Venture Capital After The Fall

How the dealmakers see it

Considering the late-autumn violence wrought on the stocks of public companies, from AAR Corp. on the NYSE to Zymos Corp. on NASDAQ, the portrait of precrash innocence that appears on the back page of this magazine is not likely to return for some time. The charts through September do not reveal even a suspicion of the peril that was soon to befall them.

On careful examination, though, perhaps there are some hints: the stubborn failure of the INC. 100 Index -- the fastest revenue growers in the land -- to participate in the bull market; the Dow Jones Industrials being bid up blissfully past a collective price-to-earnings ratio of 20, as if those 30 ancients were the sprinters; the month-after-month magic gains of untested initial public offerings in the aftermarket. Sure, excesses eventually get their comeuppances, as we have learned from Dutch tulips and Hunt silver and a dozen other pinpricked balloons, but what, pray tell, were investors indulging in this time to warrant the vaporizing of $500 billion in a single day? Weren't earnings expanding, wasn't there ample cash around, weren't assets solid and balance sheets sound, wasn't entrepreneurship earnest? And hadn't Wall Street's truly greedy denizens already been thrown in jail? Be justice as it may, you can't argue with the market. What happened happened, and fiscal life must go on.

Perhaps reassurance can be found among those who beget that life: venture capitalists. If it turns out that these risktakers have skulked away from the mass destruction of their own noble instruments -- shares of corporations -- one would be concerned for the underpinnings of commerce. Not only would energetic new businesses not be founded, but maturing companies wouldn't get the unencumbered money they will need to push forward from here. Nobody would be able to sell stock to a rightfully dubious public.

Let us not despair. Maybe it was only professional bravado, but one immediately encouraging sign during October's panic was that venture capitalists actually answered their phones, which was more than some over-the-counter dealers and mutual-fund managers did. And from the testimony gathered from a trio of practitioners, it would seem venture capital is relatively undaunted by the rape of stocks.

"I don't follow the market, and I don't really care what happens," proclaims Stanley Pratt, a 25-year VC veteran who is general partner of Abbott Capital Management, a venture-fund investment management firm in Wellesley, Mass. "I would say it's a little distressing," hedges Don Valentine, general partner of San Francisco's start-up-oriented Sequoia Capital, "but it will have no bearing on whether we invest or not." Adds William Hambrecht, president of Hambrecht & Quist, a San Francisco-based venture capital firm, "When emotions clear, the market will catch up with performance. If you build a growth company, the market will recognize it."

And if there's a recession? "We'll manage to handle it," Pratt promises. Venture capitalists have learned a great deal since 1982-83's indiscriminate surge in start-ups, says Pratt -- a period he calls their "silly season." One lesson was that you can't get away too long with foisting earnings- and history-less companies on the public merely to secure 40% annualized returns for a few venture partners. Not that the players ultimately deemed their royal return on investments unfair to the populace; it's that the shaky enterprises they spawned didn't endure. For example, of the 44 disk-drive companies that were funded around silly season, only about half a dozen survive today. And if October's careening equities have dictated a deep freeze in which capital spending will be severely curtailed, several of those will probably disappear.

On the other hand, Hambrecht proposes, perhaps technology is not as dependent on capital spending as people think. The new generation of technology will "force a move in product that's more important than the economic climate," he reasons. Companies will have to spend for advances in technology, because they won't dare risk forfeiting competitive advantage.

Thus unfazed, high-tech specialist Hambrecht & Quist, which has about $800 million locked up in 10- and 12-year venture pools, will continue to invest, says Hambrecht. "Prices are a lot more attractive now," he feels, "and the sources of our money aren't running away." Because of the drop, H&Q will look harder at mezza-nine financing -- a later round of equity that, because the enterprise in question is older and hence a safer bet, is usually more expensive than start-up funding. But the crash is narrowing the gap. "Now there's a chance to buy in 50% at what amounts to start-up prices," Hambrecht observes.

