The Billion Dollar Gamble

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More than mere coincidence ties venture capital's comeback to the decrease in capital gains taxes from 49% back to 28% in 1978. (Not to mention the distinct possibility of a further reduction to 20% in the near future.) The ability of public policy to direct capital to a specific sector has seldom been more clear. Future policy toward Small Business Investment Companies is just as important an issue today.

SBICs were created by act of Congress in 1958. They were meant to fill at least part of an "equity gap" for small businesses identified by a Federal Reserve report presented the same year. After more than two decades of experience, it's safe to say that, in part, they have fulfilled their mission. "We're the ultimate supply-side industry," says NASBIC president Stults. "Show me another government program that has done so much for business at so little cost to the taxpayers." On the evidence, one has to agree. During 1980 approximately 350 SBICs invested $295.2 million in more than 2,000 small companies at a net cost of approximately $2.5 million to the government. The latter figure includes about $1.5 million in defaulted loans, a figure consistent since the beginning of the program. Of more than $3 billion invested in more than 40,000 small companies since the program began, a mere 1% -- barely $30 million -- has been lost by the federal government. And there are secondary benefits as well. A 1980 Arthur D. Little study of SBIC investment recipients showed that a permanent new job was created by every $6,000 invested.

SBICs are licensed by the federal government and allowed to borrow money at favorable government rates through the Small Business Administration. Once an SBIC has $500,000 of private capital committed, it can leverage that amount by borrowing up to four times the private commitment. Thus, with its government loan backing, an SBIC can afford to invest in many companies that traditional venture capitalists, who need to show an eventual return of 30% to 40%, dollar for dollar, on their investment, cannot or will not touch.

All is not happy on the SBIC front today, however. From the mid-1970s until this year the availability of leverage capital was never a problem. Now it is -- at least potentially. "It was an evergreen money tree," says Stults. "Any well-managed SBIC could count on loan approval within a month to six weeks." That sort of stability was critical to SBIC managers, who could commit all of their private capital to investments knowing that they could borrow an equal amount from the SBA to make further investments.

Stability suffered a setback this spring, however. The Reagan Administration proposed cutting back the SBA's loan pool to $145 million per year, a far cry from the last Carter budget's allotment of $190 million for the same period. SBICs with deals ready to go suddenly found their primary source of funds uncertain. Michael Cardenas, the new head of the SBA, imposed a freeze on all licensing approvals while he studied the program along with all other SBA operations. The freeze sent a shock through the SBIC community. While the freeze had been lifted by mid-summer, and it appeared that the SBA loan program would have about $160 million to disburse both this year and next, the program suddenly was less certain of its own future. "We feel we can live with a one-year squeeze," says Stults. "Many of the older SBICs have been through an investment cycle, have cashed in, and are liquid. But if our leverage didn't increase for a long time, or if the opportunity to cash in disappeared because the new-issues market soured, there might be trouble."

Stults and others in the SBIC community hope that, in time, the Reagan Administration can be made to see the great benefits they believe SBICs bestow on business, employment, and the economy in general, and that the Administration will sharply increase he level of funding. Or, if Reaganomics proves disastrous, and a new recession occurs, perhaps, Congress will go back to its old spending ways and water the money tree again. For now, though, there's a disquieting pause in the middle of an otherwise healthy trend.

Or is it healthy? Far from crowing about the flood of money into venture capital today, many old hands are unabashedly nervous about the phenomenon. They look back on the lean years of 1974-75 as the time when really good deals were made by sharp investors. Says Stan Golder, for years the head of venture capital for First Chicago Corp. and now general partner of his own firm, Golder, Thoma & Co., "We made a lot of good deals in '74 and '75, because the entry prices were quite low. Most of those companies have turned out to be big winners, for us and for the entrepreneurs who had the courage to start them." How profitable the deals will be that Golder and his fellow venture capitalists are making today won't be known for some time of course. But almost everyone concedes that the current surge has put added pressure on the deal makers. "The competition isn't necessarily among ourselves," says Craig Burr, "but against the public market. The deals we did five years ago can now go public at a much higher price. Five years ago my partner Bill Egan took four months to make up his mind about Federal Express. Now we have to analyze a proposal and reach a decision in three to four weeks. Otherwise we lose it by default."

Dan Cronin backs up part of Burr's claim. "I've seen companies we rejected because we didn't think they were good enough turn around and go public at high prices within a matter of months," he says. Morton Collins doesn't even want to get involved in the race. "If someone tells me that the only way to do a deal is to do it in three weeks," he says, "then I just won't do anything." Collins hasn't made an investment in more than a year, in part because he's been busy raising more money but also because he believes that "it's almost axiomatic that when it's easy to raise money it's the wrong time to invest it. My investors have enough faith in me to sit and wait. If I didn't put a dime into anything for three years, they wouldn't say boo."

Predicting the future of venture capital, even in the short term, is almost as risky as playing the investing game itself. But it seems fair to say that the performance of any firm, much less a particular investment, must be measured over periods of years, not months. There may be, for example, one time omen for those who like to find historic precedents. The last boom period for raising money, in 1968 and 1969, preceded the seven-year slump by just 24 months. Is another shakeout in the works? No one can say for sure, but in venture capital, as in business in general, the race does not always go to the swift. Slumps are made to be ridden out and used; that takes courage, skill, patience, and financial staying power. There's more of all of them in the venture capital community than ever before.

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