This episode takes an anecdotal wander through the business of financing start-ups. Our guide is Sixtus, an old-Etonian who imported ‘business angel’ investing to the UK. Along the way, I’m waspish about public schoolboys, perceptive about pickles, explore the difference between equity and debt, and wonder whether stock markets must always be about those billion dollar valuations.
I have long harboured a prejudice against old Etonians. You can drink with them, or listen to their stories, or watch them on television – they’re everywhere when you start to look – but just don’t let them hold your wallet or take your significant other for coffee. I’m almost prepared to make an exception on that point for our present Archbishop of Canterbury, but no, I think not. And God forbid, don’t let them run your country. I used to try and sneak this snippet of wisdom into lectures. If you learn anything from me, I would intone, let it be this…Unfortunately, the spectacle of British politics over the last few years has made such warnings redundant. Cameron, Boris, Rees Mogg… I am almost speechless with rage when I see the damage done to our nation in pursuit of petty self-advancement.
Another deeply held prejudice involves the wearing of velvet collars, so when I spotted a photograph of JRM sporting one such, well, I felt like ‘some watcher of the skies when a new planet swims into his ken’. But this is beginning to sound like one of Rees-Mogg’s own man in the street moments so I am reluctantly forced to concede that I am unfairly singling out that great educational establishment. It would be more simple and accurate to say that one should never trust a former English public schoolboy. For those listening beyond the UK, a public school is – inexplicably – a private one. It’s an educational system built for empire, modelled on Sparta; the ancient world offered two models for a state, one based on democracy and philosophy, the other on military might and hierarchical caste segregation, and the Victorians chose…
Well, enough said. Back to its products. We are mendacious and unreliable. All we can do is talk. There’s James Dyson, the engineer who persuaded us all that vacuum cleaners should look like spaceships and campaigned for Brexit before shifting his factory to Singapore. Or youth icon, gangsta rapper and YouTube phenomenon KSI, who learned his vowels at the same school that I did. We are long on patter and short on substance. Have a look at the KSI youtube fight night if you doubt me on that.
On the other hand, that mixture of assured self-presentation and a natural economy with the actualité – in the words of the late Right Honourable Alan Clark, old Etonian, confessing to lying to Parliament – does suit us well for some occupations outside of politics. We make good actors, acerbic columnists, and amusing enough podcasters, I hope. And financiers. ‘There is,’ writes Michael Lewis in Liar’s Poker, ‘a genus of European, species English, to whom slick financial practice comes naturally. The word for them in the Euromarkets is spivs.’ And then, unusually, Lewis makes a wrong call. ‘Oddly,’ he writes, ‘we had no spivs. Our Europeans-especially our Englishmen-tended to be the refined products of the right schools.’ They, dear Michael, are the spivviest of all.
It seems appropriate, then, that the next step in our journey through stock-market skulduggery is guided by an old Etonian. His name is Sixtus (or something equally silly) and he invented ‘venture capital’ investing.
Hello, and welcome to How to Build a Stock Exchange. My name is Philip Roscoe, and I teach and research at the University of St Andrews in Scotland. I am a sociologist interested in the world of finance and I want to build a stock exchange. Why? Because, when it comes to finance, what we have just isn’t good enough. To build something – to make something better – you need to understand how it works. Sometimes that means taking it to pieces, and that’s exactly what we’ll be doing in this podcast. I’ll be asking: what makes financial markets work? What is in a price, and why does it matter? How did finance become so important? And who invented unicorns?
In the last episode, I opened up another key idea for our building project: that stock exchanges are – and have always been – entangled with states. We saw how countries and markets have formed an uneasy alliance since the beginning, one with the laws and the other with the money. I explored how London’s fledgling stock-market exploded at the end of the seventeenth century when the English government issued its first national debt, a tradable, interest-bearing security. The early corporations recycled this debt through their own shareholdings, forming the basis for a liquid market in stocks. The demand for trade attracted professional speculators, known as jobbers and generally disliked by the population. Their instruments, trading on time, may have been morally questionable but formed the basis for a global mercantile economy. We saw too how moral questions sometimes have to be settled by the state. Chicago – whose dominance as a centre for financial derivatives we explored in the second episode – wrestled with the limits of permissibility in trading financial abstractions. The matter came before Justice Holmes of the Supreme Court, who declared that speculation ‘by competent men is the self-adjustment of society to the probable’. The judge was influenced by Henry James and fashionable pragmatist philosophy to make such a probabilistic argument; in doing so he made a link between stock exchanges and risk management that persisted until, and arguably underpinned, the credit crisis of 2008.
