A whopping $57.5 billion has been invested in U.S. venture-backed companies since the start of 2018, according to Pitchbook. Two University of California researchers, Martin Kenney and John Zysman, are concerned that all this early-stage risk capital may in fact be hurting, not helping, the innovation economy, according to a new working paper titled "Unicorns, Cheshire Cats, and the New Dilemmas of Entrepreneurial Finance."

In their paper, Kenney and Zysman argue that "the VC industry lacks discipline, seeking disruption and market share dominance without a clear path to profitability." They believe that the uneven playing field of expectations and the recent influx of capital into the VC ecosystem create a situation where "money-losing firms can continue operating and undercutting incumbents for far longer than previously," as their VC backers reward growth metrics with higher valuations:

"Arguably, these firms are destroying economic value. This new dynamic has social consequences, and in particular, a drive toward disruption without social benefit. Indeed, in some cases, they may be destroying social value while also devaluing labor and work in the enterprise."

While I agree that venture capital isn't for all entrepreneurs (in fact, in some cases it can hurt your venture), and that VC-backed startups disrupt current industry incumbents, I cannot, on a macro level, buy into these findings. 

Why They Are Wrong

I am not going to argue against unicorn overvaluation. Nor am I going to warn that the lower cost to launch is a bad thing because it creates more signal than noise. I cannot find fault with the fact that more people can start companies today than ever before, and that the exponentially falling cost to launch a startup makes alternative sources of seed capital feasible (think: crowdfunding, ICOs, and Angellist). As a capitalist, I find all of these to be healthy results of democratizing startup investing. 

But what I take great issue with is the conclusion that venture capital is hurting our economy. Yes, Uber has made taxi drivers a commodity and likely driven down driver pay across the industry. But at least my Uber driver keeps his vehicle clean. Yes, Airbnb has taken a chunk out of the hotel business. But now homeowners that participate can pay down their mortgages quicker. I disagree with the notion that venture capital is a bad thing.

Why Your Startup Should Not Discount Venture Capital

Don't get me wrong--venture capital isn't for all new ventures. Many pundits have espoused reasons why founders should avoid venture capital. The two most common reasons are dilution and control. The former refers to the fact that VCs take an equity stake in your company, and thus you own less--meaning you get less of the upside if you succeed. The latter refers to the fact that as soon as you accept outside investment, you have to answer, explicitly or implicitly, to investors.

My answer to the dilution problem is that founders might have less, but they have less of something worth much more (i.e., a smaller slice of a much bigger pie). And as for the control issue, many hands make light work--you can never have too much brainpower. For me, the real issue is premature scaling. At its heart, venture capital is meant to fuel growth and scale up a venture. Most startups raise it in order to expand. However, premature scaling--growing resources before you grow revenue--is a top killer of startups worldwide. Taking VC money to scale before you're ready to scale is a surefire recipe for diaster. 

But you shouldn't discount VC money all together. Innovations exist because an entrepreneur discovered that a customer segment had an unmet market need. That need, in most cases, is pent-up innovation. That need leads startups to push for industry disruption, and that's what investors, especially VCs, back.

Blaming VCs for hurting the economy is a lot like blaming Tesla drivers for abandoning costly, traditional gas stations. Remember, Netflix (and its investors) didn't kill ABC, CBS, or HBO--it just addressed unmet market needs with better solutions. Unmet market needs are being addressed with exponentially better solutions generated by VC-backed startups. And that is never bad for the economy.

Published on: Jul 23, 2018