Creative Class

… one victim will be entrepreneurship.

I monitor the financial blogs quite a bit and over the last two weeks an amazing transformation has occurred. Initially, many were calling the current wave of government takeovers “socialism.” Now, with the most recent Bush-Dodd-Frank plan to give enormous amounts of U.S. government money to global financial institutions, few believe this has nothing to do with “socialism.” What a canard. This is simply the final act in a long bout of “crony capitalism.”

Socialism is about government ownership of parts of the economy in an effort to transfer some of the gains to the less fortunate in society. For anyone to believe that the last two decades of financial deregulation and the current giveaways of government monies have anything to do with socialism is simply ridiculous. This is about some sort of booty capitalism where theft was legitimated. When the State abdicates its role as an enforcer of rules of the game, things quickly get out of control and outright fraud becomes the rule.

The New Deal was not socialism, though many accused it of being that. It had many components, but one of them was the enforcement of transparency and rules upon the stock market. It was this that made U.S. markets the envy of the world. These have now collapsed as few trust the financial results being reported by U.S. firms or even a day’s trading results, as investment banks are clearly investing in their own stocks for day trading profits. The SEC and the Fed have openly told firms they do not need to report their results truthfully. This is extremely dangerous throwing the major principles necessary for operating markets overboard at the first whiff of a crisis is extreme and dangerous short-termism. Regaining public trust will take a very long time.

How does all of this affect entrepreneurship and creativity? The U.S. entrepreneurial model was to start a firm, build it, and then use public stock markets to raise capital to build the firm further. In the last decade, many of the advocates for entrepreneurship came to think of public markets simply as exits from which the promoters got rich. This type of thinking is a fundamental misunderstanding of the role of stock markets. The initial public offering is meant to raise more capital so that a firm can grow. The EXIT is only a by-product of the raising of capital for further growth.

This mistaking of a private goal for the public good led to the offering of ridiculous firms in the dot.com bubble, which made billions for unscrupulous “entrepreneurs,” venture capitalists, and investment bankers. It also destroyed the public markets. Unfortunately, this most recent meltdown, which is only in its first stages, will be catastrophic for small firms wanting to raise capital.

For Schumpeter’s gales of creative destruction to work, one needs the transparency that can only come from stern and fair regulation. Otherwise, the creativity that creates new value cannot be expressed because of a generalized lack of trust.

I know I have combined two thoughts in this post. We need to sharpen up our vocabulary so that we can discuss the issues clearly and thoughtfully.

What do you think will be the effect of this collapse on entrepreneurship?

For a class to exist - the working class, the capitalist class - it has to inherit something to continue from one generation to the next. Money, or the lack of, was usually the thing that helped define a class. Titles and status also worked pretty well. If a class is defined by intangibles - like drive, character, education, creativity - can it be inherited and, if it cannot, can it be a class?

Think of entrepreneurship. If one cannot inherit the “claw with the prey,” how does the class continue? What holds it together from one generation to the next? This has interesting public policy implications. What should public policy support? Are we still in the Schumpeterian world where the capitalist class invites in the gifted few to revitalize the system from time to time? We seem to invite immigrants and they seem to perform rather well.

The world of venture capital investment can seem murky and opaque, especially for a first-time entrepreneur. Depending on your perspective, the venture capital industry can look like a densely networked set of professionals or the so-hot-right-now party to which you didn’t get an invite.

While the prevailing wisdom is that venture capitalist is in the driver’s seat in the relationship with the entrepreneur, that’s not necessarily so. The relationship is better characterized as one rife with asymmetric information. And, as it turns out, both sides are flying by instruments. For example, an entrepreneur inevitably possesses more knowledge about their business and its prospects than the venture capitalist. It’s pretty easy to imagine an optimistic founder overstating the technology, business environment, or the capability of the management team in order to secure financing or negotiate better terms. A more unpleasant - but unfortunately not uncommon - scenario is outright opportunism where, after receiving financing, the team squanders the invested cash, turning the startup into their own personal ATM.

