Historical evidence shows that the rich have an interest in maintaining their relative wealth. This is done in means of using their wealth to further themselves or repressing the innovative class. It is easy to think of this as evident in the Feudal Age when monarchs ruled, but harder when considering the modern age and the prevalence of venture capital. Venture capital, which is in the business of supplying a temporary cash flow to entrepreneurs, is often looked at in an almost philanthropic way but it can hardly maintain that image with returns of investment and a company-destroying exit strategy in mind. The practice of maintaining comparative wealth through venture capitalism and other financial tools is just another act which further entrenches the wealthy despite the venture capitalist’s mission of value-adding services and their denial of such claims.
The economic and political elites have been a franchise of economic interest and heredity-based opportunities for the since the times of the Roman Empire. In an essay concerning the elites in universities and business, Brezis and Courzet observe the circulation of elites in the past: “…recruitment of the elite was actually carried out via heredity, nepotism, and violence and the word “aristocracy” cam to describe the hereditary upper ruling class. Hereditary monarchy was for centuries considered the most legitimate means for recruitment for rulers, based on the assumption that morality and intellectual prowess are inherited, according to God’s will.” These actions in the feudal age were the most legitimate way of retaining wealth and transferring prosperity to the children of previous leaders.
With the growth of nations and industrialization, there was a fundamental shift from the power of the ruling class to the business class, but both wanted to ensure economic well-being. Before an increased of importance of university education, large business leaders were often hereditary. Brezis and Courzet explain “Most of the British economic elite were recruited and trained via the traditional channels of family connections and patronage, the so-called“old boys’ networks”of those who had attended public schools.” Essentially, even though there was the creation of the business class, heredity still ruled. Barriers of entry are high when it is your father or his friends who give you the opportunity to become economically well-off. Although obtaining wealth was becoming easier, there were strong methods for elites to retain wealth.
The twentieth century brought the advent of the availability of the university education. There is evidence that the economic elites still had a fairly large monopoly on gaining entrance into the elite schools, such as the Ivy League. However, this change brought a fundamental shift in the retention of relative wealth. It was no longer viable for practice of heredity-based opportunities in large businesses in the scale of previous centuries. The retention of wealth was brought by investment vehicles and trusts.
In 1946, the first venture capitalist firm was created by Georges Doriot and was called American Research and Development Corporation. Although it isn’t the most popular avenue for majority of economic elites to retain their wealth, it was the creation of a vehicle to do so. Typical venture capitalists buy shares of a start-up company to provide liquidity for the company to grow and become profitable. A large percentage of today’s most successful companies are a product of venture capitalism. Since 1946, the rise of venture capitalism has grown immensely. By 2000, Venture Capitalism was a $105 billion dollar industry (PricewaterhouseCoopers 2008).
Historically, elites have made tremendous efforts to retain their wealth and have done so throughout the progression of society and economic development. There is no reason to believe that altruism is a product of the twentieth century. Through investments and now with the proliferation of venture capitalism, investors take a share of all profits and growth in a company. This does not prevent people from gaining new levels of wealth, but it does help maintain a continuation of growth of their wealth to levels that are fairly consistent in terms of relativity.
Revolutionary ideas and the products they create are the cause for loss of relative wealth for the economic elite. Even despite an economic interest in new companies, their share is not large enough to make the economic elite a permanent position. Barriers of entry help preserve their wealth. However, in an economic situation where the entrepreneur can make massive amounts of money and usurp the previous economic elite, there has to be some mechanism to stop that.
Venture Capital has had a history of pseudo-philanthropic work. Ideally, their firms would provide the liquidity for companies to grow to their potential and would further propel society. They risk their capital in the name of progress and often take a handsome reward for the risk take. However, through growth in of the venture capital market and less altruistic venture capitalists involved in that growth, the business plan for the firms has been severely been altered. Previously, the prevalence of the initial public offering in a S.E.C. regulated market, such as the New York Stock Exchange or Nasdaq, provided venture capitalists to seek their returns on investment in profit and growth building methods.
In March 2000, the internet bubble popped. Many venture capitalists had invested in internet start-ups which exit strategy was an IPO. The majority of these companies were purely speculative based and some were not revenue generating businesses. Internet entrepreneurs and venture capitalists had taken advantage of a speculative market and had profited immensely from it. It transformed the IPO into something that wasn’t economically stable as an investment and, in the process, negated the requirement for company to be viably profitable and growth-based. As a result, with the advent of the bursting of the internet bubble, IPO’s were no longer a relevant exit strategy for most entrepreneurs and venture capitalists.
With the most prevalent exit strategy erased, venture capitalists have turned to use mergers and acquisitions as the primary way to gain the return on their investments. However, it is beginning to become apparent that this exit strategy is potentially harmful to innovative ideas.
The problem arises from the same agenda of three very different groups of people; the entrepreneur, the venture capitalist, and the large companies buying the new ventures. They all, generally, would like to make a lot of money of the products created.
