'Godfather Capital' Is Seen As Helpful
Addressing the subject was Robert Smart, a certified financial planner and owner of The Smart Planning
Smart, whose offices are in the Comerica Building, said he has a number of entrepreneurs among his clients.
And he hears from them that some major corporations — particularly in the auto industry — are taking a leaf from the U.S. Army or DARPA. The OEMs, he said, are providing seed money to entrepreneurs who happen to be developing a product or system that they need.
Smart told the Business Journal he considers the traditional venture capital market to be highly inefficient. “It involves intermediaries, a lot of fees and a lot of friction that can increase the cost of capital or reduce the return. It’s a source of financing for a very limited number of enterprises,” he added.
“In most of these venture capital arrangements,” he explained, “there is some option to convert to formal equity ownership at some future point. So then, in many of these cases, it becomes kind of a beat-the-clock thing,” he said.
By that, Smart said he means the entrepreneur usually is betting that he or she can get whatever they’re doing to market and earn enough money to pay back the venture capitalist before the venture capitalist triggers the right to own a substantial equity interest in the company.
“Because normally the venture capital investor is exacting a very high price for his capital,” Smart said, “the entrepreneur is really his adversary to some extent because he doesn’t want to have to pay that much to his venture capitalist.”
But he believes it’s a potential winning situation for everybody when an entrepreneur is capitalized by an industry godfather.
“This may be a model we’ll see more of,” Smart said.
“Let’s say I’m a major automobile company. I’ve got all the pressures of market capitalization, and the need to produce increased profits every quarter.”
Moreover, he said, most major manufacturers have large overhead because of their benefits systems and the bureaucracy of a large company.
“So it may be more expensive for me to develop new components that I need,” Smart said, “than it would be for me to go provide some seed capital to a promising small company where the entrepreneur is willing to work 70 to 80 hours a week and can absorb all the risk.
“And, in fact, it may be able to develop the component I need faster than I would be able to do internally. And now — either through the nature or contracting or my equity investment in this start-up — I’ve got first call on this component so that it’s not available to my competitors.”
Smart said that from the entrepreneur’s standpoint — provided his or her product can command the attention of an OEM — the advantage of the arrangement is cheaper capital.
“The automotive manufacturer’s cost of capital — because of their easy access to both the credit and the equity markets and their established position — is much cheaper than if that same entrepreneur were to try to raise that capital on their own.”
Smart said that he sees targeted venture capital from major manufacturers as a possible emerging model for the venture capital market.
Moreover, he views it as a healthy thing for the nation.
“In the current environment,” Smart said, “it’s going to be small companies where we’re going to see most of the employment growth. So we’re going to have to do something to stimulate the availability of capital to these kinds of enterprises.”
He said the recession and a number of other factors are what drove the trend in the auto industry to beat prices down. But now he believes godfather capitalization may become more common.
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He said the need to make capital more readily available is one of the reasons that he applauds the recent federal tax cuts.
“If your system depends on capital to be competitive,” he said, “it’s not good for the tax system to constantly attack capital.”