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Why Smart Companies Are Saying No To Venture Capital

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It seemed, at first, like the logical next act in the classic entrepreneurial script. Having developed his new database software on his home-built Heathkit microcomputer, Wayne Erickson packed his bags and set off on a pilgrimage to the venture capital mecca of San Francisco in search of the help he needed to turn his creation into a multi-million-dollar enterprise.

It was a well-worn path, that route from the entrepreneur's garage to the investor's suite. It was part of an initiation rite through which hundreds, if not thousands, of dreamers and doers had passed before. On the surface, at least, Erickson seemed little different from the rest.He was 35 years old, a former bass player in a rock band who at some point had discovered that his real talent lay in computers. Going to work as a software programmer at Boeing Computer Services Inc., he had developed something called the RIM (relational information management) software system to help track missing ceramic tiles on the space shuttle. After leaving Boeing in 1979, he had done contract work for the National Aeronautics and Space Administration at the University of Washington in Seattle, and -- in his spare time -- experimented with adapting RIM for use on microcomputers, eventually developing a powerful database system that could quickly and easily organized data from as many as 40 different files.

The system seemed to have commercial potential, so in 1981, Erickson and his older brother Ron, an attorney, formed Microrim Inc., to make and market the product, which they called R:base. Selling to a few large customers, Microrim enjoyed revenues of $360,000 in its first year, and the Ericksons began to think about broadening their horizons. They believed that with a little help, Microrim could become a major player in a burgeoning industry. What the company needed was capital and, equally important, the wisdom of those who had done it before. They hoped to find both in San Francisco's venture capital community.

And so, in late 1982, they traveled down from Bellevue, Wash., accompanied by Microrim's chief operating officer, Kent Johnson. Arriving in the city, they were as nervous as novices entering the Holy See. "We felt a little intimidated," Johnson recalls. "We were all small-town boys from Washington in big San Francisco. We knew that the venture capitalists there had made fortunes and had seen hundred of plans. We were the new guys on the block, and no one knew us."

Over the course of three months, they made two trips to the Bay Area and met with more than a dozen venture capital firms. Wide-eyed and reverent, they were ushered into the very offices where some of the greatest entrepreneurial successes in recent memory had been launched. There they demonstrated their product, analyzed their competition, talked about themselves, their company, and their plans for the future.

And something odd began to happen. As they moved from meeting to meeting, their awe gradually dissipated, giving way to a different emotion. They looked across the table at the people whose help they were seeking, and they felt -- disappointment.

Were these the venture capitalists they had heard so much about? They could scarcely believe it. To be sure, these guys acted powerful and important, and they undoubtedly had access to a great deal of money, some of which they indicated they might be willing to part with. But they were hardly the experienced sages that Erickson and the others had been hoping to encounter, people who had built fast-growth companies from coast to coast. Some of these venture capitalists didn't even know very much about running a business, having only graduated from business school two or three years before.

"Just because they had MBAs from Stanford or Harvard, they thought they knew everything about everything," Wayne Erickson recalls bitterly. "Their approach was pretty much antagonistic. 'Why don't you do this? Why don't you do that?' they would say. They wanted us to redo everything we had done, and most of them didn't know anything about writing software. I felt I had been nursing this baby and they were telling me that they didn't like the way the baby looked. But the fact is that we had done some things right."

In the end, several of the venture capitalists expressed interest in backing Microrim, and one made a firm offer. The company sorely needed the money: Erickson and his associates were well aware that their meager cash reserves and their bank credit line would soon be exhausted. Nevertheless, they decided to turn everybody down.

"I remember sitting in this high-rise in San Francisco, talking to this young venture capitalist, and thinking, 'This guy is so precious, he's such a nerd. I don't want him on our board, telling us what to do," says Ron Erickson. "We were sick of haughty disdain. Maybe we wouldn't go silk-stocking, but we didn't care. We were going to find a different route."

