Venture Capital in the 1990s
L. John Doer
General partner of Kleiner Perkins Caufield & Byers, San Francisco, a partnership noted for lead participation in major high-tech deals. An entrepreneur himself, Doerr founded a successful software company before switching to finance.
Edward J. Mathias
A managing director at T. Rowe Price Associates, Baltimore, a $30-billion multifaceted portfolio manager with more than $200 million invested in private companies through partnerships that focus on late-stage and mezzanine rounds.
Thomas B. Judge
Director of alternative investments at AT&T, Berkeley Heights, N.J. Judge administers the portion of the company's $36-billion pension fund that seeds small businesses.
General partner at Crosspoint Venture Partners, Irvine, Calif., primarily a seed and start-up investor with a $120-million capital base. Previously, Hoff was president of a successful small-business investment company.
Gregory M. Avis
A general partner at Summit Partners, Boston and Newport Beach, Calif., a diversified venture capital investor with a base of some $400 million. Before coming to venture capital, he was in corporate finance on Wall Street.
Peter C. Wendell
Founder and general partner of Sierra Ventures, Menlo Park, Calif., a firm with about $100 million invested in early-stage companies, many of which are in technology-related businesses. Wendell teaches a course on entrepreneurship and venture capital at Stanford.
Late fall, 1990. With venture capital's best-ever money-raising decade drawing to a close, Inc. invited six prominent practitioners to San Francisco to contemplate the industry's future.
The hotel suite may have been elegant, but the table setting wasn't: on it were rising unemployment, growing debt, higher taxes, lower stock prices, and a host of other economic worries. To make matters worse, the venture capital industry itself, long accustomed to easy annual returns of more than 20%, had suffered some stinging reversals.
Few of the country's small businesses are launched through professional venture capital anymore, and multitudes succeed without it. So who needs all this confounded deal making, anyhow? The system does. Shrinking venture dollars and poorly performing venture-backed businesses -- should those be the conditions we have in store for us -- will sap investment enthusiasm across the board. By the same token, expansion of venture capital at even a modest fraction of its 1980s rate would embolden entrepreneurs and backers of every stripe.
In a session moderated by senior writer Robert A. Mamis, these financiers thrashed across fresh and revealing ground as they considered a variety of causes and effects that might indicate which road we are going down.* * *
INC.: As we talk, the overall economy is falling into disrepair. What are the current prospects for a small-business person hoping to start a new company?
DOERR: It's the kind of economic climate that allows you to get going without competitors' being ready to rip your throat out by starting a business just like yours. There's never been a better time than now to start a new company.
MATHIAS: I don't know that there's never been a better time. Let's say this seems a good time. But it's not the same as when those big returns that people talk about today were achieved. Those were made from seeds planted during the late '70s, when there were major new technologies and much less competition, the people starting new businesses were highly experienced, and private companies were less expensive than comparable public companies. Now you have a quite different situation: few major new technologies, intense competition for good deals, and attractive private companies that are more expensive than public ones.
INC.: Did venture capital run out of good ideas to fund?
WENDELL: That there's nothing to fund anymore is a common misperception. As the amount of venture capital available to entrepreneurs has grown, the range of opportunities that venture capital has focused on has gotten much, much wider. Almost half our current fund is in technology-related service businesses, and over the past six years we've done six environmentally related companies.
INC.: There's been a huge increase in institutional money going into public companies over the past decade. Can we assume that the pool of risk capital for private companies is dwindling?
HOFF: Not yet -- but it probably will be soon. The total venture capital pool has grown every year since '78, from $4 billion to $34 billion. I expect that growth will come to an end in 1991, and that available capital will shrink for several years after. The decline should be gradual and will likely stabilize in the mid-$20-billion range -- still quite a robust number.
AVIS: Frankly, I'm puzzled by all the gloom and doom. Venture capital is reaching maturity like any industry. What happens when an industry reaches maturity? Growth rates slow, competition increases, consolidation ensues. It's a natural evolution of any industry. There's no reason for us as venture capitalists to think we're immune from natural market forces. Overall, the long-term outlook for the survivors is quite positive.
INC.: But aren't venture funds facing returns of zero -- and less?
MATHIAS: That's not true for all venture capital funds. But there is a "lost generation" of funds, largely those started from 1983 to 1987, whose returns probably will be negative in the end. Those results already have begun to affect capital commitments adversely. It's possible there will be a significant shortage of capital. Let's hypothesize that we're going to have a relatively slow IPO market and that exits in any form won't be easy. There were 1,500 or so early-stage financings in 1989. All those companies will need three, four, or possibly five times the amount of their early-stage financings. This represents a huge potential need for capital -- around $10 billion to $15 billion. As of now, it's hard to identify where it will come from.
