The Floodgates Are Open

Loosed by recent tax reductions, a surge of investment dollars has filled venture coffers to record heights.

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In his 1976 book, The Unseen Revolution: How Pension Fund Socialism Came to America, economist Peter Drucker warned that our capital markets were becoming increasingly distant from entrepreneurial needs because of the influence of conservative pension fund capital investment. Drucker called for the creation of new institutions that would provide both capital and management guidance to young and growing businesses.

In fact, the organized venture capital community has been evolving since the 1960s toward filling this role. In 1969, the capital committed to professional venture capital firms was approximately $2.5 billion to $3 billion. It remained at that level until 1978, when the capital gains tax reduction spurred further investment. By the end of 1980, the pool was an estimated $4.5 billion. Annual venture capital disbursements from this pool increased even more dramatically, from approximately $365 million a year between 1970 and 1977 to about $1 billion a year in 1979 and 1980. During the past decade, between 400 and 600 firms were involved in business development investments.

There are three major components of the venture capital pool: independent private venture capital firms, which represent some $1.8 billion; Small Business and Minority Enterprise Small Business Investment Companies (SBICs and MESBICs), $1.4 billion; and venture capital subsidiaries of large financial institutions and industrial corporations, $1.3 billion.

The independent firms include family groups such as the Rockefeller, Phipps, and Whitney organizations that were the forerunners of today's capital industry. But more important now are the professional partnerships and corporations funded by pension funds, major corporations, individuals and families, endowments and foundations, insurance companies, and foreign investors. There are about 100 such firms, ranging in capital size from $10 million to $60 million. They participate in the whole range of investments, from start-ups to expansion phases, and normally make about 5 to 10 investments a year, ranging from $250,000 to over $1 million.

Some firms specialize in start-ups and even seed financings, while others prefer expansion financing or leveraged buyouts that enable the management of larger corporations or privately owned firms to make acquisitions.

High-technology businesses attract most of the investments of these firms, though a growing number are looking for manufacturing, distribution, and even consumer-oriented companies. There has recently been a trend to investment in service businesses with promise for growth, particularly computer software businesses that are broadly based.

Independent venture firms usually look for a strong management team, a product with a clear market niche and high growth potential, and the possibility that the company will develop into a major new business. These firms are generally active investors who work with the operating management to develop the business over a five-to-seven-year period. They often provide assistance in planning, personnel development, supplier relationships, marketing, and future financing requirements.

The second component -- SBICs -- are licensed by the federal government. There are currently some 340 of them, about half of which are primarily involved in venture capital investment. The rest are principally involved in making loans to small businesses or in making investments in specific industries, such as grocery markets or movies.

SBICs usually have a minimum private equity capital of $500,000, though this may range as high as $10 million. They also have access to government loans, thereby achieving a total investment potential of as much as five times the private capital. Like the independent firms, SBICs normally make 5 to 10 investments a year, ranging from $100,000 to more than $1 million for each portfolio company. SBICs usually avoid straight equity investments in early-stage companies; because they generally borrow part of their investment capital, they prefer income-producing investments, such as preferred stock or debt instrument investment structures, that enable them to service the interest on the money they have borrowed.

Because they place less emphasis on high technology, there is far more diversity in the types of investments SBICs will consider than in those of the independent firms. They are excellent sources of financing for businesses with moderate growth prospects and lower potential risk.

MESBICs are privately owned and managed firms licensed to provide financing for small businesses that are at least 51% owned by members of minority groups, Vietnam veterans, and other socially or economically disadvantaged persons. Private capital in the more than 120 MESBICs ranges from $300,000 to more than $4 million; those with more than $500,000 in private capital are eligible for government borrowing leverage of four to one. Most MESBICs operate in a manner similar to SBICs.

The third part of the venture capital pool is made up of separate divisions of larger institutions. A number of financial corporations, especially bank holding companies, have formed subsidiaries to invest in business development situations that don't meet the parent corporation's usual investment or loan criteria. Such subsidiaries are limited to 5% of the parent's capital; they range from $5 million to $100 million. Most investments by these groups are in later-stage business development and management-leveraged buyouts. Commitments to individual companies generally range from $1 million to $5 million.

Venture capital investment divisions have also been formed by some 40 large industrial corporations, including Exxon, General Electric, and Xerox. They typically invest in companies that have products, markets, or technology related to the parent company's operations, or where the business is of interest as an opportunity for diversification.

These corporate groups, after some false starts in the venture investment field during the '60s and early '70s, now seem to follow proven venture investment disciplines, such as independent profitability and the five-to-seven-year investment time frame, rather than orthodox investment analysis. If the corporations are able to maintain these special disciplines, the corporate subsidiary segment of the venture capital community, which has already showed notable growth in 1979 and 1980, could become an even more productive source of capital.

Most of the organized venture capital industry is concentrated in New York, the San Francisco Bay area, Boston, and Chicago, with secondary centers of activity in Minneapolis-St. Paul, Dallas, Houston, southern Connecticut, and Washington, D.C./Baltimore. Activity is increasing in Southern California, the Pacific Northwest, and the Southeast. New York and Chicago, as major financial centers, are leading markets for leveraged buyouts and expansion financing. San Francisco and Boston, also financial centers, tend to concentrate in technology-based business development investment. Minneapolis-St. Paul is a center for medical and health care and computer-related ventures, while Dallas and Houston are centers for energy-related ventures.

But although location remains important, many venture capital firms now operate virtually coast to coast. A stimulus to cooperation among venture capital firms has been the development of two major trade associations, the National Association of Small Business Investment Companies (NASBIC) and the National Venture Capital Association (NVCA).

Boosted by its accomplishments in the past two years, the organized venture capital industry currently enjoys excellent health. It can boast a record amount of available investment capital and the experience of two decades of development, and is well situated to respond to today's healthy entrepreneurial climate.