Is this really what stock markets should be doing? Remember that they started out as a means of raising money for struggling exchequers. Remember too that the narratives of shareholder obligation, which I discussed in the very first episode, hinge on the claim that stock exchanges have funded business from the beginning. So it sounds as if raising capital for organizations of all kinds might be one of the primary obligations of exchanges, but the reality is that stock markets don’t do nearly enough of this kind of thing. Raising money for new ventures is risky and a specialist occupation. Let’s re-join Sixtus to find out more…
The son of an esteemed civil servant, Sixtus grew up in the days when esteemed civil servants could afford a rambling pile in near the Thames, a flat in a smart part of town and still have small change left over to push several children through Eton. Oxford followed. But being possessed of a maverick bent Sixtus eschewed a job in the City and instead, in 1969, headed for graduate business school at Harvard. He returned to Britain in 1971 and after an unhappy year consulting for Hanson – Sixtus knew by then he was a ‘doer’, not an ‘adviser’ – he determined to start a business. But doing what, exactly?
‘The problem,’ he says, ‘was that not only did I have no idea of what business to start, but that I also had no money… Also I had no track record of any kind, being then only nine months into my first job, and that not a success, so that the prospects of persuading someone to back me did not seem bright. On the other hand, I had little to lose by trying.’
Only an Old Etonian would muster this level of sangfroid in the face of such appalling odds. On the other hand, being an Old Etonian does seem to shorten the odds considerably.
So Sixtus wrote a business plan to set up a chain of American-style hamburger joints in the provinces. He raised some half a million in today’s money, from a friend made at Harvard, another friend from back home, and a few high risk investors recruited via a small-ad in the Daily Telegraph. He set up his own outfit in a former truckers’ café in Bristol, mopping floors, making milkshakes and flipping burgers. By 1977, he had three restaurants, fifty staff and a manager. He sold the restaurants off in the early 1980s, just before the golden arches arrived in Britain and did to Sixtus’ burger joints what they had done to just about every other burger bar in the USA. He even made his investors a profit.
Then, in 1978, Sixtus did something truly maverick. In the same era that that the UK government was waking up to the galvanizing potential of small company investment and converting the sleepy government venture capital house ICFC into the dynamic behemoth 3i, and Ronnie (now Sir Ronald) Cohen was importing US-style venture capital through his legendary Apax Partners, Sixtus launched a magazine. It featured write-ups of small companies seeking to raise equity investment from business angels. He would charge subscribers £350 a year, charge the companies for a write-up, and take a percentage of any investment completed by means of an article in the magazine. His thought honed along classic business school lines, Sixtus sought to put together the pent-up demand for investment and for investment opportunity by a means more elegant than small ads in national newspapers. He would become an intermediary: a broker of information.
The magazine was never more than moderately successful. It had black and white photos and a small circulation and was sustained by successive investors whose business school training inclined them to see its potential and overlook its profit and loss account. The company was staffed by cheery, sporty doers who had never quite managed to make the break from their alma mater. Sixtus would invite them to the crumbling mansion, which he now occupied, and persuade them to play croquet. Anyone mistaking him for a harmless eccentric in a threadbare white school shirt and knee high socks would soon be caught out by the competitive malice with which he wielded his mallet, sending opponents’ balls hurtling into the flowerbeds at the slightest opportunity.
As a proto-spiv – worse still a proto failed spiv – I’m in this story too. I joined the magazine in the summer of 1998, fresh from a Masters’ degree. The firm occupied two small office suites in a science park outside the city. The room I worked in was small and filled by piles of boxes containing unsold copies of Sixtus’ self-published book. There were three of us in that office, while Sixtus and his assistant had a room adjacent, from which he ran his newly-launched investment funds. It was a hot summer, and the first thing a new employee noticed was the smell. A sewage farm lay on the other side of the science park, and when the wind blew in the right direction, as it did most afternoons, a heavy, foetid pall would settle on the office. Of course, one could brave the lack of air conditioning and close the window, but there lurked a Scylla to the sewage farm’s Charybdis. Sixtus had been forged in a time when real men did not wash, and belonged to a class that regarded personal hygiene as the surest sign of the petit bourgeoisie. An office legend held that many years previously the staff had drawn straws as to who would tell Sixtus that his musk was making their lives a misery.