DOERR: If there's a need for capital in given sectors of industry, the rates of return for those sectors will go up. There probably would be a lag, but they'll be able to get money.
WENDELL: Large pools of money contributing capital to the venture area see it as an asset class and part and parcel of a portfolio, so they're willing to accept a fairly long time horizon, given that their performance expectations remain intact.
INC.: Maybe so, but surely there's a floor on the return a limited-partner contributor such as AT&T expects from its commitment, below which the risk and illiquidity just aren't acceptable.
JUDGE: We do look at it from the point of view of what we expect from stocks, bonds, and other asset classes, but if we're going to accept the illiquidity of venture capital as compared with the public markets, of course we have to have a higher return. For many years now we've expected a return 50% higher than we expect for stock. Our capital-market assumption on stock is 12%, so we expect 18% from a venture capital investment.
MATHIAS: But can you assume this is a normal cycle and we're going back to business as usual? The new-issue market has been very disappointing. Here's a damning observation: a large number, I'd say more than half, of venture-backed new issues since 1983 are under water today. That's bound to take a toll on venture capital investment, because it doesn't so much have to do with how the IPOs were priced initially, but that most venture-backed companies didn't deliver their promised growth.
INC.: There's an accusation that venture firms don't stand behind business ideas long enough -- and that venture capital is an inefficient launcher of companies.
JUDGE: That's another knock on venture capital. Go back over the '80s and see how many employees were laid off and eased out by the Fortune 1,000 versus how many jobs were created by venture capital -- and don't forget, the reason we invest is to make money, not to create jobs. Creation of jobs is a fortunate by-product. If venture capital hadn't created those jobs, we probably would be in a deep recession right now.
INC.: If there's about to be a capital squeeze, shouldn't smart new companies be concerned right now?
WENDELL: Companies just now obtaining venture capital ought to make sure the fund they're obtaining it from has sufficient reserves. If there's not going to be an IPO takeout, it's important that the fund has deep enough pockets to go the distance with the company, because there may not be other options. Any entrepreneur who takes money from a venture fund without checking out that fund and talking to other CEOs whom that fund has backed deserves what he gets.
INC.: Certainly start-up entrepreneurs are past the blind-faith stage by now.
WENDELL: Oh, sure. They're checking us out as much as we're checking them out.
DOERR: Right. Five years ago this was strictly a buyer's business.
INC.: If the economy foundered for a while, wouldn't you run out of exit strategies? With IPO windows closed, doesn't venture capital get defensive?
HOFF: Granted, right now it's a bad IPO market. But IPOs were going out at P/Es of 30 before the Iraq crisis hit. I wouldn't agree that 30 was the right number, but I wouldn't say that 8 is, either. Bad IPO markets affect the price at which we invest in companies more than the amount we invest. Building companies requires a long-term perspective -- maybe a couple of years to develop the product and two to four years more to build enough sales to qualify for an IPO. A new company in which we invest today has three to six years to an IPO. Therefore, today's stock market simply doesn't matter. Anyway, there's still a Fortune 1,000 out there that continues to buy companies year after year. Historically, that's been the best exit route.
AVIS: And foreign buyers continue to be interested in attractive young companies.
DOERR: The point is, when you build a company of value, somebody will want that value.
WENDELL: If a company is making money and throwing off cash, who cares if it takes another 18 months? If you don't have negative cash flow, you're willing to wait.
JUDGE: You don't rush to the IPO market just because you think limiteds like me want you to. And if you can't find a deal this month or this quarter, you don't do any.
INC.: But isn't the pension portfolio that you direct expected to perform under any conditions?
JUDGE: It is performing the way we expect it to perform. Our return on venture capital right now is only about 7% to 8%. But our portfolio is a very young portfolio. On a weighted basis, our partnerships are only about four years old, so I expect our returns to be very low. Granted, we'll have to see some good returns in the future to pull them up.
INC.: Has the ratio of deals seen to deals funded decreased since the early '80s?
DOERR: Speaking for Kleiner Perkins, it's been the same for the past 10 years. We receive 2,000 proposals a year, and we look seriously at 100 of those and end up investing in 12 new companies.
HOFF: Crosspoint looked at about 1,000 start-up deals in 1990, and out of them we'll probably make 8 investments.
