FOOL'S EYE VIEW
Free Money Is Bad For Your Health

By David Berger
August 29, 2002

One of the important things to learn as a child is the value of money. Pocket money comes in small amounts each week. Saturday jobs inject a litle more into the coffers and, welcome though it is, it doesn't leave most kids rolling in lolly. This relative scarcity of the folding stuff is a useful lesson for managing your money in later life. The stock market shenanigans of the past few months can be attributed, at least in part, to an abundance of "free" money in the capital markets over the past couple of years.

How so? First let's look at the two ways in which any business can raise money: the debt and equity routes. Debt is simple and is a place most of us have been at some point in our personal lives. It works like this:

"You lend me £1,000 to get my money-making project on the go and I'll pay it back to you with interest at a rate of x% over the next y years."

In the olden days, say 5 years ago, this was almost the only way that most businesses in the UK could raise money. Financing your business in this fashion has immediate and obvious consequences. The need to repay the initial sum plus interest – even if repayments are deferred for a while – imposes a clear imperative to make enough money to pay off the loan. Seems obvious, doesn't it?

The other way of raising money is through the equity route and it works like this:

"I will sell you x% of my company for £1,000."

This route does not carry the immediate baggage of having to repay a loan. It does, however, mean that someone else owns part of your company. If you sell them 5% of your company, they will have relatively little control over what you do, but if you sell them 75%, they will have more control. That's self-evident.

In the dot-com boom time of 1999 and the early part of 2000 money became almost "free". It was easy to get investment in relatively large amounts from venture capitalists for a relatively small percentage of your (usually fledgling) company with very few strings attached. This was because the venture capitalists were able to envisage quick, mega returns by sending your company public within a short while and watching its share price soar and soar, and with it the value of their equity stake.

The vision of quick riches for the venture capitalists meant they were chucking money about like water. It is a breathaking fact that almost half of all capital that has ever been invested in the internet was invested in the last quarter of 1999 and the first quarter of 2000. This over-abundance of capital, combined with no real way to gauge the potential of the Internet meant that things like business models, market research and business experience were no longer at a premium. You were able to get silly amounts of money to do just about anything and with relatively little obligation. If the supply ran out, you then went back for more. Money became, to all intents and purposes, "free".

Meanwhile, prices on the stock market continued to rise and the recipients of the "free" money were like kids let loose in Hamleys with their mum's credit card. Out of the window went the sense and frugality learned from husbanding precious pocket money and Saturday job money and in came wild excess which would have done Elton John proud. Huge TV advertising campaigns selling a website, but no apparent product, lavish launch parties and over-ambitious expansion plans became the order of the day, none of them backed by a grasp of commercial reality. All this came with apparently no consequences.

The thing is, though, as we've all learned, there are always consequences to everything. In this case, the consequences came a little farther down the line in the eventual drying up of venture capital as the dream went sour. The turning off of the money tap has since led to the collapse of many of these companies and a slashing of the stock market valuations of others.

Now, don't get me wrong. I'm not using this soapbox to slam the concept of equity financing, nor the venture capitalists who make it possible. On the contrary, I see them as essential parts of a healthy capitalist economy. But it is clear that "free" money, wherever it comes from and whoever it is given to, is bad for the economic health of all of us.

This article was originally published in March 2001.