There will be enough money around, Pratt assures, but deals will be scrutinized much more carefully. Why not, he argues, when, as the fallout from '83 proved, fast funding leads to fast failure? Asserts Valentine: "More money than is needed to start all the companies that want to start in 1988 is already in the hands of the venture people." And it will stay in their hands, since major risk-capital sources such as pension funds can't back out of their long-term commitments. "That's why this is a stable industry -- it doesn't flee down markets," says Hambrecht.

As self-imposed as the long-haul discipline is to venture capital, nonetheless it makes little sense to nurture fragile companies, only to set them loose in an unreceptive climate. Even that prospect doesn't bother veteran venturer Valentine. "I've given up trying to be clever about the economy," he admits. "We've gone through one kind of perturbation after another -- recession, high interest rates -- and we just keep starting companies on the assumption it takes us maybe five years to get a company to any kind of scale, and there's no way for us to know what the economy is going to be like then. Our approach is just to keep grinding away, finding good people with good ideas, attacking big markets, and financing them." Pratt is equally sanguine. "Tandem Computers was started in 1974, and Federal Express in 1971 -- terrible times to start a new company. But the entrepreneurs hung in there, and convinced the venture capitalists to do it." Will venture capital "do it" after October's wholesale slaughter of equities? "The market will get back to earnings," Hambrecht predicts. "The rational question is, is the company making money and is that earnings power growing? There will be people with money to put in. They won't pay such high prices, but they will be there."

Undoubtedly that's true, but October's hasty retrenchment of risk/reward sentiment means that emerging businesses are going to receive less capital and give up more ownership than before. And venture capital is going to have to shave its usual 40%-or-so expectations. All the better, says Pratt, savoring battle within what he calls venture capital's inefficient market. (In Pratt's view, the stock market is hopelessly efficient; since every participant receives the identical information at the identical time and makes the identical decision, everyone ends up with the same results.) No matter what pressures befall an inefficient market, there can always be exceptional winners, and Pratt aims to be one: "Even if average returns go down -- which I think they will -- my portfolio is going to be better."

Presuming such prowess, how will equally clever capitalists cash in their profits, when bringing any company public at previous earnings multiples will be looked on with deep suspicion? The answer is that it doesn't matter that the IPO window has been nailed shut and boarded over, since venture capital had been resorting to other cash-out routes well before the fall. "The public market has always been less than 50% of our funding resources," says Valentine. "On average over 15 years, we've raised as much money by selling all or part of the company to corporate investors. I don't see that changing," Indeed, if there is a change, it will likely be for the better. In a recession, if big corporations cut back on in-house research and development, they may buy outright venture's seedlings instead. Pratt points to a third way out -- the leveraged buyout. Via an LBO, venture capital sells its position to the company's managers after three or four years, pocketing traditionally hefty returns.

But who's going to chance leverage these days? Wasn't the stock market saying that small companies are just plain bad risks? Responds Valentine: "It was saying it doesn't like IBM and GE and GM. When the great wits who manage big money get into a panic, they don't care whether they're selling pork chops or potatoes. They sell everything."

Ironically, what was beginning to make capital sources chary of the venture process -- the lack of liquidity within the partnership's multiyear lockup -- so far has been its salvation. Concludes Valentine, "The venture community now is the only group of long-term investors, and I see no reason to change our stance simply because some computers in New York have run amok. The source of the problem isn't in the fundametal performance of our companies, it's the lack of investors who buy companies. Instead they buy indexes, and they buy options on indexes. Computers keep track of everything, and they end up buying and selling in an unconscionable way."

Like it or not, computers are here to stay. And, in some form or other, so are futures indexes, hedging programs, and a host of similar gewgaws for The Street's well-heeled. But next time -- assuming there is one -- couldn't they leave the smaller guys alone?

Last updated: Dec 1, 1987

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