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The 1994 NewcomenPrize Essay

The Rise and Fall of Venture

Paul A. Gompers• GraduateSchool of Universityof Chicago

Smallfirms and new business creation have become potent forces of economicdevelopment in the UnitedStates. Prior to 1980,large firms createdthe majority of new jobs in the Americaneconomy. During the last decade,however, a major structuralshift occurred. Fortune500 companieslost 4 millionjobs. At thesame time, firms with fewerthan 100 employeesadded 16 millionnew jobs [Birch,1990]. This wasthe firsttime in the 20th centurythat the shiftfrom largeto smallfirms occurred and it representeda fundamental change in the natureof growthin theAmerican . During the same ten year period, the rate of new firm incorporationrose dramatically. By the endof the decade,over 1.3 million new businesseswere being started annually. Scherer[1991] demonstratedthat during the 1980s,small firms were more innovative thanlarge firms. He foundthat during the 1980s,firms with fewerthan 500 employeescreated 322 innovationsannually for each million employeeswhile large companies contributed only 225 innovationsper millionemployees.

• I would like to thankJoanne Dushay, Nancy Koehn, Josh Lerner, Thomas McCraw, WilliamRodgers, Richard Ruback, William Sahlman, Andrei Shleifer, and Jeremy Stein for helpfulcomments and suggestions. Any errorsor omissionsare my own. Thisresearch was fundedby the Divisionof Researchat the GraduateSchool of BusinessAdministration, HarvardUniversity.

BUSINESS AND ECONOMIC HISTORY, Volume 23, no. 2 Winter 1994. Copyright¸1994 by theBusiness History Conference. ISSN 0849-6825. PaulA. Gompers/ 2

This dramaticshift toward small firms makes it imperativethat capitalsources for fundingstart-up companies are efficient. This paper exploresthe effects of theunprecedented increase in moneyflowing into the sectorafter changesin the 1979 Employee RetirementIncome Act's (ERISA) "prudentman" rule. Prior to 1979, funds were severely limited by ERISA in theamount of moneythey couldallocate to high-riskassets, including venture capital.The 1979change explicifiy allowed fund managers to investup to 10%of theircapital in venturefunds. Pensionfund commitments to venturecapital rose dramatically, increasing annual new contributions to venturecapital funds from $100-200 during the 1970sto in excessof $4 billionby the endof the 1980s. The floodof moneywas a mixedblessing. Many successfulfirms receivedventure capital financing and created tremendous growth in bothtechnological development and jobs. The increasein capitalalso had negativeeffects on the industry,however. Overinvestmentin certainindustries occurred. Firms backedby inexperiencedventure capitalistswere brought to market too early. Monitoring of entrepreneurialprojects deteriorated. The future health of venture capitaldepends upon measures that will alignthe incentivesof venture capitalinvestors (i.e. thosewho invest in venturecapital funds), venture capitalists,and entrepreneurs who seekmoney to financetheir projects.

Start-up Financingand Venture Capital

Entrepreneursoften developproducts and ideasthat require substantialcapital duringthe formativestages of their companies' lifecycles.Many entrepreneurs do nothave sufficient funds to projectsthemselves, and they musttherefore seek outside financing. Severalalternative capital sourcesexist. The informalrisk capital marketconsists of individualsknown as "angels."These "angels" are wealthybusinesspeople, doctors, lawyers, and others who are willing to take an equitystake in a fledglingcompany in returnfor moneyto "start-up."Wetzel [1987] estimates that 250,000 individuals are active in the informalrisk capitalmarket and investbetween $20 and $30 billion annually. Firmsthat requiresubstantial amounts of money, however,may not be able to receivesufficient capital from the "angel" The Riseand Fall VentureCapital / 3 networkbecause the market is dispersedwith little informationsharing andthe amountof investedcapital tends to be small(usually less than $100,000). Banksare an importantsource of start-upfinancing for a subsetof new .Companies that lack substantialtangible assetsand are associatedwith significantex ante uncertaintyare unlikelyto receivesignificant , however. These firms face many years of negativeearnings and are unableto make interest paymentson debtobligations. Venturecapital firms will financethese high-risk, potentially high-rewardprojects. Venture capitalists take an equitystake in the firmsthey finance,sharing in bothupside and downside risks. Most firmsthat receive venture capital financing are unlikely candidates for alternativesources of .They have few tangible assets to pledge ascollateral and they produce operating losses for manyyears. A commonmisperception is thatventure capital funds only high technologycompanies. A substantialportion ofhigh-tech start-ups have receivedventure capital, including such present-day industry giants as Apple ,Microsoft, Lotus, and .Yet 1ow-tech companiessuch as Staples,TCBY, and FederalExpress have also receivedsignificant amounts of venturecapital money. Each of these firmshad a uniqueidea or productand venture capital was able to help theentrepreneur exploit that opportunity. Between1972 and 1992venture capitalists brought 962 firmsto the publicmarket. Thesefirms have been a sourceof innovationand job creation.Table 1 presentsstatistics from thirty venturecapital- backedcompanies that eventuallywent public. The companies representvarious industries and firms at variousstages of development. Total1993 sales for these thirty firms totalled nearly $74 billion. They employedmore than 420,000 people and their market value was $88 billion. This list of firms demonstratesthe importantrole venture capitalistshave played in shapingthe American economic landscape. Whetherthe projectis in a high- or low- technologyindustry, venturecapitalists are active . They monitor the progressof firms, sit on boardsof directors,and mete out financingbased on attainmentof milestones.Venture capitalists retain the right to appoint key managersand removemembers of the entrepreneurialteam. In Paul A. Gompers/ 4