There have always been young companies that, for one reason or another, have preferred to grow without venture capital, but lately it seems that more and more have, like Microrim, begun searching for "a different route." The entrepreneurs in question cite a variety of reasons. Some share Microrim's complaint about the quality of the expertise available. Others fear loss of control over key decisions.But perhaps the most frequent criticism -- and, in some ways, the most devastating -- is that venture capital, by its very nature, distorts the process of growth.

"Venture capitalists make you too 'now' -- too profit-oriented, instead of quality-oriented," says David Fast, president of Perennial Software Services Group (see sidebar, page 74), a leading software service firm that has avoided venture funding. "You introduce factors with venture capital that don't really help build the company. We want to use our profits to do the things we want to do, not to please some investor who's screaming, 'Fifteen percent or you're out!' I'd rather have the steady, balanced growth that comes from pulling yourself up by the bootstraps."

That may be something of an overstatement, but it is also an increasingly common refrain in Silicon Valley and other centers of new-business formation. It reflects a growing disenchantment with an industry whose successes have become synonymous with the resurgence of the entrepreneurial spirit in America. Since the late 1950s, venture capitalists have played a crucial, even heroic, role in launching some of the nation's most spectacular growth companies, from Digital Equipment and Federal Express to Apple Computer and People Express. At a time when the giant commercial banks, investment houses, and large corporations disdained small startups, venture capitalists were ready and willing to take the risks necessary to build their economic future.

But venture capital today may well be becoming a victim of its own successes. Once a collection of small firms run by brilliant, if often idiosyncratic, individuals, the venture capital business is developing into a large-scale, highly institutionalized industry. The main impertus has come from pension funds, investment banks, insurance companies, and the like. Lured by annual returns as high as 40% to 60%, they have poured huge amounts of money into venture capital funds, boosting new capitalizations from $39 million in 1977 to more than $4.1 billion last year (according to Venture Capital Journal) -- a hundredfold increase in just seven years.

As the money has flowed in, the game has changed. "You have to understand this is an industry where people are not used to having a lot of money," observes Oxford Partners's Steven Birnbaum, who has been a venture capitalist for 15 years. "Then somebody gives you $150 million, and you start to feel you can walk on water. You read in the paper that you're a genius, and you believe it. Some of the old constraints tend to get eroded away."

One manifestation of this tendency has been the recent emergence of so-called megafunds -- venture capital funds of $100 million or more. The first one was established in December 1982 by the well-respected firm of Kleiner, Perkins, Caufield & Byers, which raised $150 million for the purpose. Since then, nine other firms have followed suit, including such pillars of the industry as T. A. Associates, Hambrecht & Quist, and The Mayfield Fund. As a result, some of the larger venture capital firms now have total capitalizations running upwards of $300 million.

Those are big numbers for an industry in which, five years ago, the largest fund was about $40 million and the average fund was about $15 million. The problem of managing such megafunds, however, may be even bigger. "In this business, you don't multiply your talent with size," notes John Hines, president of Continental Illinois Venture Corp. Stretched thin, the often illustrious general partners of the larger firms have had to depend increasingly on inexperienced subordinates for much of their investment decision-making and due diligence. This, in turn, has had an impact on the venture capital process itself. From the entrepreneurs' standpoint, it means that they may not get the expert advice, or "intelligence equity," which they often value more than cash. From the investors' standpoint, it means that they are entrusting their money to people with limited knowledge of the business.

Part of the problem has to do, quite simply, with the dearth of available talent. Experienced venture capitalists are hard to come by, and their number has not kept pace with the explosion of the industry as a whole. Consider that, while the amount of venture capital has increased 283% since 1978, the number of practicing venture capitalists has barely doubled, from about 600 to about 1,200. Of those 1,200 people, nearly half are estimated to have two years or less of experience in the business. "Venture capital is rapidly becoming a very talent-short market segment," observes Gary Helms, former vice-president of Hughes Aircraft Co.'s $2.7-billion pension fund and a leading investor in venture capital partnerships for the past five years. "There's a tremendous danger in this. Inexperienced people can be like the proverbial loose cannon on the battleship."