The short straw fell to one of the firm’s few female employees. She tarried for a while, planning her strategy, and eventually sidled up to the boss:
‘Sixtus,’ she said, ‘I must say, you’re smelling very manly today’.
‘Thank you very much’, he replied.
And that was that.
Despite his eccentricities and his absurd, frontiersman do-it-yourself-sufficiency –Sixtus did, in his way, contribute something to British business. He had imported another concept beside hamburgers. What he grandly called venture capital wasn’t really venture capital in the established sense of the word today. Modern day ‘venture capitalists’ put much more emphasis on the second word than the first: they prefer low risk deals like takeovers and management buyouts where margins can be squeezed and quick profits returned to investors. What Sixtus had in mind were informal venture capitalists, happily known as ‘business angels’, who are prepared to put up moderate sums in return for a share of the ownership of a firm. They are often successful business people in their own right. These angels have been glamorised as the Dragons in the BBC’s reality TV show Dragons Den, but the principle is much the same as it was when Sixtus first brought it into town: a tough negotiation, a stake, a partnership.
Let’s go back to basics. This kind of investing is a variety of equity financing. The distinction between equity and debt is important. Someone who buys equity buys an actual stake in the firm; the firm takes the money into its legal body and issues more shares in return. Debt is just a loan. It has to be repaid while equity does not. Debt incurs interest, while equity does not. If debt repayments fail the creditor can go to court and perhaps even wind the company up; if the company goes bust creditors stand at the front of the queue while equity holders (shareholders) kick their heels at the back. But debt only earns interest, and never more, whereas equity holders have a stake in the company. If it all goes to plan, the sky is the limit.
This asymmetry gives rise to a structural problem. Because lenders can never earn more than their interest they dread losing the money loaned, or ‘principal’. Even if one were to charge absurd interest rates it would take several years to recover from a default. Lenders tend to cope with this in two ways.
The first is only to make investments in rock-solid businesses. Assuming for a moment that risk and reward increase hand-in-hand, it follows that anyone who believes that their business will be able to repay a loan at 20% is a riskier proposition than someone who can only pay 5% on dull-as-dishwasher trading. For this reason ‘better safe than sorry’ was the collective motto of the banking industry for the second half of the 20th century. It is also the reason that the less in need of money you are, the more cheaply you can borrow, while the truly needy seek out loan sharks and payday lenders. Lending is an industry hard-hearted to its DNA. The bankers’ caution is another variant on George Akerlov’s Nobel prize-winning ‘markets for lemons’ thesis. Akerlov demonstrates that in a market where buyers cannot distinguish quality they will protect themselves by offering low prices. Sellers of high quality goods will react by leaving the market and soon only the problematic ‘lemons’ will be left. He is talking about the used car market – hence the lemons – but he could be talking about banking too. If you offer bad enough terms, only rogues will take them; better to offer good terms and be very selective about the loans you make. 
The second thing bankers do, having assured themselves that you are respectable, reliable, that your business is solid and that they will absolutely get their money back under all circumstances, is to ask you to personally guarantee the loan, just in case.
I am not suggesting that commercial banks should not be lending money to high-risk businesses. The money that they lend belongs to us and we do not want the banks losing it. When, periodically, banks get carried away and make excessively aggressive loans, as happened with sub-prime lending in the run-up to 2008, the result is catastrophic. Depositors queue up to withdraw their money and banks suddenly go bust and have to be rescued by the taxpayer. Nonetheless, the lack of lending does deter anyone from contemplating starting a risky venture, which really includes anyone considering any kind of entrepreneurial venture at all. Slow-growing, traditional business start-ups may be able to get by on debt, but more capital intensive start-ups will struggle. Anything truly innovative has no chance.