Table 1. Impactof VentureCapital-backed Companies, 1993 Sales Employees EquityMarket Value Company ($mil) (00Os) ($mil) AppleComputer 7,977 14,910 3,576 Au Bon Pain 123 1,250 223 Biogen 149 415 1,110 Chiron 217 2,179 2,171 Cirrus 354 1,353 885 CML Group 645 5,608 697 CompaqComputer 7,191 13,010 9,978 ConnerPeripherals 2,151 9,097 774 CrayComputer 352 383 50 Data General 1,077 6,500 271 DigitalEquipment 14,371 94,600 3,223 Evans& Sutherland 142 1,100 132 FederalExpress 7,808 95,000 4,206 Genentech 650 2,510 3,189 8,782 29,500 27,082 LotusDevelopment 981 4,738 2,705 Micropolis 382 2,298 99 MicrosoR 3,573 14,430 15,117 Oribital Sciences 190 1,123 315 Quantum 1,167 2,455 695 Raychem 1,385 10,772 1,581 Seagate 3,043 43,000 1,648 Staples 883 7,539 1,063 Starbucks 163 4,585 866 SlratusComputer 514 2,610 723 SunMicrosystems 4,308 13,300 2,009 TandemComputer 2,030 9,963 1,368 Teledyne 2,492 21,000 997 Teradyne 555 4,500 891 Well fleet 180 738 784 Totals 3,227 41,148 88,428 The Riseand Fall VentureCapital / 5 addition,venture capitalists provide entrepreneurs with accessto consultants, bankers, and lawyers.

