I updated this post for Enterprising Investor. See it at: http://blogs.cfainstitute.org/investor/2014/10/23/is-venture-capital-a-giffen-good/

Economist Sir Robert Giffen stumbled upon a curious thing: Low quality foods experienced rapidly falling prices and eventually disappeared in Victorian era England when people became more well-off. This violates economic theory: When consumers become wealthier, prices should rise because more of them desire scarce goods for which they can pay more. But so-called “Giffen goods” are pushed out of the market when consumers get richer. The income effect of the goods outweighs their substitution effects. This opens up the following discussion: Could entrepreneurs be less in need of venture capital today than they were back in the dot.com boom, when VCs entered the spotlight and became a public buzzword among the entrepreneurial community? After all, entrepreneur “wealth” has increased a great deal in recent years. Reasons for this are few barriers to entry in almost every domain and the resulting network effects. So do more entrepreneurs compete for less venture capital, or is it the other way around? I believe traditional VC is becoming less important for certain sectors, namely Internet businesses and software developers. Let’s examine why.

I am often amazed how little capital is needed to carry out on an initial idea. The term “Ramen profitability” describes the stage where a startup can cover the founders’ expenses on a minimal level. This is possible within months if done right. So do such founders need venture capital? Probably not, unless they think their idea rivals Microsoft and Google. Capital intensive businesses, such as server hosting or anything else that has to do with hardware, also still need massive funding. Going head-to-head with established players by trying to outspend them is most likely a bad idea that no VC wants to pursue with you. Nonetheless, entrepreneurs in the software or service space probably are better off without the traditional venture capital.

Traditional venture capital is a hits business: A portfolio manager invests capital in projects, expecting that at least a few of them succeed and pay for the dogs. More often than not, especially in Europe, venture capital does not really care smaller tech businesses. Fred Destin, partner at Atlas Ventures in Boston and seasoned European VC, has written an interesting blog post about the topic, entitled “European VC needs a revolution, not evolution.” There are many Internet businesses sprouting up every day that are lean in capital and have the potential for explosive growth. By no means are they are not short of capital. What they lack is expertise in business building and scalability, which young first-time entrepreneurs have not internalized yet.

Even though first-time entrepreneurs do not need financial capital to start, they can still benefit from human capital such as expertise and networks of seasoned entrepreneurs. That’s where the door opens for the new kind of investor who sees his contribution not in capital alone, but in hands-on support, advice, and network building. He can help entrepreneurs make the right decisions and speed up their learning curve. There has been a new breed of VC emerging for a while now. An example is seed accelerator Y Combinator in San Francisco. While they invest very little sums in new companies, they set up a strict pipeline for projects that eventually leads into the arms of venture capitalists. More often than not, this can stifle business growth just when it started. I find that if VCs focused first on capital-efficient business-building, qualitative assessment, and support networks for entrepreneurs instead of comparable sales, IRR and NPV, both sides of the table would be better off. Indeed, the traditional route to external funding is a Giffen good for Internet entrepreneurs.