Wealth Distribution – Storm Clouds on the Horizon

by Ron Stites

Executive Director, CC4ICC

In his 2017 book, Capital in the Twenty-First Century, French Economist, Dr. Thomas Piketty, describes two important factors that contribute to the widening wealth gap. That is, the gap that exists between the richest members of society and the bulk of society. These factors are:

1. Unfettered increasing salaries for large company executives, and
2. High returns on capital combined with low economic growth rate.

The first of these is an especially important problem peculiar to the US and, to a lesser degree, Britain. Unprecedented consolidations, mergers, and organic growth has resulted in larger and larger businesses being controlled by a smaller percentage of the population. According to Piketty, this has resulted in top managers being able to “set their own remuneration, in some cases without limit and in many cases without any clear relation to their individual productivity….”

The second factor is more ubiquitous. In fact, Dr. Piketty dedicates much of his book to chronicling the relationships between high return on capital, low economic growth and wealth inequalities. Those with money (especially historical wealth) can demand high returns on that capital. Venture Capital (VC) funding is especially high cost funding. In their search for “unicorns,” VC’s demand IRR’s of 25% or more. Their rule of thumb is “at least triple my money in 5 years.”

VC’s frequently get promised such returns because capital is so tight but, paradoxically, they don’t often achieve those kinds of returns in any sustainable way. On average, return on capital runs around 6%, well below historical highs of 10% during the 1950’s and far below VC “expectations.” The typical VC strategy is to invest relatively small amounts of their money into a number of “highfliers” with lots of promise, bring in later investors and get most of their money out to reduce their risk. while hoping that a few of the “highfliers” come through.

The result for the VC is:

1. Low losses for them on many of the “highfliers” that turn out to be losers and
2. Big gains for them on the very few winners.

The impact on the capital market is that a bunch of “suckers” are left holding the empty bags of the crashed “highfliers,” a lot of useful capital getting wasted on poor risk versus reward deals and VC’s poisoning the market by bragging about the obscene amount of money they made on the 1 in 20 deals that succeeded. Capital ends up even more scarce and capital “demand” for high yields goes up even higher. Real capital returns never come close to meeting expectations, but expectations continue to rise. And finally, only the few, high-risk, overly hyped plays are funded.

This gigantic game of VC liars’ poker contributes little to economic growth. The serious growth that does occur is low risk, high volume expansions, mergers and acquisitions. In many ways this is a zero-sum game when it comes to economic growth. The companies involved may increase their value, but the economy doesn’t grow. In fact, it may tend to shrink due to layoffs and closures. The beneficiaries of this form of “growth” are the investment banks and the high-level managers who propose and implement the expansions, mergers, and acquisitions. Those managers benefit from another round of inflated salaries and other compensation perks.

And where is small business in all of this? Where is the real engine of economic growth? Where is the economic institution that has given women and minorities significant opportunity to grow their wealth? Nowhere…small businesses are not significant players in the “high flying” VC scene nor the low-risk, high volume scene. Our capitalization processes do not favor small business and haven’t done so for many years. Despite all the rhetoric to the contrary, changes in banking, investment and other regulations since the 1970’s have favored large, easily taxed and controlled large businesses. What’s worse, COVID-19 has destroyed much of our existing small business.

It is little wonder that inequality in the distribution of wealth has been a problem that has become consistently worse beginning in the 1970’s. It is a “baked in” result of numerous government policies that have been harmful to small business. But we ain’t seen nothin’ yet!

The next few years will likely see inequality in the distribution of wealth explode. The collapse of small business will further erode economic growth and reduce direct woman and minority owned business participation in our economy. The perception of increased business risk will further concentrate capital into narrower segments of perceived high returns. The new US Presidential Administration will find it difficult to meet the expectations their coalition of supporters once the economic consequences of COVID become clear. They could find themselves trying to respond to exploding poverty in our minority communities – a political nightmare for them.

One key to success will be investment capital efficiency. The consensus is that government intervention will be needed to recover from COVID. Throwing money at small business will relieve some immediate pain but will have the downside consequence of devaluing our money. Targeted investment in small businesses that can be economically sustainable would be far better. I would urge every group interested in economic development (including serious investors) to carefully vet companies before investing valuable and scarce resources.

At CC4ICC we have developed methods to evaluate small businesses and determine their readiness for receiving investment. Furthermore, our process allows us to focus on specific weaknesses that, once remedied, make small businesses more attractive to serious investors. We have worked with government agencies to assist them in selecting good candidates for economic support and directly with small businesses to improve their chances for success.

For more information contact Ron Stites at:  [email protected] or visit our website at:  www.cc4icc.com.

 

Ron Stites is an inventor and serial entrepreneur. His specialties are start-ups and early capitalization – especially with high-tech and “deep-tech” businesses. His is a founder of the Colorado Center for Innovation in Community Capital (CC4ICC) as well as several other businesses serving various facets of business improvement, growth and technology development.