Venture Capital And The American Dream
August 21 will mark the 25th anniversary of President Eisenhower's signing of the Small Business Investment Act.
This silver anniversary is a proper cause for celebration for small businesspeople. The act has helped us reach what may be the halfway mark in building a national venture capital industry adequate for the modern U.S. economy. Since its passage, more than $4.5 billion has poured into some 60,000 small businesses through small business investment companies (SBICs). There are almost 500 SBICs functioning today. This seed money has had a disproportionately favorable impact on jobs, exports, and tax revenues.
Until the act was passed, venture capital was almost entirely a quiet game for a few wealthy families who lent money to a handful of companies. More deserves celebration, therefore, than the vast increase in the size of the venture capital pool. The legislation made the obtaining of venture capital a substantially public process, by requiring companies funded by SBICs to be licensed and registered by the government. The SBICs also began to stabilize the venture capital industry by a systematic effort to recruit professional managers.
By increasing public awareness of the need for small business funding, the growth of SBICs led to expansion of the entire U.S. venture capital industry. According to "The State of Small Business," President Reagan's second annual report to Congress on the subject, issued in March, our organized venture capital pools hold more than $7.5 billion. Less than one-fifth of that is in federally licensed SBICs; more than half is in private, specialized companies; the balance is in subsidiaries of large corporations. Despite the fact that private venture capital has outstripped the government in providing venture capital funds, the role of SBICs continues to be essential to small business. The range of investment opportunities they make possible is necessary to serve the diverse needs of small companies.
The venture capital system got its latest big boost in the 1970s and '80s. The two cuts in the maximum federal capital gains tax rate (from 49% to 28% in 1978, and from 28% to 20% in 1981) moved far more money into venture capital than the 1958 statute did. The relaxation of pension fund regulations in 1979 freed those behemoths to put 0.1% of their assets into venture capital. These three significant changes in the tax code and in pension fund regulations made investments in small companies more attractive, and more than half the money now flowing through the pools was raised in response to them.
In its April 18 issue, Business Week ironically underscores the progress we have made. In an interview, Gordon E. Moore, chairman of the board of Intel Corp. (itself originally financed by venture capital when key people left Fairchild Camera & Instrument Corp. to form the new company), worried about the current venture capital explosion: . . . the possibility exists of there being too much venture capital, in which case everything gets fragmented and all the continuity in things that established companies can do gets lost. From the mid-1970s to now, we've gone from one extreme to the other. Right now there are venture capitalists chasing awfully hard to get money invested. I believe they are supporting a lot of things that don't deserve support."
Despite Moore's assertion, it is clear that we don't yet have enough venture capital for all the deserving start-ups. The money we do have is concentrated in too few areas and in too few industries. Vast reaches of the country and the economy are still outside the mainstream of venture capital. Inevitably, most of the recent flood of new funds has flowed first into the well-worn ruts leading to the high-technology, computer-related companies in Silicon Valley in California and along Route 128 in Massachusetts.
A General Accounting Office report in August 1982, "Government-Industry Cooperation Can Enhance the Venture Capital Process," detailed what it called the "venture capital shortfall," that is, the amount of money still needed to fund the underserved sections of the country and the economy. In 1980, the GAO thought this shortage was "$5.5 billion to $13.5 billion on the optimistic side, to as high as two to three times these figures on the pessimistic side." The annual shortage appears to be at about the same level now. But those left out of the current venture capital pool because they are included in the shortage are at last fighting to make themselves more attractive.
On this anniversary of the event that got the venture capital ball rolling, here are some suggestions to make the industry still more responsive. Write to the President, your senators, and your congresspeople and ask them to provide SBICs with the funds intended by legislative design, so that the money can flow more readily to small businesses. Remember that private citizens invested in SBICs with the expectation that the government would make matching funds available to start-ups. Yet for the remainder of this year, the Small Business Administration has budget approval for $90 million to $100 million less than the SBICs will need. Most of the money available will simply go to refinance existing SBIC debt to the government. The Small Business committees of both houses of Congress have sponsored bills (S.1323 and H.3020) that will add the needed funds. The Senate bill has been sent to the floor; the House bill is expected to be out of the Committee on Rules some time this summer.
