JULY 2002 IN

“Stone Soup” Capitalism

As capital becomes less important in the way businesses are formed, you might think that the capitalist system would be forced to change. But so far, that has not proved to be the case.

Capitalism is built on the work of capitalists, entrepreneurs who acquire capital and use it to build businesses. Capital is the equipment that does part of the work of a business. It includes such things as machinery, molds, tools, containers, and computer software. Almost every business uses capital, but it is becoming less important compared to the other costs of a business. Labor takes up most of the revenue of most businesses today, and other major cost categories such as real estate, supplies, and advertising might each exceed the capital costs of a typical business.

This marginalization of capital became especially evident in the rush of Internet investments in the late 1990s. Dot-com companies spent next to nothing on capital. Their most critical piece of equipment, the web server software that delivered their web sites to customers, was actually free of charge. A billion-dollar Internet startup might have capital of less than one million dollars, one one-thousandth of its initial investment. Instead, the Internet boom created the term “burn rate.” The burn rate measures how quickly an unprofitable company uses its venture capital — investor funding provided theoretically for capital — to pay its operating expenses.

An obvious question arises: How did it happen that venture capitalists were so excited about subsidizing unprofitable businesses? Part of the answer is that it is the nature of venture capitalists to invest in unlikely business ideas in the hope that a small fraction of them will prove out. Part of it, too, is that venture capitalists grossly overestimated the importance of capital in the development of the Internet — and, to a lesser degree, they overestimated the value of brand name recognition and market share. But the more fundamental and more profound answer is that the actual capital required to test new startup businesses is no longer enough to use up the available venture capital funding.

Perhaps it shouldn’t be a surprise that the capitalist model works as well as it does when there is little or no capital involved in the formation of a business. When an entrepreneur brings together ideas, capital, and workers to form a business, there is no one there to ask the entrepreneur how much capital is involved or how essential it really is. It is like the “Stone Soup” fable, in which a hungry entrepreneur says he has a stone that can make soup. In the end, it appears that the stone might not be a necessary part of the cooking process, but the soup still gets made.

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