The History of Venture Capital

The ancestorsof modernventure capital in the developedin the late 19thand early 20th century. Wealthyfamilies beganto look for waysto investin potentiallyhigh-return, high-tech undertakings.David Lamplewrites in his historyof the Route 128 venturecapital region: The city's [] greatfortunes, including those of the Vanderbilts,Whitneys, Morgans, and Rockefellers, were based on such ventures as railroads, steel, oil, and banking. Althoughnot all investorswere so well known, it was wealthy families such as these that bankrolled 'searliest high tech entrepreneurs. When the young Scot AlexanderGraham Bell neededmoney in 1874 to completehis early experimentson the telephone,for example,Boston attorney Gardiner Green Hubbardand Salemleather merchant Thomas Sanders helped out, and later put up the capitalto startthe Bell TelephoneCo. in Boston[Lample, 1989]. The marketfor risk capitalremained largely unorganized and fragmentedthroughout the late 19thand early 20th century. The first impetusto organizeinvesting came from wealthyAmericans. In the 1930sand 1940s,members the Rockefeller,Bessemer, and Whitney families hired professionalmanagers to seek out investmentin promisingyoung companies. The first modernventure capital fh'm was formed in 1946, when MIT presidentKarl Compton, Investors Trust chairman Merrill Griswold, Federal ReserveBank of Bostonpresident ,and Harvard Business School professor General Georges F. Doriotstarted American Research and Development (ARD) [Lample, 1989]. The goal of the companywas to finance commercial applicationsof technologiesthat were developed during World War II. Doriot wasthe heart and soul of ARD andis justifiablycalled the "father of venturecapital." Doriot's focuswas on addingvalue to PaulA. Gompers/ 6 companies,not just supplyingmoney. Companiesfunded by ARD wereconsidered to be "membersof the family" [Sextonand Kasarda, 1991.] ARD's staffunder Doriot's direction began providing industry expertiseand experience to thecompanies they backed in order to increase their chances of ultimate success. Doriot servedas ARD's presidentuntil it was acquiredby in 1972. During the courseof his tenureat ARD, Doriot's vision was not one of "makingmoney" but ratherfm_ancing "noble" ideas. The first investmentmade by ARD in 1947 was in High VoltageEngineering Company. The firm, foundedby severalMIT professors,was establishedto develop X-ray technologyin the treatmentof cancer. ARD investedin thecompany for reasonsnoted by Compton'scomment to Doriot: They [High Voltage EngineeringCompany] probably won't evermake any money, but theethics of the thingand the humanqualities of treatingcancer with X-rays are so outstandingthat I'm sure it shouldbe in your [Doriot's] portfolio. [Lample, 1989] When High Voltage went public in 1955, the original $200,000 investmentwas worth $1.8 million. ARD createdthe standardventure capital paradigmwith its highlysuccessful investment in Digital EquipmentCompany (DEC) in 1957. ARD invested$70,000 for a 77% stakein DEC. Doriot's disdainfor quickprofits was displayed in thedispleasure he expressed with KennethOlsen, Digital's founderand president,the first time DEC reporteda . Doriot wasconcerned that not enoughmoney was being reinvestedin researchand developmentand that the companymight suffer in the run [Kotkin, 1984.] Over the ensuingfourteen years, the investmentin DEC increasedin value to $355million. Almosthalf of all themoney earned by ARD duringits 26 yearexistence was earned by itsinvestment in Digital. Theconcept of the "homerun" in venturecapital was synonymous with DEC and theterm would become pervasive in theindustry during the 1980sand 1990s. Everyonewanted to financethe next DEC. In 1958, the Federalgovernment decided to play an activerole in promotingsmall firm developmentby becominga participantin and regulatorof smallfirm financing.The SmallBusiness Administration The Riseand Fall VentureCapital / 7 was given the authorityto charternew small businessinvestment companies(SBICs). SBICswere to provideearly stagefinancing for companiesin variousindustries. The numberof SBICs increased rapidly. By the mid-1960s,700 SBICscontrolled the majorityof risk capitalinvested in the UnitedStates. SBICsdiffered markedly from ARD. SBICstended to provide little more thanmoney. Most managersof SBICshad little industry expertiseand couldnot provideentrepreneurs with informationor accessto industryexperts. SBICsdid not monitorthe f'Lrmsas active investors,but insteadrelied on the repaymentof loansto evaluatethe successof a project. Problemsquickly developed. In aneffort to leverinvestments in , SBICs were able to borrow four government guaranteeddollars for eachdollar of equitycapital in the investment company.Because SBICs needed to makeperiodic interest payments, theychose to financefirms with debtrather than equity, as ARD had chosento do. Had theyused equity, SBICs would not havebeen able to servicetheir own debtobligations. Because high-risk projects are unsuitedfor leveragedcapital structures, the use of financing meant that SBICs focused on more stable industries. A secondmajor concern was the incentiveproblems inherent in governmentguarantees. As the recentS&L crisissuggests, when the managers of certain financial institutionsunderstand that the governmentwill bail out the depositorsif thingsgo wrong,they have little incentiveto monitortheir investmentsclosely. The implicitput option offered by the governmentgave individual institutionsan incentiveto gamble. The initial publicoffering (IPO) marketof the late 1960swas extremely active, and many SBICs were able to bring a numberof companiespublic during the boom. But theIPO "bubble"and adverse investmentincentives caused by the guaranteesled to increased investmentsin riskyprojects. The recessionafter the ftrst oil embargo of 1973-1974hit youngfirms particularly hard. IPO activitydropped to one-tenthits previouslevel and many SBIC-backedf•rms began losingmoney. SBIC-backedcompanies, which were often financed with debt, could not meet interestobligations. At the sametime, SBICs themselveswere highly leveragedand could not meet their PaulA. Gompers/ 8 interestand principalrepayment schedules. Many were forced to liquidate. By 1978, only 250 were still active. In 1988, SBICs accountedfor just 7% of venturecapital financing; they provided over 75 % of the investments25 yearsearlier. Companieslike ARD andthe firms they financedsurvived many recessions because they relied on equity financing of both the venture capital fund and the entrepreneurialfirm. The earliest venture capital fn-ms were organized in the Northeast, centeredboth in Bostonand New York. It was not until 1957 that West Coast venturecapital came into existence. ,then an investmentbanker at Hayden,Stone & Co. in , wassent to investigatea potentialproject in [Venture Capital Journal, 1991]. Rock called various individual and institutionalinvestors to securefinancing for EugeneKleiner and a group of ShockleyLaboratory employees. Rock's efforts led to ShermanFairchild, the largestholder of IBM sharesat the time, who invested$1.5 million to form FairchildSemiconductor. Four years later, Rockmoved to Californiato form the first of two early venture capitalfunds in SiliconValley. His investmentsin suchindustry leadersas Intel, ScientificData Systems,Teledyne, and Apple have hada tremendousimpact in transforminghigh-tech in California. By 1992, West Coastventure capital had becomeone of the nation'scenters for entrepreneurialactivity. Figure 1 showsthat in 1992, 48 % of the dollars investedwere invested in the West Coast regionof the country. The Northeastaccounted for 20% of invested venture capital. While other regionsof the country seem to be underrepresented,venture capital is expandingrapidly in the Midwest and Southwest. The dramaticsuccess of ARD inducedindividuals to startnew, private venturecapital firms in the 1970s. Someof the earliest imitatorswere actuallyformer members of the ARD team, including Bill CongeRon,the ARD associatewho initiatedthe DEC investment. This spawningproduced private venture capital firms thatcarried the spiritof Doriotinto new companies. The goalwas always the "home run" while the modusoperandi was always "hands-on"management. The "new" venture capitalist(unlike the managerof the SBIC) provided many servicesto the entrepreneurincluding accessto The Riseand Fall VentureCapital / 9 ent bankers, corporate lawyers, accountants,and ae of the early disciplesof the Doriot tradition • ae. Valentine had been marketing director at l •ductor. Like manyother early venturecapitalists, V yearsof industryexperience to the firms he financed 'obsand Stephen Wozniak sought his help in 1976, V at the two engineersneeded a competentmanager to he start-up,Apple Computer. In addition to the m• •, Valentine cajoled A.C. Markkula, Jr., a form ß, to be Apple'spresident [Kotkin, 1984.] Valentine's1 af early venture capitalfinancing. In additionto st • of capital,Valentine brought in $600,000more in g by syndicatingthe investment with otherventure cal • its initial publicoffering, Apple received$3.5 m capitalmoney. Thatinvestment grew in valueto $271 mber 1980, whenApple went public.