Companies, such as Microsoft, Yahoo and Google are buying a multitude of smaller companies that are the product of venture capital pipelines. These companies are small companies that often only offer one service that are very specific in nature. Viability is a challenge for these companies if they are not acquired by a large corporation. However, the large corporations are buying the start-ups in an effort to gain the value-added products of the start-ups offer. In the process, the sell-side of the equation is getting their exit strategy.
Just as the economic elite have maintained their relative economic wealth by preventing the capable of gaining wealth through meritocracy, these large companies are doing the same. However, these companies are not creating seemingly impossible barriers of entry through heredity and “old boys’ clubs.” They are preventing the growth of companies and new innovative ideas from fruitation through acquisitions. Fred Wilson, a venture capitalist and discussion leader of this trend, talks about these activities with Google as an example. “[Google] has bought a number of assets over the years and several of them have languished.” He continues with the comment, “we can argue about the magnitude of the return we need and a host of other things, but the fact remains that without a path to liquidity, all the innovation that is being created by the entrepreneur/VC equation will stop happening.”
Fred Wilson gives an example about the acquisition of a company, which he was a venture capitalist for. The company, delicious (http://del.icio.us), was acquired by Yahoo in 2005. By tracking the user base of the company after the acquisition by Yahoo, the company’s popularity decreased immensely and is growth has essentially become a stand still. Wilson states, “I see what happens when a company gets purchased. The service languishes. The team leaves. It stops getting better and often gets worse. So, even though I am happy to take the money, I am left wondering, frankly wishing, if there is a better way.”
Umair Haque, writer for the Harvard Business Review, wrote a response to the issue. He agreed with Wilson, “public offerings are tough, and acquisitions end up trapping innovative startups in corporate bureaucracy.” He continues with, “Every company that had the potential to be economically revolutionary over the last five years sold out long before it ever had the chance to revolutionize anything economically… All sold out to behemoths that are destroying every ounce of radical innovation within them.”
The discussion often leads to the example of Google. Google was a company that had a multitude of offers to sell the company to a large company like Microsoft or Yahoo. However, Google declined all offers and is now a strong, revolutionary company that is a successful in both profit and growth. Google has since become the idealistic venture company and is the result of a successful exit strategy.
Haque continues the discussion with a criticism of the current state of the venture capital industry, “The venture industry is fast becoming an old boys club: one big boardroom mostly full of guys with the same perspectives, beliefs and incentives.” This gives way to the idea that the economic elite, which are now not only defined by investors but the largest corporations, have successfully monetized the process of killing innovation. Venture capitalists gain money from the sell of their assets and the large corporations continue to maintain their market share by eliminated the competition through acquisitions.
With the market demanding more reasonable exit strategies, large financial institutions have created a secondary market for private and venture equity. Goldman Sachs recently created the GS Tradable Unregistered Equity OTC Market (GSTrUE). Similar secondary markets have also been created, such as Opus-5, more recently by other investment banks.
These new markets are a combination of the venture capital market and the process of initial public offerings. The companies under the new GSTrUE are private companies and are unregistered by the SEC. They do not trade publicly and there can be a maximum amount of 399 shareholders of the company. Investors who participate in these new secondary markets must have assets over $100 million dollars and are closed to individual investors with smaller assets.
A Wall Street Journal article by Randall Smith on the new secondary markets states that “it represents he latest step in the creeping exclusion of individual investors from a growing proportion of financial-market activity. The growing importance of hedge funds -- which are generally limited to wealthy investors, institutions and endowments -- also excludes individuals.” The new secondary markets do not necessarily create a new end game for venture capitalists. Large shareholders could still demand certain exit strategies, such as a buyout. Fundamentally, this new market does not change the dynamics of venture capitalism, but provides liquidity to venture capitalists. The problem is not solved, just changed.
New innovations in the financial services industry are bringing the franchise of the economic elite to a more solid foundation, since education and hereditary barriers of entry have lost their viability. Instead, the barriers of entry are much more clear and simplistic. If you do not have copious amounts money to invest, you can not invest in these high-return investments.
The income share of the top decile of American is a good indicator of the establishment of the economic elite. The graph below (Piketty and Saez 2006) shows the top 1% of people in 1917 with about 18% of the national income. This could be correlated to the hereditary process of opportunity and the elite school education. After the end of World War II, the income share decreases to below 8% in 1973. With the increase of financial tools like venture capital and hedge funds (the first hedge fund was created in 1949), the income share rises dramatically to around 17% at the time of the internet bubble. The top decile of Americans earned an aggregate of around 44% of the nation’s income at this same time.
Throughout history, innovations in the barriers of entry into the economic elite have changed, but are still strongly entrenched. The process is still alive today with the creation of the asset-heavy industry of venture capitalism, the creation of hedge funds and, most recently, the creation of a secondary market for private equity. The availability of these resources needs to be made accessible to the common person for this vast economic inequality to start eroding.