INC.: What are the characteristics of the 99.2% that failed?
HOFF: In most cases, it's just another company, a clone of what's already out there, or it's in a slow-growth market, or it doesn't fit our start-up investment focus.
INC.: Not to make a moral judgment, but doesn't it bother you to some degree that so many fail to get capital?
MATHIAS: The sheer number of companies that do get started speaks for the vibrancy and efficiency of the system. Most new businesses are local situations that never come to the attention of the venture capital community.
AVIS: Well, some do -- companies that have been initially financed by sweat equity or credit cards or rich uncles. By the time we see them, their founders have been toiling at it for two or three years and have achieved $2 million, $3 million, $4 million in revenues and haven't even paid themselves along the way.
WENDELL: You can take what appears to be an everyday, mundane business, give it some venture capital, and dramatically boost its fortunes. It becomes supercharged within its industry because the capital differentiates it so much.
For instance, we did a deal for a technical temporary-help company. Now, temporary help is not an industry venture capitalists have been all over, but our substantial capital markedly changed the company's growth rate. Corporate America is downsizing, trying to outsource everything it can, and contract labor is becoming much more popular. Suddenly here is one well-financed source of technical temporary help among a whole bunch of ma-and-pa companies, and the ma-and-pas were left way behind. That company has since gone very far and has yet to face a major competitor.
MATHIAS: A venture round would also dramatically change the way a company is managed. And that has a lot of implications, some potentially negative for the entrepreneur or sole proprietor.
Loss of control is at the top of the list. When you accept sophisticated venture money, in one way or another you lose some control over your company and give a role to active, forceful people. Entrepreneurs are often surprised that they have to make this trade-off to attract capital.
WENDELL: But it's not an unreasonable trade-off. The way we make deals, the founder owns a chunk of the company and wants it to be valuable as much as we do. In the case of the temporary-employment company, we worked with the founder, first to identify good people to put on the board, then, over a two- or three-year period, to bring in some senior management under him. Finally, we decided with the founder that he would become chairman, and we got a top guy out of Kelly Services to come in and run the thing.
INC.: The founder was eased out.
WENDELL: Not at all. In fact, our original understanding with this particular founder was that he would serve as CEO for a shorter time than he actually did.
DOERR: Here's how lots of entrepreneurs can get their businesses started without professional venture capital: equity funding from angels. A study from the SBA just came out that says there's another $55 billion flowing from individuals into start-up companies. That's a staggering number: 13 times our $4-billion-a-year rate of investment!
INC.: Then is professionally managed capital losing its importance?
DOERR: I doubt it. There's often a lack of understanding of how much money it takes to grow a substantial business. In that $55 billion, you have neighbors funding neighbors, thinking they can do the next Apple Computer for $300,000. We often run into companies that have started with individuals' monies, and they get to the point where they're at a stage of product development but the angels have no more capital to invest.
MATHIAS: And a lot of this has happened at a time when the tax laws have not been conducive to starting companies. The '86 tax act really said debt is better than equity.
INC.: Will lowering capital gains really do anything to spur capital growth? Doesn't $55 billion from wealthy individuals suggest it doesn't matter, that they'd have invested anyway?
HOFF: You can't tell me that the billions that came from individuals wouldn't be much, much larger if they weren't looking at putting out an illiquid, long-term investment at no tax advantage over keeping it in a bank at the CD rate.
MATHIAS: It's incontrovertible: money follows tax policies. The elimination of the capital gains differential has clearly been detrimental to venture-related activity.
DOERR: We desperately need more capital formation. Until very recently, this country has been relying on an influx of foreign capital -- which I welcome. But we have to reduce -- I mean, eliminate -- the deficit. Stop spending and use the peace dividend to balance the budget. And we have to encourage savings. The interest you get in a savings account in Japan up to 5 million yen is tax-free. If you look at America's global competitiveness, it's a bleak picture.
INC.: In the end, maybe all this is a tempest in a teapot. Just how significant an economic force is a few billion dollars of venture capital, anyway?
WENDELL: To put it in humble perspective, the entire venture industry's total annual investment in new and existing portfolio companies is less than a single year of IBM's R&D budget!
DOERR: When you consider that $4 billion per year of venture capital is not even one-tenth of a percent of the $5-trillion U.S. economy, it's hardly worth a mention. But think of it as a pilot light under that economy, and the balance changes: less than $100 million in total was required to ignite Apple, Genentech, Lotus, Sun, and Compaq.
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