Figure 1 1992 VentureCapital Disbursements by Region

Midwest/Plains9% Mid-Atlantic 5% West Coast 48% Northwest 20%

Southeast Southwest/ 7% Rockies 11%

(percentof dollar amountinvested) PaulA. Gompers/ 10

The Growth of Venture Capital

Prior to the 1980s,venture capital was a cottageindustry. The mild "boom"of the late 1960sgave rise to the bustof the 1970sas SBICssank into obscurity. The annualflow of moneyinto new venture capital fundswas nevermuch more than $200 million, and usually substantiallyless. As figure2A shows,money flowing into the venture capitalindustry increased dramatically during the 1980s.In 1987,$4.9 billion was committedto new venturecapital funds. The trendsin venturecapital commitments appears to be highlycorrelated with the initial public offeringsmarket. Figure2B graphscycles in the IPO market.The totalnumber of IPOsin eachyear are plotted for theperiod 1969 to 1992. The correlation coefficient between the level of IPO activityand venture capital commitments in 0.70and is significantat the 5% level. The increasein venturecapital coincidedwith two important legislativechanges. The first was the 1978 RevenueAct, which decreasedthe capital gains tax from49.5% to 28%. The secondwas the changein ERISA's"prudent man" rule in 1979,which explicitly allowed pensionfunds to investin venturecapital. While bothchanges may havebeen favorable to venturecapital investment at the time,the long termimpact of the"prudent man" rule change was substantially greater thanthe reductionin the capitalgains tax rate. Manyprofessionals in theventure capital industry argue that the cut in the capitalgains tax spurredthe increasein venturecapital investing.The cut may havehad a marginaleffect, but the overall impact was likely quite small. Prior to 1978 the tax favorabilityof capitalgains, i.e. the difference between the highest marginal tax rateon normal incomeand the tax rate on capital gains, was 20.5% (the maximummarginal tax rate was 70% and the capitalgains tax was 49.5%). The Tax ReformAct of 1978lowered the capitalgains tax to 28% withoutchanging the top marginaltax rate, increasingthe tax advantageof capitalgains to 42%. Thiswould, ceteris paribus, give an incentiveto taxableindividuals to investin venturecapital because the returnsfrom venture capital are realizedprimarily in the form of long-runcapital gains. While the flow of moneyinto venture The Riseand Fall VentureCapital / 11

Figure 2A - New Commitmentsto Venture Capital Funds in Constant 1993

$7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 1969 1972 1975 1978 1981 1984 1987 1990 1993

Year

DollarData from Venture Economics.

Figure 2B - Number of Initial PublicOfferings

700.

600

500.

400.

300.

200.

