By now anyone with more than a passing knowledge of business and finance knows that venture capital is "hot." Venture capitalists raised more than $900 million in fresh capital during 1980 alone and invested more than $1 billion in new or growing companies during the same year. No one connected with the venture capital community expects the pace to slacken during 1981 or in the immediate future.
Does this mean that the heralded "decade of the entrepreneur" is indeed upon us? Are the possibilities for seed money and growth financing of small business unlimited? And if not, what limits do exist? To find out, INC. spent several weeks talking with leaders of the venture capital community across the country.
Venture capital is a highly personal business, where profits are made as much from correct gut feelings about a company's prospects for success as from painstaking analysis of financial ratios. So while it's fair to say that there is such an entity as an organized venture capital "community," at least among the 50 or so largest, most active firms (see table, page 66), the group does not speak with one voice. But a clear consensus does emerge on some points:
* A lack of experienced venture capital fund managers who can identify promising investments will be the most important constraint on the growth of the business in the years just ahead. Despite the increased flow of funds into venture capital, there may be no significant increase over the 4,000 deals funded per year that is the current average. So, despite its present affluence, organized venture capital will have little impact on the expansion capital needs of the vast majority of small businesses (see box, page 60).
* The increased flow of money into the venture business, however, will continue unabated for several years, barring a major catastrophe in the overall economy. Institutional investors, particularly pension funds freed from past legal shackles, are impressed with venture capital's track record as a hedge against inflation during the past decade and believe the rewards of participation will continue to outweigh the risks. Foreign investors, too, are increasingly interested in entering the U.S. venture market by investing through established firms.
* Stable, long-term public policy commitments to venture capital, particularly support of federally licensed Small Business Investment Companies, are a must. After a decade of smooth growth and increasing success, the SBIC program is currently in a holding pattern while the Reagan Administration and the new administrator of the Small Business Administration, Michael Cardenas, review their options.
* Further capital gains tax relief, including the possibility of establishing different rates of tax on sales of "new" investments, remains a critical element in the continued strength of venture capital.
* The booming market for new public stock offerings, both fueling and fueled by venture capital, has enticed an unprecedented number of would-be entrepreneurs to strike out on their own. Many are experienced managers from big technology-based companies. As a result, there are more good ideas to choose from today than at any previous time in the history of the business. But experienced venture capitalists worry that too many deals are being made too quickly, and at too high a price to the investor. The result, some feel, will be a bursting of the bubble, leading to another contraction similar to that which the industry suffered in the mid-'70s. In their minds, venture capital will remain a cyclical business, and many of the "fool-proof" investments of today will suffer through some lean years before the real winners are sorted out by the market.
While all five of these factors will probably affect the future of venture capital, who's available to call the capital investment shots is the critical issue. Venture capital is the ultimate management-intensive business, requiring hundreds of hours of study before making a deal, and an even greater commitment of managerial time after it's made. Walter Stults, president of the National Association of Small Business Investment Companies, estimates that there are no more than 3,000 people managing organized venture capital today. Craig Burr, a 10-year veteran of the business and a partner in the Bostin-San Francisco firm of Burr, Egan, Deleage & Co., puts the number far lower. "I'd say there are about 25 mainstream firms, and maybe 150 people with outstanding track records in the business right now," he maintains. What this means is that there are only so many people with only so much time to evaluate prospective investments and sit on the boards of companies in the venture fund's portfolio once the deals are made -- not good news for needy small companies.
Nor is hiring freshly minted M.B.A.'s the immediate solution. Says Burr, "How can I tell the president of a highly successful, fast-growing company that I'm turning my seat on his board over to somebody one year out of Harvard? Is that supposed to be an example of the kind of wisdom and insight venture capitalists can provide?" Good judgment, as any veteran in the business will tell you, is the key to success in the business. "And the only way you acquire good judgment," says Dan Cronin, general partner of Ampersand Associates, a Boston venture capital firm, "is to exercise bad judgment and get burned a few times."
One of the reasons for venture capital's current heady successes is the good judgment men like Burr and Cronin learned while slugging their way through the near-dormant mid-'70s. The period between 1972 and 1978 may someday be remembered as venture capital's years in the desert. After a heady adolescence in the late '60s, the business almost disappeared from public view after the bull market of 1968-69 went into eclipse, taking with it the new-issues market that had buoyed the venture business.
Of course, venture capital didn't disappear. Many of the venture high-fliers of the late '60s were busy "working out" their deals. Morton Collins, current president of the National Venture Capital Association and general partner of DSV Associates, a venture firm in Princeton, N.J., recalls the era. "I formed my partnership in 1968," he says, "raised several millions, and went shopping for deals. At the time, a more experienced gentleman in the business said to me, 'Now's not the time to invest. Deals are too expensive. Wait till it cools.' But I went ahead and plowed money into good-looking propositions. Things soured in 1970, and I spent the next five years working them out. By 1975 I had gotten back to zero."
Collins and his peers have no difficulty identifying the primary reason for venture capital's slump. It was the increase in the capital gains tax from 25% to 49% in 1969. Since at that time almost all venture financing came from wealthy individuals, who had little desire to pay twice as high a tax on their gains, many of the venture money sources simply dried up. The 1973-74 stock market slump and subsequent recession merely added to the bad news.
