Financial leverage is not limited to debt, and debt is not an absolute number. When borrowing equates to a borrower’s unencumbered cash, for example, there is no debt at all – and when cash exceeds liabilities, leverage is actually negative. By the same token, preferred equity (ranking senior to common stock) is not equity properly speaking but rather another variation on debt when seen from the angle of common shareholders. In short, all of these matters must be understood in context, and leverage is a question of perspective.
Economists and other pundits have made a great deal of fuss about the excessive leveraging of individual and institutional balance sheets that took place in the past decade. Exhibit A in such discussions has been the sub-prime mortgage bubble that led to all kinds of other debt-related ills. Exhibit B has been the level of sovereign debt and risks associated to it, a flavor of which risks were sensed some months ago. More recently, in reaction to what has been pointed out by economists and punditry, segments of the global economy have begun to delever. Corporations, for example, have hoarded cash (which is a net debt reduction), consumers have reduced credit card obligations, and sovereigns have implemented austerity measures. Few market observers, however, (if any), have commented on the financial leverage that is venture capital, and the degree to which this segment has encouraged its “borrowers” to over-extend themselves. Unchecked, the problem will continue, which is to say, entrepreneurial deleveraging is unlikely to occur.
Clarification by example: When entrepreneur/founder “X” raises venture finance, this allows X to multiply his or her capital resources, and X sacrifices a subordinate position to the venture capitalist’s preferred equity in order to attain such a benefit. This is financial leverage. With liquidation preferences typically structured into the transaction, sometimes in multiples of the original investment, X will not see any positive economics accrue to him or her until this liquidation preference has been satisfied. Conceptually, the structure is not unlike debt… though, in a way, somewhat worse: Because unlike a bank or other lender that would allow – indeed, encourage – a borrower to reduce debt with cash flow that operations generate, venture capitalists don’t want to hear from cash distributions. Venture funds are not designed to take dividends. Venture funds profit from exits – the bigger, of course, the better – and for this reason wouldn’t want cash flow accumulating on the balance sheet either, but rather to be reinvested in the business for growth. No cash hoarding in this scenario, and no way to deleverage but one: sell the enterprise and hope for a sufficiently large price to take care of common stock with excess. A most inflexible structure.
Which would be well and good if it worked. But for the most part, it hasn’t. According to newly released data, 10-year venture capital returns through time-present have been negative. Given the preferred positions of venture rounds in capital structures, if these tiers show negative returns then common shareholders get nothing. To be clear, this observation is based on aggregate data rather than individual deals or individual funds; but, aggregately speaking, entrepreneurs have nothing to show for the last ten years of work. Aggregately speaking, entrepreneurs have “borrowed” too much, and exits have been insufficient to pay down enormous financial leverage. If such entrepreneurs had been sub-prime mortgage borrowers or the nation of Greece, they’d be on the receiving end of a talking-to surely. Is it not time to revisit plans and models? Is it not time to revisit financing strategies? Is it not time to try a modified approach?