100

0. 1969 1972 1975 1978 1981 1984 1987 1990

Yell• PaulA. Gompers/ 12 capitalfunds did increasesubstantially following the change,causality is not established. Capitalgains policy seems to havehad little impact after the 1978 reform. Subsequentchanges in thecapital gains tax ratehave had little effect on the flow of money into venturecapital. The Economic RecoveryTax Act of 1981lowered the capital gains tax to 20% butalso reducedthe top marginaltax rate on incometo 50%, reducingthe capitalgains tax advantageto 30%. New commitmentsto venture capitalincreased in thefollowing two years, however. When the capital gainstax differentialwas totally eliminated in the Tax ReformAct of 1986,the flow of moneyinto venture capital increased from $4.5 to $4.9 billion. If the incentiveto investin venturecapital was affectedby capitalgains tax treatment, then the money committed to venturecapital shouldhave declined after both the 1981and the 1986tax changes. Theprimary reason that capital gains taxation has a smallimpact on the amountof moneyflowing into the venturecapital industry is that up to 70% of the moneyflowing into new fundsis from tax-exempt sourcessuch as pensionfunds, endowments,trusts, and foreign companies. Changesin thetax code haveno effect on this group. Corporations,which can be taxed, constitute a significant fraction of the remainingcommitment to venturecapital funds. Corporations invest for bothpecuniary and nonpecuniary reasons. Investment in venturecapital is viewedas a way to buy"a windowon new technology." Many firms maybe unwilling or unableto undertakenew investment in researchor productdevelopment. Funding the development through venture capital mayprovide a wayto avoidthe immediate "hit" on earnings that occurs becausestandard rules require research and development to beexpensed. In addition,the corporation does not bear the entire cost of thedevelopment process, spreading the risk to otherlimited partners. Any changein the capitalgains rate is likelyto havea small,second- ordereffect on corporateventure capital investment because firms are lookingat morethan the monetary gains. The singlemost important factor accounting for the increasein money flowing into the venturecapital sector was the changein the 1979amendment to ERISA's"prudent man" rule. Priorto thatdate, the EmployeeRetirement Income Security Act of 1974prohibited pension fundsfrom investing substantial amounts of moneyin venturecapital or The Riseand Fall VentureCapital / 13 otherhigh-risk asset classes. The Departmentof Labor'sclarification of the rule explicitly allowedpension managers to investin high-risk assets,including venture capital. Therule change opened the door to tremendouscapital resources. Pensionfunds controlled over $3 trillion by the end of the 1980s. Stocksand bondsperformed extremely poorly during the 1970s,the sametime thatventure capital was earning in excessof 25% peryear. Pensionfund managers saw venture capital as a way to earnexcessive rewards.But they did not always understand the inherent risk associated with higherreturns, and they poured money into new fundsat a rapid pace.Figure 3A showsthat in 1978when $218 million was invested in new venturecapital funds, individuals accounted for the largestshare (32%). Pensionfunds supplied just 15%. By 1988,when $3 billionwas committedto newfunds (figure 3B), pensionfunds accounted for 46%, by far the largestshare. The participation of individualshad fallen to the lowestfraction of new moneycommitted (8%). The institutionalizationof venture capital has had some dramatic effectson the venture capital industry and its performance. The "- term" focus of institutionalinvestors has been examinedby several economists. Their research indicates that the mismatch of time horizonsmay have had adverseeffects on incentivesin the venture capitalindustry. Because money was poured into venture capital and the flowswere directed on the basisof myopiccriteria (e.g. short-run performancemeasures), the structureof venturecapital investment deteriorateddramatically. Lakonishok,Shleifer, Thaler, and Vishny [1991] investigate pensionfund moneymanagers. They examineeach quarter's equity holdingsand calculate the quarter-to-quarter performance for eachstock in theportfolio. Their results indicate that funds sell "mistakes" (poorly performingstocks) every quarter. This sellingactivity is particularly strongin the fourthquarter. Large, established funds do notseem to windowdress as much as smaller funds. Reputation (as proxied by age or size) may alleviatesome of the adverseincentives of short-term performanceevaluation. Paul A. Gompers/ 14

: 3A - Sourcesof Commitmentsto VentureCapital Fu

corporations foreign insurance11% 14% 9% endowments 12%

individuals 8%

pension funds 46%

1978 - $216 million e 3B - Sourcesof Commitmentsto VentureCapital Ft 1988 - $3.0 billion

corporations foreign 10% 18% 16% endowment 9%

pension funds 15% individuals 32% TheRise and Fall VentureCapital / 15

Patel,Zeckhauser, and Hendricks [1991] report a similarresult. They show that past performanceis rewardedwith greatermoney inflowsto themanagement of investmentcompanies. For an average- sizeinvestment fund of $80 million,a onepercent increase in annual returnis correlatedwith a $200,000increase in capitalcommitments. Rankorder, or relativeperformance, is moreimportant in explaining cashinflows than absolute performance. Sirriand Tufano [1992] examine the flow of fundsinto 632 equity mutualfunds for theperiod 1971-1990. They find thatan increasein oneperiod's performance leads to greaterinvestment inflows in thenext period.Sirri and Tufano also find thatpoor performers are, in general, notpunished. One exception is small,young funds which appear to be judged harshlywhen they performpoorly. Youngfunds might be punishedbecause the marketis uncertainabout the fund managers' investmentabilities. Initial returns move the market's posterior estimate of youngfund mangers' abilities to a largerdegree than they would for olderfund managers. The myopic horizonsof pensionfund managersresult from quarterlyevaluations of the funds. A pensionfund manager cannot affordto havea pooryear or sherisks losing her job. Janssonnoted that pensionfund managers are obsessed with short-run performance [1984, p. 7]. Becausethe returnsfrom venturecapital may take five to ten yearsto showtheir results,the mismatchof time horizonscould have seriousconsequences. Institutional noted in 1984 that a potentialproblem existed: In fact, the only thing that could destroythis market, [Raymond]Held [vice president of venturecapital investing at ManufacturerHanovers InvestmentCorp] and his colleaguesinsist, is pensionfunds themselves and their obsessionwith the short-termrelative performance game. Ventureinvesting requires patience as problems are worked throughand with all themoney that has flowed into venture investmentsthe lastfew years,the problems are bound to multiply [Jansson,1984]. PaulA. Gompers/ 16

PensionFunds and Venture Capital

Thehuge increase in institutionalmoney had a dramaticimpact on the processof venturecapital investing. This processcan be broken downinto three main stages. All threehave been adversely affected by the institutionalizationof venturecapital. The first stageis identificationof deals. For each100 business plans thata typicalventure capitalist might review, she will investin onlyone. An experiencedventure capitalist concentrates onnot only the skillsand ideas of the entrepreneurbut also on his personalqualities. The secondstage is the actualstructuring of the deal. The deal containscontractual elements including the type of financing(e.g. convertiblepreferred stock, common equity, etc.), timing of capital infusions,explicit and implicit options, board representation, and advice provided. Thefinal stage is the harvesting of investments.During this phase the investmentis madeliquid by performingan initialpublic offering, negotiatinga merger, acquisition, buy-back of theentrepreneurial firm, or liquidatingthe assets.