"It's like a large law firm," adds Hines of Continental Illinois Venture. "You can say you're with the greatest law firm in the world, but, if a junior person is handling your account, I'd say that's baloney. The question is: Who is your individual lawyer? This is not a profession for a lot of inexperienced young people in their 20s and 30s."

Then again, it would be unfair, and wrong, to blame most of the industry's woes on MBAs, whose role, after all, is more a symptom than a cause of the problems. Certainly, there were very experienced hands involved in many of the venture-backed flascos of the past year -- Osborne Computer, Fortune Systems, Victor Technologies, Piza Time Theatre, Diasonics, and so on. What those cases reveal is a broad pattern of mistakes and misjudgments. "There's been a lack of tough-minded checking out of deals," admits one top Bay Area venture capitalist. "People get into situations with entrepreneurs or companies that they soon realize aren't going to work out, but once you start, you often find a deal takes on a life of its own."

Exacerbating this situation is the growing involvement of major financial institutions in the venture capital process itself -- not just as suppliers of capital, but as direct participants in latter, or "mezzanine," round financing. As investment banks, insurance companies, and other large institutions have formed their own venture capital arms, they have added millions of dollars to the already huge pool of money available to companies on the verge of going public. The temptation is to pump these companies full of cash in hopes of increasing the appeal of their initial public offering. It is a temptation that some venture capitalists have found impossible to resist.

"A lot of our troubles started when the institutions began co-investing with us," laments one prominent San Francisco venture capitalist. "It's a fundamentally unsound process. It's like believing in Santa Claus. The pressure is to short-cut the whole process. Instead of giving companies five or six years to grow, they try to do it in two years. Some companies have been rushed and grossly overfinanced as a result. The institutional involvement distorted everything. It's a process that will lead -- is leading -- to disaster."

"Disaster" may seem like a rather strong word, and "over-financing" a rather strange concept -- especially to young companies that are struggling to make ends meet. Yet that concept touches the root of the problems precipitated by the influx of new money and new players into the venture capital business. "The business has become very chic," says venture capitalist Don Valentine of Menlo Park, Calif., one of the deans of the industry. "Five or 10 years ago, many of these same [institutional investors] would react to venture capital like venereal disease. Now they think it's the greatest thing in the world, but they have picked up none of the skills."

In their enthusiasm, says Valentine, the new players often fail to comprehend the fundamental difference between venture capital and conventional financing mechanisms. "They think it's an investment business, but that's wrong. Venture capital is not a business of trading stocks and investing for fast returns. I am not a banker. I am into building companies."

That is, indeed, what venture capital used to be all about -- building companies -- and Valentine's own record on that score is extremely impressive. The companies he has helped build bear names like Apple Computer, Tandem Computers, Altos Computer Systems, and LSI Logic. But the man whose work best exemplifies this approach to the business is a predecessor of Valentine, a French emigre by the name of General Georges F. Doriot.

Doriot, now retired, was a highly influential professor at the Harvard Graduate School of Business Administration during the 1930s and '40s. In World War II, he served in the U.S. Army, rising to the rank of Brigadier General. On his return from war, he decided that the business climate around Boston had become too stale for his taste. So, in 1946, he founded American Research and Development Corp. (ARD), a company dedicated to fostering new, exciting companies.

Backed by Yankee financiers, Doriot began scouring the depressed New England countryside, looking for business and technological talent. One of the high points of that search came in 1957, when he was contacted by a young engineer and entrepreneur named Kenneth Olsen, who had an idea for something called an "interactive computer." By that, he meant a computer with which a user could communicate directly via a keyboard or terminal, rather than punchcards.(This was, in fact, the forerunner of the minicomputer.) Olsen wanted to start a company to develop and produce the device.

On the face of it, his prospects seemed bleak. He had no prior business experience, and nobody but IBM Corp. was making money on computers anyway. But Doriot saw the opportunity and persuaded ARD's board to invest $70,000 in Olsen's fledgling company, which became known as Digital Equipment Corp. (DEC). Headquarters were set up in an old woolen mill in Maynard, Mass., a Boston suburb -- on the second floor, with a narrow stairway and no elevator. Such was Doriot's style. He believed that with too much money, a company's founders might "start buying Cadillacs, 50-room mansions, go skiing in summer and swimming in winter." Then again, he himself never invested in his companies, fearing a conflict of interest.

