Why tech uses equity as a main source of funding

By | Tech

(Excerpt from Capitalism Without Capital by Jonathan Haskel and Stan Westlake)

Even those intangibles that can be sold, like patents or copyrights, present problems to creditors: they are typically difficult to value because a patent or a copyright is unique in a way that a van or a building or many types of machine tools are not. The liquid markets that exist for assets like vans and office blocks, or the professional advisers who will value your mine or your chemical tanker, have fewer equivalents in the world of intellectual property: it is a newer and less developed field and is conceptually more difficult. The result is that it is much harder to offer even well-specified intangibles as security on a loan.

We see this discrepancy in typical leverage ratios among large businesses in different industries: industries with mostly tangible assets have high leverage—that is to say, they are funded more by debt than by equity—while intangible-intensive industries have less debt and more equity.

… VC is often sequential, with rounds of funding proceeding in stages. This is a response to the inherent uncertainty of intangible investment.

Funding in rounds helps resolve uncertainty by working through the development of business in stages. For investors, it creates an “option value,” that is, a value to delaying follow-on investment until information is revealed. These options are particularly valuable for businesses whose cost of innovating is relatively high.

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