The moveto late-stageinvestment

The dramaticrise in pensionfund moneyflowing into venture capitalcreated a mismatchbetween the duration of mostventure capital investmentsand the time horizonof investors.Incipient investments in firmsare known as "seed and start-up" investments. In 1980,25% of all venturecapital investing was in theseclasses. Table 2 showsthe changingmakeup of venturecapital investing. By 1988,seed and start- up investingaccounted for only 12.5%of new investments,half the fraction of 1980. The big increasecame from leveragedbuyouts (LBOs). In 1988,20% of venturecapital money went into LBOs. The shiftto late-roundfinancing and LBOs is evidencethat short- term performancepressures increased dramatically with the institutionalizationof venture capital sources. Seed and start-up projects manytake five to tenyears to showreturns. The industrypractice is to waitto write-upthe investmentuntil it is harvested.Because of venturecapital-backed firms is very difficult and subject to potential The Riseand Fall VentureCapital / 17 biases,institutions have no ideahow theirportfolio is performingfor severalyears. In fact,bad venture capital projects are usually identified muchsooner than goodones. Most bad investmentsare written-off earlyin thefund's life, depressingthe stated value of theventure capital portfolio. Becauseone bad year could end the careerof a money manager, investorsput significantpressure on venture capitaliststo performquickly. Kaplan [1991] shows that the lifetime of an LBO investmentis significantlyshorter than that of a comparable venturecapital investment. Assets are soldoff almostimmediately to meetdebt burden, and many companies go publicagain (in a reverse LBO) in a veryshort period of time.

Table2. Percentof venturecapital invesmaent by typeof financing

Seed& Start-up Expansion LBO & Late Stage

1980 25.0% 75.0% 0.0%

1981 22.6% 77.4% 0.0%

1982 20.0% 68.0% 12.00%

1983 17.2% 70.8% 12.0%

1984 21.0% 67.0% 12.0%

1985 15.0% 69.0% 16.0%

1986 19.0% 58.0% 23.0%

1987 13.0% 69.00% 18.0%

1988 12.5% 67.5% 20.0%

The shifttowards later-stage investing and LBOs is a directresult of theneed to realizereturns earlier. With lessmoney flowing into the developmentalstages of investment,the U.S. economymay be heading into a periodin whichnew firms will be lessinnovative. The success of venturecapital in the 1980swas driven by thetremendous amount of moneyinvested during early-stage projects in the late 1970sand early PaulA. Gompers/ 18

1980s. The dramaticdecline in early-stageinvesting may meanthat therewill be feweropportunities for profitablelate-stage investing in the 1990s.

Herdingand venture capitalists

The largeincrease in moneyalso affected the identificationof opportunitiesin a perverseway. Becauseventure capitalists were now bloatedwith , they could pursue many projects. Certain industries appearedparticularly attractive and a herdmentality resulted. Too muchmoney was chasing too few dealsand venture capitalists paid far too muchfor theprojects. Sahlmanand Stevenson [1987] chroniclethe exploitsof venture capitalistsin the Winchesterdisk drive industry. Sahlmanand Stevensonbelieve that a typeof marketmyopia affected venture capital investingin theindustry. During the late 1970sand early 1980s,$400 millionwas investedin 43 diskdrive companies. Two-thirds of this investmentcame between 1982 and 1984. Many diskdrive companies alsowent public during this period. Over$800 millionwas raised in publicofferings by 1983. Whileindustry growth was rapid during this periodof time(sales increased from $27 million in 1978to $1.3billion in 1983),it is questionablewhether the scale of investmentwas rational given any reasonableexpectations of industrygrowth and future economic trends. In mid-1983,the twelve publicly traded disk drive companies had a marketvalue of $5.4 billion,which represented four times sales and a price-to-earningsratio of nearly50. Thebubble had to burst,and it did in 1984. By year'send, the market value of thetwelve public disk drivecompanies had fallen to $1.4billion. Industryincome fell 98% as overproductionand competition cut margins.Many of the industry's leadingcompanies went bankrupt during this period, including Priam and Miniscribe. Ex post, it is easyto establishthat investorspoured too much money into an industry,but the caseof the Winchesterdisk drive industryis onethat could have been predicted. The sudden and dramatic increasein venture capital commitmentsmeant they had to find somethingin which to invest. The large fractionof inexperienced The Rise andFall VentureCapital / 19 venturecapitalists changed the rules of investing.Too manycompanies were funded in various industriesat prices that were clearly unwarranted. The dramatic failure of disk drive and other venture capital-backedcompanies substantially reduced returns in the venture capitalindustry.