Over the next 14 years, Doriot worked to help build the company. He stayed in close touch with Olsen, advising him on a wide variety of matters, always pushing him to focus on long-term development. Doriot even became upset the first year that DEC reported a profit, because he feared the company was not spending enough on research and development. In the end, however, everyone profited. By 1971, ARD's initial investment of $70,000 was worth an estimated $350 million.

Doriot had similar successes with other companies, including Ionics, the water treatment company; Cordis, the manufacturer of pacemakers; Teradyne, the electronic test-equipment maker; and Cooper Laboratories, the pharmaceutical company. Throughout the low-inflation era of the late 1950s and '60s, ARD consistently enjoyed a 15% annual rate of return. For Doriot, however, such returns were a byproduct of his work, not a goal. "I don't consider a speculator -- in my definition of the word -- constructive," he once observed."I am building men and companies." To do that required, above all, patience and loyalty, and Doriot often worked with a company for a decade or more, through good times and bad, before realizing any return at all. Small wonder that he came to refer to his companies as his "children."

In 1972, Doriot sold ARD to Textron Inc. and retired. But the Doriot tradition lived on in a new generation of venture capitalists, men who had themselves built companies and now wanted to help others do the same. Among them were Eugene Kleiner, a founder of Fairchild Camera & Instrument; Thomas J. Perkins, former director of corporate development of Hewlett-Packard; Burgess Jamieson, a onetime chief development engineer of Honeywell's Computer Control Division; and, of course, Don Valentine, who had been marketing director of National Semiconductor Corp. What these venture capitalists, and others like them, had in common was a particular sort of knowledge and experience that was, and is, especially valuable to young, growing companies.

That knowledge allows the venture capitalist to serve, for example, as a kind of clearinghouse -- a screen through which bad ideas, even bad business plans, cannot easily pass. It was just such a screen that Wilf Corrigan was looking for when he approached Don Valentine in late 1980. Corrigan had an idea for a company, LSI Logic Corp., that would make semicustom integrated circuits. He believed that Valentine, as a veteran of the semiconductor industry, was particularly suited to assess the viability of the scheme. Indeed, Valentine relentlessly challenged Corrigan's theses, and he forced him to define his ideas more sharply.As a result, says Corrigan, LSI Logic started on a firm footing.

"Don is one of the world's toughest negotiators, but it's good to talk to someone who knows what he's talking about," Corrigan says. "He's very analytical, very unemotional. He does a lot of analysis before he makes a decision. He won't be rushed into anything. He's got the ability to turn deals down. A lot of venture capitalists are just parallel investors who follow what other people do. When Don went with us, we knew that the idea made sense."

Valentine performed a somewhat different service for Steven Jobs and Stephen Wozniak when they were trying to put Apple Computer Co. together back in 1976. Their problem was that many of their potential backers felt the two young engineers lacked the necessary management experience to succeed. They turned to Valentine, who persuaded a friend and former Intel executive, A. C. Markkula Jr., to serve as Apple's president. Markkula, in turn, played a central role in guiding the fledgling company through its initial period of rapid growth and into the public market.

But it is often later -- after the company is up and running -- that the knowledge and experience of a skilled venture capitalist becomes most important to the entrepreneur. In the case of Altos Computer Systems, for example, Valentine was able to contribute his substantial marketing expertise, helping to mold the company's marketing program, as he had previously done at National Semiconductor. Beyond that, he served as a sounding board for Altos founder and chairman David Jackson. "Venture capitalists came to me, but I didn't see where I needed them," Jackson recalls. "I run a tight ship, and I didn't need the money. What I did need was somebody who could tell me what a big company is all about. I needed a strategist, and Don's a great one. He's not a witch doctor, but you tell him a problem and he sets the guidelines for you, so you can get a solution."

