That prospect also serves as a reminder that  not all growth companies require external funding. For example, Smart Technologies, which grew to revenue of almost $1 billion in Calgary, received no external funding.  Their CEO described the approach as “make a few, sell a few, make a few more, sell a few more, and so on.”

The economically bustling island of Taiwan also offers a distinct VC model, without many of the downsides found elsewhere. It is based on local capital and requires an IPO on the Taiwan stock exchange, so profits remain in the country.

Conclusion

Venture capital is a powerful force driving innovation. However it is not a reliable way of building a local community as many. We therefore badly need some innovative thinking, to come up with other business models for channelling capital to high growth companies, while also benefiting the people and communities who make these investments attractive in the first place.

Peter Josty is Executive Director of The Centre for Innovation Studies (THECIS), a Calgary-based not-for-profit research company specializing in innovation and entrepreneurship. In addition to working in private research and business development, he holds a PhD in chemistry from the University of London and an MBA from the International Institute for Management Development in Geneva.