Grandstandingin theventure capital industry

The largegrowth in newfunds affected fund returns in additional ways. Gompers[1994] has exploredthe processof initial public offeringsby venturecapital-backed firms. The numberof new venture capitalparmerships increased from 225 in 1979to 674 in 1989. Eighty percentof venturecapital investing is providedby fundsthat are organizedas limitedpartnerships. (A limitedparmership is an entity thathas a legallydefined ten year lifetime.) The fund may be extended upto threeadditional years in one-yearincrements with the approvalof limited partners,however. The money from investmentsmust be returnedto limitedpartners within the ten yeartime. Venturecapitalists usually invest all themoney from their fund in the first five yearsof a fundand wait duringthe secondfive yearsto harvestthe investments.This strategy means that the venture capital partnershipmust start a secondfund during the first five yearsof the 'sfirst fund in orderto investin attractivenew projects. Gompersfinds that unseasonedventure capital firms (thosethat have beenin existencefive yearsor less)are undertremendous pressure to performduring the initial stagesof their first fund. Youngventure capitalistsare concernedabout having a track recordand showing pensionfund investors that they are financing worthy projects in order to raise additionalfunds. The empiricalresults show that these inexperiencedventure capitalists have an incentiveto "grandstand,"or bringfirms from their first fund to thepublic market sooner than would otherwisebe optimal. Firmsbacked by inexperiencedventure capitalists are nearly two yearsyounger at theirinitial public offering date than similar firms that arefinanced by older,more reputable . On average,young venturecapitalists lose almost $1 millionon each becausethey bring the companies to markettoo early. Whenthe results Paul A. Gompers/ 20 areexamined by year,inexperienced venture capitalists were under less pressureto signaltheir abilitieswhen pension funds accounted for a smallfraction of the venturecapital pool. Pressureto performearly IPOs seemsto have increasedas pensionfunds became the major supplierof moneyfor venturecapital funds. The short-termfocus of pensionfund managersmay be a contributingfactor. Becausetwo- thirdsof theventure capital partnerships were founded during the past tenyears, returns in the industryhave been dramatically affected by the increasinginstitutionalization of venture capital and its effect on young venturecapitalists' incentive to signaltheir abilities.

Theeffect on returnsin theventure capital industry

The abovestructural and behavioralchanges in the venturecapital industrydramatically affected returns. Figure 4 showsthe median return on all venture capital funds tabulated from the Venture Economicsdatabase [Bygrave and Timmons, 1992]. The figure demonstratesthat median returnson venture capital investments increasedfrom the early 1970s and peaked in 1982 at 31%. Subsequently,fund performancehas decreased,and in 1989 median annualreturns were only 8%. The low returnsin theearly 1970sresulted primarily from the oil shock-inducedrecession and the failure of manySBICs. As theindustry shiftedtoward more efficientlimited partnershipsthat usedequity financingand provided advice and the economy expanded in theearly 1980s, venturecapital returnsincreased. During the 1980s, funds becameswollen with moneyand problems arose. While the twenty pluspercentage decline in venturecapital returns since 1982 may not be entirely due to the factorslisted above, they are certainlymajor contributorsto the precipitousdrop. The decliningcommitment to new venturecapital fundshas resultedprimarily from pension funds losing interest in venturecapital eventhough some of the excesseshave been corrected. Many of the parmershipsthat performed poorly are no longer active. Understanding The Riseand Fall VentureCapital / 21

Figure4 - MedianRates of Returnon Venture Capital

3SY,.

• 2SY,.2•Y,. • 1SY,. •, SY,. •Y,. -SY,.

the natureof venturecapital can also change investment behavior and manyventure capitalists have gained considerable experience during the difficult yearsof the mid-1980s.Industry experts believe that most venturecapital partnerships are more efficientand experiencedthan ever before. The storyis all toofamiliar. Excessesin investmentlead to new excessesin pullingout. C. Kevin Landry,managing partner at TA Associates(a leadingventure capital firm) notes: Pensionfunds all wantedto getinto venture capital in 1983, andthat was the wrong time [becausereturns had peaked]. Now, mostinstitutions want to getout at thewrong time. [Retkwa,1990] While the surgein pensionfund contributions to venturecapital did dramaticallyreduce returns in the industry,other factors were important.The returnson venturecapital investments are affectedby the strengthof theinitial public offering market. If venturecapitalists cannotmake their investmentsliquid, they standto losesubstantial amountsof money.Alternative avenues of harvestingthe venture exist and an increasingnumber of venturecapital-backed firms have been mergedor acquiredby large corporationsin recentyears. But PaulA. Gompers/ 22 alternativeexits provide returns on investmentthat are significantly less attractive than IPOs and still remain a second-best harvest. The recent surgein IPO activityhas once again boosted returns and venture capital contributions. Thesupply of newtechnologies is also an importantrequirement for venturecapital investing. Many technologiesand companies have beenspawned from large corporations asa by-productof government- fundedresearch. Federal funding for scientificresearch, both military and nonmilitary,has decreased in real termsover the last ten years. Privatefunding of R&D hasalso stagnated. While it is tooearly to say that future areas for potential venture capital investingwill be substantiallysmaller, the decline in R&D fundingis reasonto be concemed.