By playing such a role -- by helping to build companies -- venture capitalists of the Doriot school earned the loyalty of the entrepreneurs they served. "I think venture capital has been fantastic for the country," says James Treybig, founder and chief executive officer of Tandem Computers Inc., launched over a decade ago with $50,000 from Kleiner, Perkins, Caufield & Byers. "Without their help, there'd probably be a lot fewer new companies around today. And it wasn't just the money. The venture capitalists were always there to help."

In the early 1980s, however, the venture capital business began to change. Indeed, it is almost possible to fix the date -- December 12, 1980, the day that Apple Computer went public. The initial offering price was $22. By the close of trading, Apple stock was selling for more than $34 per share.

The Apple Computer offering was, of course, a bonanza for the company's founders and backers, and it provided dramatic proof of the fortunes that could be made by entrepreneurs and venture capitalists alike. Beyond that, it showed how receptive the public equity markets were to new issues of technology stocks -- a lesson reinforced by the subsequent initial public offerings of companies like Cetus, Pizza Time Theatre, ASK Computer Systems, Vector Graphic, and Altos Computer Systems. As the IPO market heated up, investors realized that, instead of having to wait 5 or 10 years for returns on their investments, they could count on Wall Street to produce 10-to-1 paybacks in as little as 2 years. It was a message heard loud and clear from New York to San Jose, Calif., and it set off a stampede to the public market, boosting the number of new issues from 281 in 1980 to an astounding 888 in 1983.

"People say power corrupts, but I think it's money that does the trick," observes San Jose venture capitalist Burgess Jamieson. "We have the symptoms of the heightening of greed among venture capitalists and entrepreneurs. I suppose greed is okay up to a point, but it's like wine. A glass is pleasant; a bottle will have a different effect."

This particular form of inebriation produced a variety of effects and manifested itself in a variety of ways. To begin with, it drew into the venture capital business a lot of people and institutions that were less interested in building companies than in scoring "quick hits" -- that is, realizing enormous returns in a relatively short period of time. That was all right for entrepreneurs of a similar mind, but it posed a dilemma for those who were interested in something more than a fast buck.

A case in point is Mark Richardson, a former Hewlett-Packard engineer, who teamed up with three of his colleagues to found San Jose-based Structural Measurement Systems (SMS), a company that develops software packages for diagnosing such design-related problems as stress and noise. Launched in 1979, SMS got off to a fast start, with sales running at about $1 million per year, but it needed additional capital infusions to maintain that growth. So Richardson began contracting venture capitalists.

"One of the first things the venture guys did was to come in and ask, 'Do you want to be rich, or president?" Richardson recalls. "The guy was consulting for [New York venture capitalist Frederick] Adler. When he said that, I tell you, I had to wonder about whether I wanted to make that choice."

Richardson and his partners soon came to believe that taking venture money could have serious consequences for SMS. They had dreams of building a company like Hewlett-Packard, with a strong emphasis on product quality and a humanistic orientation. The venture capitalists they encountered tended to stress financial considerations and the prospects of going public.An obsession with "putting up big numbers," observed vice-president of marketing Ken Ramsey, could threaten not only their control of the company, but its fundamental character as well -- something that the partners were not willing to risk.

"We would have taken money from the right person," says Ramsey, "but we wanted a sympathetic party, someone who would help us out. We never got the sense that these guys wanted to be partners. They seemed like cutthroat types, and that isn't the kind of company we wanted to build."

But even if the new venture capitalists were not particularly cutthroat, they often had little to offer companies that were striving for solid, long-term growth -- little besides money, that is. "If I could have had an experienced venture capitalist, I would have considered" taking venture capital, says Chuck Colby, who founded Colby Computer (see sidebar, page 68) in 1982. "But the two venture guys who offered to invest in us were a completely different breed. One was a guy from New York who would show up every once in a while, and the other was a kid with no experience. They had all the money in the world, but there's no way they could help me build this company. There are things more important than money. I wanted people who would be real partners."

