How To Break Venture Capital


Over the weekend, Tom Friedman published an op-ed piece in the NY Times arguing that the US government should take the bailout money it is considering handing over to the auto industry and instead give it to the top venture capital firms. It’s a typical Friedman piece: boldly urging new economy innovation while getting almost everything that matters wrong.

Here’s Friedman’s proposal:

You want to spend $20 billion of taxpayer money creating jobs? Fine. Call up the top 20 venture capital firms in America, which are short of cash today because their partners — university endowments and pension funds — are tapped out, and make them this offer: The U.S. Treasury will give you each up to $1 billion to fund the best venture capital ideas that have come your way. If they go bust, we all lose. If any of them turns out to be the next Microsoft or Intel, taxpayers will give you 20 per cent of the investors’ upside and keep 80 per cent for themselves.

You’d think that Friedman’s idea would be universally applauded by the venture capital industry. After all, who wouldn’t like the government to throw a few billion dollars your way. But you’d be wrong. As far as we can tell, Friedman’s proposal is getting some very rough treatment from the VC community.

Fred Wilson cuts right through to the heart of the problem, explaining that you cannot just create successful companies by throwing money at venture capitalists.

The top venture firms don’t want, don’t need, and are never going to take government money. The same is true of the top entrepreneurs.

The worst firms, on the other hand, will gladly accept government money. And that is what is going to happen with all of these government efforts to pour more money into the “innovation sector”. That money will go to bad investors and weak entrepreneurs and management teams for the most part. It’s a problem of adverse selection.

Fred hints at an even deeper problem: easy money distorts investment decisions, encouraging investors to put money into projects that are too risky. A VC company capitalised with a $1 billion of free money would have incentives to gamble with the money, putting bets on companies with shaky prospects but possibily enormous upsides. What’s worse, this dynamic would play havoc with even those who didn’t take those risks, as pricing in start-ups would go all screwy as cheap money chased risky investments. Entrepreneurs and VC investors would lose crucial market mechanisms for evaluating businesses. At best, smart VCs would exit the market until the craziness cleared up. At worst, the level of malinvestment would increase dramatically.

It’s not hard to see how this could easily turn into a nightmare scenario that would put far more than $20 billion at risk. As the Friedman Dollars worked their way through the start-up community, those risky companies receiving the dollars would start to look like even more attractive investments to truly private money. After all, a company the once had an estimated equity value of $1 million getting an injection from VCs will increase the implied valuation. Early investors are rewarded, and new investors attracted to the “growing” company. Investment resources will be drawn away from other projects. Errors cluster as the market misreads signals confused by the subsidy. This is, simply, a recipe for another round of boom and bust.

The venture capital market isn’t yet broken by cheap government money. Let’s hope no one in Washington DC listens to Friedman’s suggestion.