Conclusions

Venturecapital in theU.S. is significantlylarger and more active thanin anyother country. The control mechanisms and tight monitoring of high risk/ high rewardprojects and the informationgenerating activitiesof venturecapitalists are clearly valuable. Venture capitalists are a long-runcompetitive advantage for the Americaneconomy. Presentand future world leading finns have been, are, and will continue to befinanced by venturecapital. Promoting an efficient venture capital sectorshould be a goalof any administration. Will venturecapital thrive in the 1990s?The questioncannot be easilyanswered because many policies the Clintonadministration has proposedhave yet to be implemented.We do not know if they will succeedin stimulatingsmall business formation in generaland venture capital in particular. Healthcare reformcould curtail investment in promisingareas like biotechnologyand medical-relatedfields. The experiencesof the 1980sand the political debate of theearly 1990s have focused attention on small firms as the engine for economic developmentin the UnitedStates for the nextdecade. New initiatives andregulations can aid in the growthof venturecapital. First,the Federalgovernment should increase the financingof basicscience research. The potentiallyprofitable spin-offs from such spendingare enormous. Spendingon spaceand defenseresearch The Riseand Fall VentureCapital / 23 created the electronics,modem communication,and computer industries.National Science Foundation funding of geneticresearch led to thebreakthroughs that made biotech companies possible. No onecan pick the nextmajor technological advance with perfectcertainty, but basicscience research is an important element of anyeconomic proposal to foster new businesses. The constantdebate over whether a lowercapital gains tax would increaseventure capital and the horizonsof venturecapital investors doesnot addressthe entireproblem. Reduction in capitalgains taxes alonewould likely have little or noeffect on venture capital investments in theabsence of otherchanges. While venturecapitalists may argue vehementlyfor decreasesin the capitalgains tax rate,the oneswho would benefitmost from sucha reductionare the venturecapitalists themselves. Becausea significantfraction of venturecapitalists' compensationis takenas a percentageof the accruedcapital gains, reductionin capitalgains tax wouldsubstantially increase their personal returns. Publiclytraded venture capital companies are a possiblesolution. ARD wasa publiccompany and periodically issued equity to raisenew capital.Incentives for long-terminvestment could be achievedbecause venturecapitalists could reinvest proceeds as retainedearnings. In addition,individuals might not be as myopic as institutional investors. Regulationslimit the appealof this option,however. Under the InvestmentCompany Act of 1940,public venture capital firms were restrictedfrom transactions with their portfolio companies and investors (6). The Small BusinessInvestment Act of 1980 easedsome of the restrictionsby allowingpublic venture capital firms to incorporateas BusinessDevelopment Companies (BDC) thatcould invest in muchthe samemanner as limited partnerships. The doubletaxation of corporateprofits remains a problem. In orderto avoid the extra tax burden,the venturecapitalist has two options.The first is to registeras a BDC withthe SEC. Theregistration must be renewedannually and is very expensiveand burdensome [Hueruer,1992]. The firm can also incorporate as a publicpartnership. This optionlimits the firm becausethe public parmerships are highly illiquid. No organizedmarket exists to tradetheir shares. Broker and underwriterfees can also be substantial[Hueruer, 1992.] PaulA. Gompers/ 24

In orderfor viablepublic venture capital firms to be a potential alternativeto thepresent form, multiple legislative changesmust occur. First, public venturecapital firms must be exemptedfrom the double taxation of corporateprofits. Second,filing requirementsneed to be simplified.Finally, if theappropriate measures aretaken, a cut in the capitalgains tax may increasefunds available to venturecapitalists. Giventhe excessesof the 1980s,one might ask what the proper scaleof theventure capital industry is. Wasthe industry too large? The answeris both yes and no. Many venturecapitalists who received moneyin the "boom"of the 1980shad little or no previousindustry experience.These firms did not understand the nature of venturecapital investing,the optimaldeal structure, and effective monitoring. The industryshake-out of thelast five yearshas repositioned venture capital for steadygrowth, however. Entrepreneurs exist who need financing. Venture capitalinvesting accounts for only about 1% of capital expenditureannually. Experienced venture capitalists are and will be in shortsupply for sometime. As longas the supply of fundsdoes not outstripthe managerial capabilities in place,the venture capital industry cangrow to be substantiallylarger than it is today. The importanceof small businessin the Americaneconomy makesventure capital a centralpart of any futureeconomic growth. Venturecapitalists have financed and continue to financecompanies that will be the drivingforce of the Americaneconomy well intothe 21st century. The importanceof long-termperspectives is not to be underestimated.Many projects take decades to showtheir full benefit. If capitalsuppliers do not haveequally long horizons, the processof newfirm development,effective product development, and cuRRing-edge research will be hindered.

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