The Billion Dollar Gamble

That's how much money venture capitalists invested in new and growing companies last year. This year they're spending even more. Will the boom last forever?

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By now anyone with more than a passing knowledge of business and finance knows that venture capital is "hot." Venture capitalists raised more than $900 million in fresh capital during 1980 alone and invested more than $1 billion in new or growing companies during the same year. No one connected with the venture capital community expects the pace to slacken during 1981 or in the immediate future.

Does this mean that the heralded "decade of the entrepreneur" is indeed upon us? Are the possibilities for seed money and growth financing of small business unlimited? And if not, what limits do exist? To find out, INC. spent several weeks talking with leaders of the venture capital community across the country.

Venture capital is a highly personal business, where profits are made as much from correct gut feelings about a company's prospects for success as from painstaking analysis of financial ratios. So while it's fair to say that there is such an entity as an organized venture capital "community," at least among the 50 or so largest, most active firms (see table, page 66), the group does not speak with one voice. But a clear consensus does emerge on some points:

* A lack of experienced venture capital fund managers who can identify promising investments will be the most important constraint on the growth of the business in the years just ahead. Despite the increased flow of funds into venture capital, there may be no significant increase over the 4,000 deals funded per year that is the current average. So, despite its present affluence, organized venture capital will have little impact on the expansion capital needs of the vast majority of small businesses (see box, page 60).

* The increased flow of money into the venture business, however, will continue unabated for several years, barring a major catastrophe in the overall economy. Institutional investors, particularly pension funds freed from past legal shackles, are impressed with venture capital's track record as a hedge against inflation during the past decade and believe the rewards of participation will continue to outweigh the risks. Foreign investors, too, are increasingly interested in entering the U.S. venture market by investing through established firms.

* Stable, long-term public policy commitments to venture capital, particularly support of federally licensed Small Business Investment Companies, are a must. After a decade of smooth growth and increasing success, the SBIC program is currently in a holding pattern while the Reagan Administration and the new administrator of the Small Business Administration, Michael Cardenas, review their options.

* Further capital gains tax relief, including the possibility of establishing different rates of tax on sales of "new" investments, remains a critical element in the continued strength of venture capital.

* The booming market for new public stock offerings, both fueling and fueled by venture capital, has enticed an unprecedented number of would-be entrepreneurs to strike out on their own. Many are experienced managers from big technology-based companies. As a result, there are more good ideas to choose from today than at any previous time in the history of the business. But experienced venture capitalists worry that too many deals are being made too quickly, and at too high a price to the investor. The result, some feel, will be a bursting of the bubble, leading to another contraction similar to that which the industry suffered in the mid-'70s. In their minds, venture capital will remain a cyclical business, and many of the "fool-proof" investments of today will suffer through some lean years before the real winners are sorted out by the market.

While all five of these factors will probably affect the future of venture capital, who's available to call the capital investment shots is the critical issue. Venture capital is the ultimate management-intensive business, requiring hundreds of hours of study before making a deal, and an even greater commitment of managerial time after it's made. Walter Stults, president of the National Association of Small Business Investment Companies, estimates that there are no more than 3,000 people managing organized venture capital today. Craig Burr, a 10-year veteran of the business and a partner in the Bostin-San Francisco firm of Burr, Egan, Deleage & Co., puts the number far lower. "I'd say there are about 25 mainstream firms, and maybe 150 people with outstanding track records in the business right now," he maintains. What this means is that there are only so many people with only so much time to evaluate prospective investments and sit on the boards of companies in the venture fund's portfolio once the deals are made -- not good news for needy small companies.

Nor is hiring freshly minted M.B.A.'s the immediate solution. Says Burr, "How can I tell the president of a highly successful, fast-growing company that I'm turning my seat on his board over to somebody one year out of Harvard? Is that supposed to be an example of the kind of wisdom and insight venture capitalists can provide?" Good judgment, as any veteran in the business will tell you, is the key to success in the business. "And the only way you acquire good judgment," says Dan Cronin, general partner of Ampersand Associates, a Boston venture capital firm, "is to exercise bad judgment and get burned a few times."

One of the reasons for venture capital's current heady successes is the good judgment men like Burr and Cronin learned while slugging their way through the near-dormant mid-'70s. The period between 1972 and 1978 may someday be remembered as venture capital's years in the desert. After a heady adolescence in the late '60s, the business almost disappeared from public view after the bull market of 1968-69 went into eclipse, taking with it the new-issues market that had buoyed the venture business.

Of course, venture capital didn't disappear. Many of the venture high-fliers of the late '60s were busy "working out" their deals. Morton Collins, current president of the National Venture Capital Association and general partner of DSV Associates, a venture firm in Princeton, N.J., recalls the era. "I formed my partnership in 1968," he says, "raised several millions, and went shopping for deals. At the time, a more experienced gentleman in the business said to me, 'Now's not the time to invest. Deals are too expensive. Wait till it cools.' But I went ahead and plowed money into good-looking propositions. Things soured in 1970, and I spent the next five years working them out. By 1975 I had gotten back to zero."

Collins and his peers have no difficulty identifying the primary reason for venture capital's slump. It was the increase in the capital gains tax from 25% to 49% in 1969. Since at that time almost all venture financing came from wealthy individuals, who had little desire to pay twice as high a tax on their gains, many of the venture money sources simply dried up. The 1973-74 stock market slump and subsequent recession merely added to the bad news.

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