Another case was Ashton-Tate (see sidebar, page 75), the software company based in Culver City, Calif., which was courted by more than 50 venture capital firms. "If we had found a partner who offered a high value added, we probably would have taken it," says company president David Cole. "But most of them represented cash, and the way we manage, that's not what we really needed. It just didn't click."

On the other hand, there were plenty of entrepreneurs who were happy to take the money. Indeed, the venture capital boom soon gave rise to a new phenomenon, what Oxford Partners's Stevan Birnbaum calls the "pseudo-growth company." These were companies founded by charismatic, charming, even brilliant entrepreneurs, whose rhetoric and salesmanship often exceeded their business skills.According to Los Angeles venture capitalist Richard Riordan, these super-salespeople succeeded in raising money partly because investors thought they "looked more like a CEO" than blander entrepreneurs, many of them engineers, who -- although introverted and awkward -- might nevertheless have sounder ideas.

It is an opinion often echoed in Silicon Valley. "In the last few years, it's gotten so venture capitalists felt they couldn't just invest in Joe Schmuck," says Duane C. Meulners, founder of Dymek Corp., a $10-million-a-year manufacturer of alignment disks for disk drives. "You have to be a celebrity. Good solid growth isn't enough anymore. The venture capitalists are looking for wild, rampaging weeds."

Whether or not they were looking for weeds, that is what they found. All over Silicon Valley, companies began to spring up that were heavily promoted and heavily financed on little more than grand schemes. In place of expertise, the venture capitalists provided the companies with tons of money. The people who ran the companies often wound up spending it like oil sheiks on a weekend jaunt to Las Vegas.

There was, for example, the leading semiconductor start-up that added a totally unnecessary, albeit aesthetically pleasing, sloping roof to its headquarters at a time when losses were running at more than $1 million a quarter. An elaborate management information services staff, elegant workstations, and a host of other extravagances helped boost this company's breakeven point as much as $4 million above that of its competitors.

"Those types are still all around the Valley," says a former manager at the company, "the hip shooters, the guys with a good front who feel they can do anything. It's a lifestyle thing. They want to live like kings on other people's money. What amazes me is that the venture capitalists let them get away with it."

There was, in the words of one executive, "an atmosphere of false euphoria." But the spell broke along about the summer of 1983, with the collapse of Osborne Computer Corp.

In some ways, Osborne Computer was the quintessential pseudo-growth company. It certainly had all the right elements -- an exciting, breakthrough product; a charismatic and articulate founder; and a list of investors that read like a "Who's Who" of venture capital and investment banking. Jack Melchor, one of Silicon Valley's leading venture capitalists, sat on Osborne's board, as did Ken Oshman, founder of Rolm Corp. and a Valley maven of the first rank. They, in turn, helped to bring in additional millions from the investment community -- including the investment banking firm of L. F. Rothschild, Unterberg, Towbin; New York's First Century Fund; and Hewlett-Packard's venture capital wing. "Melchor was the driving force in getting people to invest in the company," explains one knowledgeable source. "Some of the investors relied heavily on the fact that Melchor and Oshman were on the board."

But there were also those who let greed -- and the prospect of a lucrative public offering -- overcome their better judgment. "We invested in Adam Osborne and, looking back at it, I don't know how he did it," admits one highly respected venture capitalist. "He had a real good idea, and he's very articulate. If he could run a company, he would have made a lot of money. I knew in my gut he couldn't do it, but I guess I felt, you know, 'miracles can happen."

This was one miracle that wasn't going to happen, however. In April of 1983, the company's new president, Robert Jaunich II, canceled the widely expected public offering, citing problems of production, product quality, and cash flow. In August, the company started massive layoffs at its Hayward, Calif., factory. A month later, it filed for protection under Chapter 11 of the Federal Bankruptcy Code, amid a barrage of lawsuits.

The Osborne collapse sent shock waves from Silicon Valley to Wall Street. Blake Downing, an investment analyst at the San Francisco investment banking firm of Robertson, Colman and Stephens, states flatly, "Osborne was a symbol, and one of the factors which drove the IPO market away." Indeed, the average price of the 121 venture-backed IPOs in 1983 had dropped 18% by March 1984, according to Venture Capital Journal managing editor Jane Morris. Meanwhile, the Venture Capital 100, the journal's index of top venture-backed stocks, fell a precipitous 33% from June 1983 to March 1984.