There is a second, more insidious, consequence, in that a culture of careful lending creates a culture of perverse distrust in equity investment. Those entrepreneurs who have somehow managed to start a business, who have put their house down as a deposit to satisfy the bank manager, who have been under all kinds of stresses as a result, can console themselves with the fact that they own every single share, and that when the business finally does well it will all be theirs. Given the choice between expanding further by letting go of a stake in the company and pedalling along very comfortably where they are, entrepreneurs will take the second option.
Equity investors are seen as greedy outsiders, ‘vulture capitalists’, stepping in to profit from the business when the hard work has been done. The economic theory elaborating this line of thought is called the ‘Pecking Order’ of financing, and it gives an intellectual framing to what entrepreneurs intuitively know: they are often better off not pursuing a worthwhile project if they have to sell shares in order to fund it.
Equity investing also conceals a kind of financial alchemy, one that makes much of today’s world go round. Let’s say that I start a firm and persuade you to invest. You propose to take a 33 percent stake in the firm – Sixtus’ rule of thumb said one third for the management, one third for the idea and one third for the money. I believe I need £500,000. You are an easy negotiator, and I get my way. You pay the money into the firm, and it issues new shares in return. The firm is now worth £1.5 million: if things are worth what the market says, and we did a deal at that level, who is to claim otherwise? My stake is worth £1 million, and I am now a millionaire, on paper at least. It all goes well, and a year later the prototype widget does what it is supposed to do. Now I need to build a factory, and that is going to cost £5 million. An investor putting in serious money is going to demand 50 percent (for the sake of easy numbers) of the firm, valuing the whole at £10 million. You and I have seen our percentage holdings diluted by half, so now I have just one third of the firm, and you one sixth. But my third is worth £3.3 million, and you are holding £1.65 million. And so the process goes, so long as we can sustain momentum. But notice that the money is always coming from somewhere, especially if we want to cash out: the valuations are sustained by the influx of new capital at every round.
At some point people will start to use other methods for valuing the venture, for example asking what the eventual profits might be. We have an answer for that in the shape of a business plan that begins with baby steps and culminates in our widget being on every desk in the known world. So long as we keep hitting the short-term targets – and these are well specified and achievable – so we can justify all kinds of wonderful figures. We might even be a unicorn – an unlisted, loss making business worth over a billion dollars. We have lots of money and can court journalists and give lectures about the future too, just in case anyone doubts us. In fact, making a profit might seem quite a bad idea, because suddenly all the analysts’ models will start to work and it will become apparent that the valuation is much higher than the profit should support. Better to keep focused on the horizon and let the shares float towards it.
This is the Silicon Valley model and a testament to the power of well aligned incentives. It never quite made it to our office, though.
The magazine claimed a few successes. There was, for example, an engineer who had invented a gadget to be fitted at the bottom of grain silos, a vibrating cone that kept the contents flowing, and whose firm grew large and profitable. More usually, a succession of peculiar would-be entrepreneurs came through the door. I worked alongside a man named Charles, a gentle, cultured former financier. At home Charles had three small children, a grand piano, and a picture of his father shaking hands with the Pope. We would sit, listen to eccentric pitches and decide whether to help them or not. Our decision invariably hinged on whether the would-be entrepreneurs were prepared to write a cheque for £275. You would be surprised how many were not, but perhaps they were assessing us in reverse. Our success rates were very low indeed.
My first write-up involved a tough North Sea diver with a project to expand a hard hat diving operation. It was not funded. I remember a high-end pickle company, though I never saw the pickles on the supermarket shelves and I wasn’t impressed by the firm’s do-it-yourself marketing posters featuring stock photos of the Andes draped in gherkins. There was the ageing Harvard MBA who complained the course had gone soft and not enough people committed suicide these days, and the property-spiv who moaned about having to eat his own shoe leather in lean years. He refused to write the cheque before hopping into an enormous Jaguar. Charles and I used to peer down into the car park after meetings, and it was amazing how many penurious entrepreneurs still had much nicer cars than we did. Then there was the neuro-linguistically programmed former bond trader, a tall and unfeasibly energetic young American who claimed to have been a presidential adviser and waved his arms like windmills as he pitched to us. His project involved a life-size cardboard cut-out of a policeman. He was accompanied by a hard-as-nails sidekick who had been in the South African Special Forces and stood glowering in the corner throughout. They didn’t write a cheque either, though the bond trader was courteous enough to telephone the next day and tell us why not: he thought we were crap.
