Obama’s Economic Policy

I am frustrated with Obama for not addressing the questions about what he plans to do to turn around the economy. I am also frustrated with his anti-business, anti-globalization, and anti-free-trade rhetoric.

It has led me to ponder the question, what should US economic policy focus on to get some vitality back into the system?

And it has brought me back to a topic that I have addressed before, although not in very specific terms.

In this piece, I will.

The truth is, every economy needs a thriving small business eco-system to be able to get the virtuous cycle of job creation moving. So, instead of this anti-business nonsense, Obama really needs to turn his superlative oratory to a pro-small business / pro-business creation narrative.

And then, get into the specifics of how to re-engineer the venture capital industry, a dysfunctional business flushed with cash that is operating as a greed-infested scamville right now.

The National Venture Capital Association estimates that about $30.5 Billion was invested in 2007 by the industry, spread across 3,912 deals, at an average of $7.75 Million per deal. These numbers are pretty average, and representative of the industry over the last 5 years.

For businesses to start, the amount required is more in the $250k-$1 Million, an amount that falls below the threshold of venture funds’ investment sweet spot. This has created a funding gap in early stage venture capital, typically being filled by Angels, who are wealthy individuals and families. [Read: The Real VCs of Silicon Valley]

The reason this funding gap exists in the venture capital industry is that VC Firms are raising larger and larger funds to access larger and larger management fees. The industry operates with the structure of a 2% management fee per year and 20% carry, which is the industry term for profit sharing. [Read: Fund Envy]

While this structure works just fine if the industry returns very large profits, the problem is, business opportunities (VCs call them Deals) for creating “home run” ventures with 10x return on investment is scarce. Thus, a very small percentage of the deals that get funded by the industry actually returns serious profits. VC firms who invest in these deals lose money, but still are not required to give back their fat management fees which, in effect, they have not earned. And thus, a scam-cycle rolls on. [Read: Why The Venture Capital Model Is Broken by Dilip Rao]

If you look through the list of 3000-4000 deals per year over the last decade, a remarkably small percentage of them turn out to be home run plays.

So it is not efficient for an entire industry to be structured in a way that it depends on home runs alone, because new business creation needs to be encouraged even if they are not home run ventures. $5-$50 Million businesses – a large number of them – can create a thriving economy, and it is important that we restructure the venture creation part of the eco-system to support this goal.

Every $7 Million investment can support 7 $1 Million investments, and 28 $250k investments. But to manage 7 investments or 28 investments, venture firms need to hire more partners, and share the 2% management fee that is today being gobbled up by a remarkably small number of partners.

If the number of businesses created were to go up 7-folds to 28-folds, however, we move up from say, 4000 new businesses a year to 28,000 to 112,000 venture funded new companies a year.

I would argue, these deals, if they were pegged as interesting small businesses from the get-go, and not meant to be Billion dollar enterprises, would operate under a much healthier dynamic. Expectations, financing strategies, business strategies – everything would be better aligned with the proven reality that most ventures, indeed, turn out to be small businesses.

AND THERE IS NOTHING WRONG WITH SMALL BUSINESSES.

Here are some statistics about small businesses from the Small Business Administration (SBA):
Small businesses

* Represent 99.7 percent of all employer firms.

* Employ about half of all private sector employees.

* Pay more than 45 percent of total U.S. private payroll.

* Have generated 60 to 80 percent of net new jobs annually over the last decade.

* Create more than half of nonfarm private gross domestic product (GDP).

* Hire 40 percent of high tech workers (such as scientists, engineers, and computer workers).

* Made up 97 percent of all identified exporters and produced 28.6 percent of the known export value in FY 2004.

* Small innovative firms produce 13 times more patents per employee than large patenting firms, and their patents are twice as likely as large firm patents to be among the one
percent most cited.

So, while a small portion of the venture capital industry can go on chasing the Googles and Ciscos, most venture firms should realign to serve a different, yet to be fully figured out industry: venture capital for creating and sustaining small businesses.

Venture firms can invest their expertise on building solid $5-$50 Million businesses, and perhaps not experiencing as many write-offs for making stupid business decisions by chasing returns that the nature of the businesses in question may not support.

There are huge opportunities today for creating wonderful, thriving small businesses. Yet, the most savvy set of investors are all focusing on a wild-goose chase that is an inherently impractical endeavor.

Barack Obama, if he really wants to make a dent into the US economic crisis, should spend serious intellectual horsepower understanding how to better utilize this $30 Billion per year available cash. He needs to work with the stakeholders, and help engineer a solution that can be a “real solution” than his stupid, populist business bashing.