Clearly, Wall Street is nervous, and not without reason. What happened at Osborne unveiled, for the first time, the fundamental weaknesses of many highly touted venture-backed companies, and that lesson has been driven home in recent months as first Victor Technologies Inc., then Pizza Time Theatre have followed Osborne into Chapter 11. To make matters worse, there is a growing tribe of what one investment banker calls "the living dead," companies that were once hot, some receiving as much as $20 million in venture capital financing, but that are now struggling just to stay alive: Diasonics, Fortune Systems, Vector Graphic, Xonics, Evotek, VisiCorp, to name a few.

The consequences of all this are already being felt throughout the venture capital industry. With the souring of the public market, many knowledgeable observers expect the returns of venture capital firms to plummet over the next few years, perhaps dropping by as much as half. That, in turn, will affect the supply of venture money available from institutions. "If [institutions] are making venture investments on the basis of the returns we've seen over the past five years, they are going to be disappointed," says Walter Cabot, president of Harvard Management Co., the firm charged with investing Harvard University's $2.6-billion endowment fund and a leading venture capital supplier for the past eight years.

Similar views are expressed by other top suppliers, including Robert Knox of Prudential Venture Capital Management Inc. They all say that, as a result, they plan to be far more selective in choosing the venture partnerships they subscribe in. "Every business has cyclical peaks and valleys," says Cabot."In my opinion, venture capital is at a cyclical peak. A lot of companies and partnerships will have trouble."

The first casualties will probably be the industry's newer players, particularly those venture groups set up by investment bankers and other traditional financial institutions. At least three such funds have been dissolved in the first half of 1984, including one that had been launched by Los Angeles-based California Federal Savings & Loan Association scarcely two years before. "When [Cal Fed management] realized this was not a short-term business but a long-term business, they pulled out," says Anna Henry, who had joined Cal Fed Venture Capital Corp. just last year. "I think you'll see other institutions pulling out. A lot of people got unusual returns in the last few years, but now it's becoming clear that things aren't really that way. Venture capital doesn't fit easily with the mentality of large corporations."

But the ripples of venture capital's plunge are likely to spread far beyond the institutional funds. Some venture capitalists, in fact, fear a backlash similar to the one following the "go-go" years of the late 1960s and early '70s. That era, like the present one, had seen a spectacular boom in young growth companies, many of which went public with great fanfare. Aggressively promoted by young brokers and underwriters, these hot new issues soared briefly across the investment horizon, until the fundamental weaknesses of the companies brought them, and their investors, crashing back to earth. "There was a binge, followed by a sharp hangover, in 1974," recalls venture capitalist James Morgan, managing partner of Boston-based Morgan, Holland Ventures Crop. "There was much bloodshed and many losses. The whole structure came tumbling down."

Something like that could happen again, particularly if a significant number of the "living dead" don't survive. Indeed, it is by no means inconceivable that a series of massive failures of venture-backed companies could send a chill across the entire entrepreneurial landscape, affecting all kinds of smaller businesses, even those that might never have been candidates for venture capital themselves. After all, the rise of venture capital helped generate new interest in small, growth companies in general; so, too, its decline could have the opposite effect. To a certain extent, this is already occurring. "The number of unqualified companies going public is very detrimental to the capital markets" for young companies, notes an East Coast investment banker. "John Q. Public takes a bath, and that's bad for his willingness to buy into that market again."

But even if the worst doesn't happen, entrepreneurs will increasingly have to look elsewhere for the money and expertise that they have traditionally counted on the venture capital community to provide. That is, in fact, precisely what the managers of Microrim did after their disappointing experience with the young venture capitalists of San Francisco.