More than mere coincidence ties venture capital's comeback to the decrease in capital gains taxes from 49% back to 28% in 1978. (Not to mention the distinct possibility of a further reduction to 20% in the near future.) The ability of public policy to direct capital to a specific sector has seldom been more clear. Future policy toward Small Business Investment Companies is just as important an issue today.
SBICs were created by act of Congress in 1958. They were meant to fill at least part of an "equity gap" for small businesses identified by a Federal Reserve report presented the same year. After more than two decades of experience, it's safe to say that, in part, they have fulfilled their mission. "We're the ultimate supply-side industry," says NASBIC president Stults. "Show me another government program that has done so much for business at so little cost to the taxpayers." On the evidence, one has to agree. During 1980 approximately 350 SBICs invested $295.2 million in more than 2,000 small companies at a net cost of approximately $2.5 million to the government. The latter figure includes about $1.5 million in defaulted loans, a figure consistent since the beginning of the program. Of more than $3 billion invested in more than 40,000 small companies since the program began, a mere 1% -- barely $30 million -- has been lost by the federal government. And there are secondary benefits as well. A 1980 Arthur D. Little study of SBIC investment recipients showed that a permanent new job was created by every $6,000 invested.
SBICs are licensed by the federal government and allowed to borrow money at favorable government rates through the Small Business Administration. Once an SBIC has $500,000 of private capital committed, it can leverage that amount by borrowing up to four times the private commitment. Thus, with its government loan backing, an SBIC can afford to invest in many companies that traditional venture capitalists, who need to show an eventual return of 30% to 40%, dollar for dollar, on their investment, cannot or will not touch.
All is not happy on the SBIC front today, however. From the mid-1970s until this year the availability of leverage capital was never a problem. Now it is -- at least potentially. "It was an evergreen money tree," says Stults. "Any well-managed SBIC could count on loan approval within a month to six weeks." That sort of stability was critical to SBIC managers, who could commit all of their private capital to investments knowing that they could borrow an equal amount from the SBA to make further investments.
Stability suffered a setback this spring, however. The Reagan Administration proposed cutting back the SBA's loan pool to $145 million per year, a far cry from the last Carter budget's allotment of $190 million for the same period. SBICs with deals ready to go suddenly found their primary source of funds uncertain. Michael Cardenas, the new head of the SBA, imposed a freeze on all licensing approvals while he studied the program along with all other SBA operations. The freeze sent a shock through the SBIC community. While the freeze had been lifted by mid-summer, and it appeared that the SBA loan program would have about $160 million to disburse both this year and next, the program suddenly was less certain of its own future. "We feel we can live with a one-year squeeze," says Stults. "Many of the older SBICs have been through an investment cycle, have cashed in, and are liquid. But if our leverage didn't increase for a long time, or if the opportunity to cash in disappeared because the new-issues market soured, there might be trouble."
Stults and others in the SBIC community hope that, in time, the Reagan Administration can be made to see the great benefits they believe SBICs bestow on business, employment, and the economy in general, and that the Administration will sharply increase he level of funding. Or, if Reaganomics proves disastrous, and a new recession occurs, perhaps, Congress will go back to its old spending ways and water the money tree again. For now, though, there's a disquieting pause in the middle of an otherwise healthy trend.
Or is it healthy? Far from crowing about the flood of money into venture capital today, many old hands are unabashedly nervous about the phenomenon. They look back on the lean years of 1974-75 as the time when really good deals were made by sharp investors. Says Stan Golder, for years the head of venture capital for First Chicago Corp. and now general partner of his own firm, Golder, Thoma & Co., "We made a lot of good deals in '74 and '75, because the entry prices were quite low. Most of those companies have turned out to be big winners, for us and for the entrepreneurs who had the courage to start them." How profitable the deals will be that Golder and his fellow venture capitalists are making today won't be known for some time of course. But almost everyone concedes that the current surge has put added pressure on the deal makers. "The competition isn't necessarily among ourselves," says Craig Burr, "but against the public market. The deals we did five years ago can now go public at a much higher price. Five years ago my partner Bill Egan took four months to make up his mind about Federal Express. Now we have to analyze a proposal and reach a decision in three to four weeks. Otherwise we lose it by default."
Dan Cronin backs up part of Burr's claim. "I've seen companies we rejected because we didn't think they were good enough turn around and go public at high prices within a matter of months," he says. Morton Collins doesn't even want to get involved in the race. "If someone tells me that the only way to do a deal is to do it in three weeks," he says, "then I just won't do anything." Collins hasn't made an investment in more than a year, in part because he's been busy raising more money but also because he believes that "it's almost axiomatic that when it's easy to raise money it's the wrong time to invest it. My investors have enough faith in me to sit and wait. If I didn't put a dime into anything for three years, they wouldn't say boo."
Predicting the future of venture capital, even in the short term, is almost as risky as playing the investing game itself. But it seems fair to say that the performance of any firm, much less a particular investment, must be measured over periods of years, not months. There may be, for example, one time omen for those who like to find historic precedents. The last boom period for raising money, in 1968 and 1969, preceded the seven-year slump by just 24 months. Is another shakeout in the works? No one can say for sure, but in venture capital, as in business in general, the race does not always go to the swift. Slumps are made to be ridden out and used; that takes courage, skill, patience, and financial staying power. There's more of all of them in the venture capital community than ever before.