Now that process is unwinding.
"The higher valuations for small-cap stocks will encourage venture capitalists to get back into earlier-stage investments. The window is open again,' says Dan R. Garner, national director of entrepreneurial services at Ernst & Young, in Dallas. The robust market for IPOs in 1991 offers venture backers of small companies a viable exit and thus sufficient incentive to assume the attendant risk.
That gives hope not just to investors, but to entrepreneurs as well, notes Bill Bygrave, a professor of entrepreneurship at Babson College. "A healthy IPO market effectively lowers the cost of capital to start-up companies,' he says. "Entrepreneurs get a higher price for their stock and have to give up less of the company to get it.'
Bill Hambrecht, president of the San Francisco venture-capital firm Hambrecht & Quist, cites two more factors that will favor small, innovative companies: low interest rates and the failure of the debt-driven financial strategies of the '80s. "Fund managers can afford to sit out the market when they can get 8% or 9% on their money,' Hambrecht notes. "But if they do that at 3% or 4%, they get fired. If you want above-average performance, you have to look for above-average growth in earnings. And that means you have to look for small companies.'
Meanwhile, he adds, the '80s emphasis on borrowing placed a premium on tangible assets. "That was something banks were comfortable lending against.' That bias favored large, mature companies at the expense of small ones whose key resources were locked up inside of people's heads. Now in a climate of asset deflation, small, knowledge-based companies have returned to favor, and that, he says, "has brought us back to a level playing field.'
The return to a more classical form of venture capital will, meanwhile, stimulate related forms of alternative investment that languished in the late '80s, as lending grew more institutionalized. Prime among those are business angels -- well-heeled individuals who privately place their money in small companies. With funds believed to outstrip the formal U.S. venture-capital pool of $36 billion by roughly 10 times, angels tend a huge, murky pool of cash. Until lately, though, some of that money has been frozen out of the investment process. In the current climate, in which exit opportunities are improved by the newfound strength of small-cap stocks and IPOs, angels will come back. Take the case of Dick Morley, an angel based in Amherst, N.H.
In the past, as Morley's investments matured and required additional funding, he brought in venture capitalists to make early-round investments and boost start-ups to their next level of growth. By the late '80s, though, those venture-capital investors had all but disappeared. "We had no one to hand our investments off to,' he says. "This process is a food chain. And suddenly there was a missing link.'
Venture capitalists, ready to do early-stage deals again, will reappear and reforge that missing link, Morley predicts. The average annual return on the top quartile of U.S. venture capital over the past two decades was 29.3%, according to Venture Economics Investor Services. That, Morley notes, offers ample investment incentive. "The recession will someday end, companies will again be healthier, and investors will look for places to get a higher return on their money,' he says. "Venture capital has been proven to be one of the best vehicles to do that.' The process that Morley describes is the deinstitutionalization of investing, whereby angels and other nonconventional investors who create companies will be on a much more equal footing with the New York City pension-fund managers. "In the next five years venture capital -- not investment banking -- will be resurrected,' he predicts.
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The Private Equity Market
Money will find less conventional -- and eventually more liquid -- forms of investment
The rise in small-cap stocks and the resurgence of venture capital offer signs of the renewed flexibility in the financial markets to which Dick Morley alludes. Money will again search out less conventional -- and seemingly less liquid -- forms of investment. One universe money will move into is that of small, private, low-tech companies laboring quietly in the backwaters of the economy, heretofore ignored by mainstream investors. Those companies are not just overlooked; they're undervalued, says Stanley E. Pratt, managing partner at Abbott Capital Management, in Needham, Mass.
"I think we're about to tap into the enormous potential of private companies,' Pratt says. He labels the process "controlled investment' as opposed to the sort of less controllable investment that often results when a small company meets the shifting moods of the public stock markets. Pratt sees a parallel stock market arising in the private sector, offering the best of both worlds: planned liquidity for investors and, for management, a buffer from the short-term pressures of the public market's caprice. Management in those small companies -- newly infused with outside capital -- will have the time, money, and peace of mind to devise long-range plans and build equity that won't get clobbered with the first quarter that turns down, he says.
Yet an exit will exist, keeping investors and managers motivated to keep return on investment high. In fact, Pratt argues, the exit options will be varied enough to provide increased financial flexibility. "After a few years you can bring in new investors and take out the old,' he says. Alternatively, investors could take the company public for a while and cash out some of their gains before going private again to recapitalize and plan for the next phase of growth.