You might also remind the President and the Congress that the capital gains tax rate is still the same for high-risk gains from long holdings in illiquid small companies as it is for quick killings in lower-risk stock in big and freely traded companies. Small business needs a federal law similar to the one California has adopted (see INC., November 1981 page 14). That provision exempts from capital gains tax any profit from an investment held three years or longer in a California company with fewer than 500 employees. That is a true incentive for genuine risk-taking. A federal law would make similar sense. First, the law should stipulate a 10% tax on gains from the sale, after three to five years, of original public issues made by small companies It should also do away with the tax on the sale of private businesses, or the interest realized from them, for the same three-to-five-year period. Together, these provisions would relate risk to reward better than the current law does. It may be the fastest and least costly way the federal government can both reward investments in high-risk, small companies and increase the value of the equity in every small company in the country.
If you feel you still need more education about venture capital, give yourself a short, two-step, home reading course. (To whet your appetite, we have printed a table from one of the recommended publications.) Start with Raising Venture Capital (published by accounting firm Deloitte Haskins & Sells, $5). This pamphlet outlines how an entrepreneur systematically prepares to make a case for growth dollars. Whether or not you ever expect to use or need venture capital, it is worth your time.
Venture Capital Handbook, by David Gladstone (Reston Publishing Co., $35), is a much deeper, more detailed look at the process. It is the first book I have seen hat will enable a serious but inexperienced businessperson, lawyer, or accountant to prepare for the process. For 10 years, the author has been an executive officer of Allied Capital Corp. in Washington, D.C., one of the oldest, most seasoned, and best respected venture capital SBICs in the country. He reads 5 to 10 applications for money a day.
A great many of the proposals that are submitted, Gladstone explains, are simply "incomplete, inconsistent, and inane . . . incomprehensible. They were rejected because they were so poorly prepared that I couldn't understand the plan being presented." When all of his efforts to help on a one-by-one basis didn't seem to work, Gladstone decided to write the book.
Gladstone's experiences seem to be universal among venture capital managers. Try measuring the waste of time and money in the application process both for businesspeople and venture capital people, but particularly for the former. If 500 working venture capital managers spend 200 days a year reviewing an average of only 5 proposals a day, they will read 500,000 proposals a year. And this flood of paper probably does not produce more than 5,000 to 6,000 financings annually. As much work as this creates for fund managers, there is even more for the businesspeople preparing the applications. Gladstone's book will not only help those directly involved in the venture capital process, it will also help all of us make better use of the limited stock of available start-up funds. It should be a major asset in reducing waste.
Back when SBICs were started very few people knew anything about venture capital. In the 1950s and '60s some of us held briefings for lawyers about how important that process was to the future of small companies. Even though we have made significant progress, I wouldn't change my basic testimony very much:
For the rest of your lives, you and your small business clients will live in a capital-short world. Nations and people will demand instant economic advances. Expectations will rise as they find out about middle-class living standards. If those expectations are not met, they will quickly become strident demands for the immediate delivery of more goods and services. Rapid change in technology will help increase productivity. But at the same time product obsolescence will come even faster.
Meeting these demands will drain capital. Its costs will go up, and it will become harder to obtain, particularly in small amounts and at the rates which small business can pay. Special mechanisms and incentives to preserve and expand the venture capital supply for small companies will be a permanent high priority. What we are talking about is, after all, a key part of the life-support system of the American dream of the widest possible entrepreneurial opportunity.
Let us not wait until the golden anniversary of the founding of SBICs to make sure that the venture capital pool is large enough to support every small company that needs and deserves the help.
REQUIRED COMPOUNDED ANNUAL RATES OF RETURN
Type of investment Range for compounded
annual rates of return (%)
First stage 4060
Second stage 30-40
Third stage 20-30
From: The Venture Capital Handbook.