Microrim's "different route" opened up in the spring of 1983, when one of the company's Seattle-area investors introduced Ron Erickson to Gary Blauer, a young stockbroker from the Minneapolis-based investment banking firm of Dain Bosworth Inc. Blauer, himself a former software programmer, was intrigued by Microrim's R: base software program. "It was love at first sight," recalls chief operating officer Kent Johnson. "Gary didn't come off as arrogant.He knew what he wanted to do, and took time to understand what we were doing. There was an immediate sense of partnership that I never sensed with the VCs."

Prodded by Blauer, Dain Bosworth eventually raised $7.8 million for Microrim in two separate private placements. The money has allowed Microrim to market aggressively its R: base product family. Meanwhile, the company's founders and employees still control more than 45% of the company's stock -- two to three times the percentage they would have controlled if they had gone the venture capital route.

Microrim also managed to find the "intelligence equity" it was seeking -- in the person of Larry Mayhew, a 22-year veteran of Tektronix Inc., the Portland, Ore.-based instrumentation company. As luck would have it, Mayhew had left Tektronix in November 1982 in order to become president of Data I/O, a leading manufacturer of programmers for silicon microcircuitry, which was located just 10 miles from Microrim, in Redmond, Wash. As president of a fastgrowing company, and a man experienced in running a billion-dollar corporation, he offered Microrim's young management team a cornucopia of battle-tested wisdom and contacts. Mayhew, for his part, was intrigued by the opportunity to get involved in the burgeoning software business, and accepted a seat on Microrim's board for an option to buy 20,000 shares of company stock, less than 1/2 of 1% of the company.

"It's an almost ideal situation," says Kent Johnson."We have the money, we have the people, and we have the product. We also have a guy with great experience and insight who can give us all the counsel we could never get from a venture capitalist. And we still have control of the company. It just shows that it's possible to grow without having the VCs get their screws into you."

To be sure, other companies may not be as fortunate as Microrim, but then there are those who would argue that they might be better off without a lot of venture capital to assuage their growing pains. "Too many start-ups we've seen over the years started with too much money," says George Tate, co-founder of Ashton-Tate. "The key thing is you have to go through the pain. If you sense pain in the beginning, the chances are you won't have to deal with it later. We learned to be careful with everything in the beginning. If some VC just handed us $5 million, it would have sucked the blood out of us. The only way to stay focused is pain -- and not being able to make the rent if you screw up."

In the future, that observation may apply as well to companies that have already received venture capital. Consider Linear Technology Corp., a semiconductor microchip company launched in 1981 with $4.5 million in venture backing. A year ago, says Linear Technology president Bob Swanson, he sometimes had difficulty convincing managers of the need to control costs. With millions of venture dollars in the bank, and millions more apparently available on request, thrift seemed like an unnecessary frill. But with the collapse of the IPO market, and many venture-backed companies in deep trouble, all that has changed. "People around here now realize that whatever money is sitting in the bank may be all there is for a long time," says Swanson. "There's no substitute for squeezing the nickels and dimes. It's hard to get people to batten down the hatches when the sun is shining and the pot seems bottomless, but it all comes out in the wash. The guys who spend lavishly will go under, and those who spend carefully will survive."

Much the same might be said for the venture capitalists themselves. While the newer firms begin to fade, some of the more traditional venture capitalists are pulling in their horns. Sevin Rosen Partners, for instance, plans to make fewer new investments this year than in the past. "We're holding up for a while," says general partner L. J. Sevin. "We just aren't going to be seeing as many new faces. We have a lot of work to do with the companies we already have."

"There's a time to reap, and there's a time to sow," echoes Alan Ruvelson of Minneapolis-based First Midwest Capital Corp., who has been in the venture capital business for a quarter century. "Maybe this is the time to plant seeds and get through the long winter. The opportunities are still there at the end of the cycle. Survivorship never has been easy, but that's the way this business has been from the beginning."

So, in the long run, the venture capital industry may yet emerge from its Big Chill stronger than ever. It will, that is, if venture capitalists follow Sevin and Ruvelson, put their shoulders to the wheel, and return -- in the words of General Doriot -- to the business of "building men and companies."

Last updated: Aug 1, 1984




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