Venture capitalists invest other people’s money in small teams of unknown (often dubious) quality, shepherding bleeding-edge technology to an unproven market: a truly risky business. A rich literature details the incentives and controls that venture capitalists use to mitigate that risk and align the goals of the entrepreneur and investor (a standout paper on this subject by Thomas Hellmann is available here). Unfortunately, the existing literature tends to focus entirely on opportunism by the entrepreneur, with little or no mention of what happens when venture capitalists start behaving badly (in a forthcoming paper, I have worked with my colleagues to redress this imbalance). The fact of the matter is that a huge, dispersed collection of individuals asking for capital from a small number densely of networked investment professionals seeking an outsized return is bound to go awry for the entrepreneur a good chunk of the time.

Enter TheFunded.com. Launched in early 2007, the site allows entrepreneur-members to rate, review, and discuss their experiences with venture capital firms. By scaling up and enhancing informal entrepreneurial social networks, TheFunded.com provides entrepreneurs with more information about venture capital firm operations, as well as firsthand reports of experiences with investors and board members. It has also generated a firestorm of publicity and controversy. In 2008, the site provided the ability to upload and review term sheets, allowing entrepreneurs to compare deal terms. You can imagine how well that went over on Sand Hill Road.

Initial reaction to the launch of TheFunded.com was pretty predictable: chewed-up or jilted entrepreneurs gleefully celebrating the new state of affairs and venture capitalists trying to game the rating system or even sue anonymous posters. But many venture capitalists are discovering that the benefits of connectedness and transparency outweigh the downside of the sometimes bruising public feedback.

Both entrepreneurs and venture capitalists ultimately benefit when both sides know what’s what. Through TheFunded.com, entrepreneurs may now know a bit more about firms, partners, and deal terms. However, the knife cuts both ways. Perhaps the informal network of venture investment and startup culture will firm up a bit, and a public mechanism for quickly sorting out a capable founder from the mass of cranks, creeps, and bozos will emerge. This would benefit venture capitalists, but also the startup’s early hires, all of whom are signing up to work themselves into the ground for the chance at breakout cash. Imagine anonymous postings detailing tales of management’s goofball antics, inexperience, and malfeasance written by employees, venture investors, and board members. Reputation is an extremely powerful corporate governance mechanism.

It probably feels about as good to be a banker today as it did to be running an Internet startup back in the day. That is, until the other shoe drops. Yves Smith reports on the ennui engulfing this season’s technique-arbitragers, finance professionals with “a narrow skill, like being able to structure CDOs…unable to land jobs” in the imploding financial services industry. Reports indicate that half of the people working in debt sales, trading, or research in NYC at the beginning of 2007 will be fired at the end of the year or won’t get a bonus. For fans of Leveraged Sell-Out and the Banker Method, this is not good news.

The similarities are not lost on those of us who participated in the technology tomfoolery in the early to late 90’s, where those who could hand-code HTML had a skill they could trade - albeit for a very brief period - for 80 large and on-site espresso. Smart people understand the half-life of the trix-y things they know, and act accordingly. Those that miss the phase shift take a more stable job or shift careers, leaping from the back of one hungry crocodile to the next like Pitfall Harry. A few even become entrepreneurs. Some follow the heat and light elsewhere, “…moving west or to Europe, including Russia, or to Dubai” according to Jeanne Branthover, managing director of Boyden Global Executive Search.

Technique without creativity is a commodity, and all that this entails. What’s of interest to me is the crucial intermingling between technique and creativity, and how people use the current foundation of technical work as a mechanism to learn, incorporate, and innovate. There are heaps more places to do that then ever before. It’s a spiky world. Where will innovation in the production of complex, mission-critical software applications, energy and the environment, or finance happen next? I suspect that innovation will go where the people go.

What’s creativity and what’s technique in your line of work? When will the particular tricks-y things you do become automata, or simply routine knowledge that represents the ticket to entry? If the talent in your industry goes elsewhere, will you switch locations, switch industries, or stay put?