The problem the magazine faced was that most of the businesses, even the good ones, were simply the wrong kind for equity investment. You need a business model that, in the unlikely event of it paying out at all, pays out like crazy. It’s no good hitting one jackpot out of ten if the jackpot is only 5% a year. Hard hat diving and fancy pickles were just never going to deliver.
I say the businesses were of the wrong kind for equity investment, but what if things were different, what if investors did not demand their 20% a year return from every single business? What is the subjects weren’t business at all, but a diverse range of start-up ventures delivering social good? It doesn’t all have to be financial alchemy, chasing ever higher valuations in pursuit of the unicorn pay-out. Surely, in what I have sketched out – equity fundraising, collective subscription, a tolerance for risk – we have the bare bones of a mechanism that could actually do something useful?
Throughout 2018, Guardian columnist Aditya Chakrabortty toured Britain looking at what he called alternatives, spaces and places where local people had taken control of their economic destiny, perhaps to build social housing or a shopping centre, or to operate the bus services. One such makes children decent school meals: Chakrabortty’s report should make your blood boil. It details the daily indignity and grinding hardship of food poverty in one of the world’s richest countries – where children half-starve during school holidays, deprived of their only daily meal. These enterprises have many things in common. For a start, all are short of cash. The availability of capital is an ongoing problem. Those who have it at their fingertips, Chakrabortty writes, ‘have no place on their spreadsheets for social purpose’. Instead money is begged from grant funders or somehow borrowed.
Could we build a stock exchange to help here? It seems so. There’s something called community shares, a novel subscription method signed off by the financial regulator. Community Shares Scotland, located in Edinburgh, has run offers to support a harbour and a community school, while Chakrabortty mentions a Plymouth housebuilder that has raised £200000 this way.
So this is a private sector solution to social problems, but it’s not one that recognises the logics of high finance: profits are not at the top of the agenda.
My point here is simple enough. The stock exchanges I have talked about so far have been global giants. They’ve been formed by accident by the confluence of capital and political power. They have been shaped by technology, and as we’ll see, that continues throughout their histories. Ever since the regulars at Jonathan’s Coffee House hatched a plan to charge subscriptions stock exchanges have been first and foremost commercial organisations. But they don’t have to be, and if they are they don’t have to be the global providers of data and exchange services that we know today. Sixtus’s magazine was a stock exchange of the most rudimentary variety, and we could see that model working for a different purpose. If the ventures didn’t have the upside for high-risk investors, they might have done for more socially minded.
Between a magazine and the Chicago Board of trade lie an infinity of possible social and material combinations. We just have to decide what we want them to do.
Chakraborrty notes something else that these alternative schemes have in common. They are, he says, ‘thickly neighboured’, depending on social networks for their success. Alas, that is true of any economic venture. Too often, these arrangements are cliques. Poor Sixtus has taken a bit of a kicking here, a stand-in for the privilege and incompetence of the elite. But his story shows the power of social networks and their ability to channel opportunity and capital. The bitter truth is that getting into such networks depends little on aptitude or talent, and greatly on brass neck and connections. And, of course, where you went to school.
I’m Philip Roscoe, and you’ve been listening to How to Build a Stock Exchange. If you’ve enjoyed this episode, please share it. If you’d like to get in touch and join the conversation, you can find me on Twitter @philip_roscoe or email me on email@example.com. Thank you for listening, and see you next time, when we try and understand the markets’ social networks a little better.
 I am quoting from Sixtus’ own account of this start-up. Sixtus is a pseudonym.
 Banking economics has given us a library of studies of lending decisions, mostly following two articles: G Akerlov, “The Market for Lemons: Quality Uncertainty and Market Mechanisms,” Quarterly Journal of Economics 84 (1970); JG Stiglitz and A Weiss, “Credit Rationing in Markets with Imperfect Information,” American Economic Review 71 (1981).
 SC Myers, “The Capital Structure Puzzle,” Journal of Finance 3 (1984).
 You can find Chakrabortty’s series here https://www.theguardian.com/commentisfree/series/the-alternatives