Would you invest in venture capital? Would you advise your grandmother to? If so, would venture capitalists want your money? For at least a decade, the answer to these questions has been no. That situation may be on the verge of change.
Since their heyday in the early 1960s, venture capital companies have shunned Wall Street, and vice versa. Today only 22 venture firms are publicly held -- less than half the number 20 years ago. The others either went private, liquidated, or merged with companies in which they had invested.
Last year, though, two formerly private capital companies -- including Heizer Corp. of Chicago, the nation's largest in assets -- swam against the tide and went public. This year, a Merrill Lynch & Co. Inc. subsidiary is going a step further: It's establishing a brand-new venture capital fund and taking it public from the start. Assuming Merrill Lynch attains its goal of raising $60 million, the venture fund, to be called ML Venture Partners I, L.P., will enter life as the third largest public venture fund in the country.
What accounts for this seeming about-face by the venture capital industry is a law that Congress passed a year and a half ago: the Small Business Investment Incentive Act of 1980. Venture capitalists had lobbied long and hard for the law, claiming that it would improve the ability of innovative small businesses to raise capital for growth.
Before this law was passed, publicly held venture capital companies were regulated as though they were mutual funds. Under the Investment Company Act of 1940, for example, when an investment company acquired more than 5% of a portfolio company's stock, the two became "affiliates," and all transactions between them became subject to the scrutiny of the Securities and Exchange Commission. This never bothered the mutual funds, which maintain well-diversified portfolios and rarely buy a very large chunk of another company. But it greatly hindered venture companies, which generally acquire substantially more than 5% of the companies they invest in and can't afford to wait for SEC approval of every transaction.
The new law eliminates this hassle. A public venture company now can declare itself a "business development company" (BDC), a new legal entity which, among other things, may bypass SEC inspection on certain transactions.
All is not smooth sailing ahead, though. In going to Wall Street, venture capitalists must submit to the judgment of the market, which can be harsh.Heizer, for example, went public at $17.50 a share last May; its price then slid steadily, until in mid-March it was selling for about half of that. Such a record doesn't encourage other potential venture company founders.
If any venture firm represented a credible prospect on Wall Street, the honors seemed to belong to Heizer. It had turned an initial capitalization of $81 million in 1969 into stockholders' equity of $271 million in December 1980, in addition to $65 million in securities and cash distributed to stockholders, measuring its investments at market value. Its decline may be due largely to the state of the market in general, which started to turn bearish just after the Heizer offering.
But Heizer's showing has reawakened doubts about whether the public has the patience to assess a venture fund's prospects and await a payoff many years hence. The market's well-known preoccupation with short-run performance can wreak havoc with a venture fund's price during the years its investments are gestating.
"The public market operates on price-earnings ratios," says Morton Collins, president of the National Venture Capital Association and partner of DSV Management in Princeton, N.J. "The market has not said that venture capital is a great thing to do."
But Ned Heizer, chairman and president of Heizer Corp., thinks the market eventually will raise its valuation of venture stocks. "BDCs are still new," he says. "Anytime you do something new or different, it takes a while to educate people about it. It may take five years for the market to learn what good investments BDCs are.
"When the stock market is lousy, as it is now, people get scared and want to move into something safe. BDCs are pictured as highly risky investments. But I think out business is one of the least risky. We invest in young, well-managed, innovative companies. Since they have low penetration in their markets, they can be growing like crazy in their particular niche even if their market in general is going to hell. What's risky at a time like this is to buy the stock of some big, mature company."
The new Merrill Lynch fund isn't worried about a possible aftermarket embarrassment: Though publicly owned, it is not anticipated that a public market will develop. The fund will be structured as a limited partnership. According to the prospectus, Merrill Lynch will provide investor services to assist limited partners who want to sell their units.
One prospective BDC founder disagrees with this approach. He is Leo A. Weiss, president of Business Development Corp. of America in Alexandria, Va. "I would prefer to organize my fund as a stock company, not a partnership," Weiss says. "For the investor, better to have even a poor market than none at all. Besides, with a stock company, if the value of the shares falls, then the investor who believes in the company's prospects has the opportunity to purchase additional shares at a favorable price." But Weiss concedes that the kind of offering he makes will depend partly on what underwriters are willing to handle.
A question more fundamental than liquidity, as far as potential venture capital investors are concerned, is whether their fund will land successful ventures at all. Some in the industry think there's already too much money chasing too few deals.
"I think there's adequate capital available at this time from private sources," says Collins. "If you doubled the capital available, I doubt whether you'd bring out any more entrepreneurs than now."
Ned Heizer disagrees. "Opportunities abound," he says. "From the country's standpoint, there's very little venture capital being invested now. And there's a limit to how much money institutional investors will want to put into private, illiquid investments. So there's an important place for public venture capital firms.
"The real constraint," he continues, "is in venture capital companies themselves. There are too few people with experience managing venture investments. The ones with experience have all the money they can handle."
Whether the shortage is of new companies or of venture capital managers, Collins warns that new BDCs might not be such a smart play for unsophisticated investors. "Small investment banking firms could raise money for BDCs easily and then run them out of their back pockets -- that is, they wouldn't give the fund the attention it needs, and the investments wouldn't perform the way they would for a professionally managed venture firm. If some less savory characters take the public for a ride on BDCs like this, then five years from now we'll see the SEC stepping in with new restrictions on public venture firms, undoing what this new law has accomplished."
BDCs may yet, as one business publication suggested, "open wide the money spigot for new enterprises hoping to follow in the footsteps of Control Data, Digital Equipment, Federal Express, and other storybook successes that were nurtured with venture capital." But the verdict is several years off.