Panel IV: Capital Markets and New Technologies

Introduction

Kenneth Flamm

University of Texas at Austin

Dr. Flamm set the stage for the panel by raising three questions about the relationship between capital markets and the Advanced Technology Program (ATP).

Market Imperfections

When one thinks about the ATP, there are two kinds of market imperfections that might justify government intervention into the marketplace. The first, which was discussed extensively in the morning session, is imperfections in the market for research and development (R&D). This often is referred to as the "appropriability problem" in R&D, whereby the investor in R&D does not fully capture the ensuing economic benefit. In other words, the social return to R&D investment exceeds the private return.

As he understood the ATP, Dr. Flamm said that this was the original intent of the program, that is, to foster investment in precompetitive generic technologies in areas in which the ATP's framers believed social returns would exceed private returns.

Imperfection in capital markets is the second market failure that the ATP might address. Joshua Lerner from Harvard Business School will talk about the role of venture capital in capital markets. On the basis of his familiarity with



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--> Panel IV: Capital Markets and New Technologies Introduction Kenneth Flamm University of Texas at Austin Dr. Flamm set the stage for the panel by raising three questions about the relationship between capital markets and the Advanced Technology Program (ATP). Market Imperfections When one thinks about the ATP, there are two kinds of market imperfections that might justify government intervention into the marketplace. The first, which was discussed extensively in the morning session, is imperfections in the market for research and development (R&D). This often is referred to as the "appropriability problem" in R&D, whereby the investor in R&D does not fully capture the ensuing economic benefit. In other words, the social return to R&D investment exceeds the private return. As he understood the ATP, Dr. Flamm said that this was the original intent of the program, that is, to foster investment in precompetitive generic technologies in areas in which the ATP's framers believed social returns would exceed private returns. Imperfection in capital markets is the second market failure that the ATP might address. Joshua Lerner from Harvard Business School will talk about the role of venture capital in capital markets. On the basis of his familiarity with

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--> Dr. Lerner's work, Dr. Flamm anticipated a discussion of the information asymmetries that venture capital addresses, that is, the ability of venture capitalists to better assess and monitor technology investment opportunities than other financial institutions, thereby addressing underinvestment in technology. Dr. Flamm pointed out that the capital markets and appropriability issues are completely separate. In the presence of perfect capital markets, there still may be underinvestment in R&D because of appropriability problems. An interesting aspect of Dr. Lerner's empirical work is that it shows the ways in which venture capital addresses imperfections in capital markets, but it also shows that venture capital does not address all imperfections. Indeed, Dr. Lerner's work suggests ways in which venture capital may create new problems in capital markets. A question for the ATP is whether the government should take aim at areas in which capital market imperfections result in insufficient R&D investment, and then unleash the ATP policy apparatus at identified target areas. Dr. Flamm expressed hope that Dr. Lerner would address this. Terminological Confusion in the ATP In the ATP, terms such as small firms, small start-up firms, and high-technology firms seem to be used interchangably. Dr. Flamm said that these are really different populations with small areas of intersection, but that the failure to understand this leads to confusion. For example, small firms often are portrayed as if they were all high-technology start-ups, which is not the case. Dr. Flamm suggested that panelists be clear about the type of firm or firms that they were talking about in their remarks. Definition of High-Technology Firms Dr. Flamm also suggested that we should be careful about defining high-technology firms, asking whether it is accurate to identify R&D only with high-technology firms. There are many products in the economy that use high-technology in production or distribution, but these firms would not necessarily be characterized as high-technology firms, and many such firms do not conduct much, if any, R&D. Dr. Flamm recalled a recent Wall Street Journal article describing an Internet furniture start-up that a venture capital firm was considering funding. Such a firm probably is not what we think of when we talk about high-technology firms or R&D-intensive firms. The firm uses advanced technology, but R&D, and incentives to invest in it, may not be an issue for this firm. Dr. Flamm asked panelists to distinguish between high-technology or R&D-intensive firms and firms that are users of R&D and high-technology components.

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--> Venture Capital and the ATP Joshua Lerner Harvard Business School Dr. Lerner said that his plan was to address many of the issues that Dr. Flamm mentioned about the connection between venture capital and public policy. His talk would focus on public venture capital, or public programs to fund innovative start-up programs, and the venture capital sector more generally. Dr. Flamm noted that his research has been conducted with his colleague at Harvard, Paul Gompers, and includes large-sample analysis and case studies. For today's discussion, Dr. Lerner planned to concentrate on the case studies. In setting the stage for the case studies, Dr. Lerner first characterized what venture capital is. He defined venture capital as the subset of all the money that is available for entrepreneurial companies; it is an organized pool of funds managed not by people who provide the money (which typically are pension funds), but by people with some expertise in high-growth areas. These funds take an equity stake in the companies in which they invest. There is very much a "venture cycle" in which the General Motors Pension Fund or the Harvard Endowment provides funds to venture capitalists, who then provide money to the start-ups—the Netscapes or Genentechs of the world. The U.S. venture capital business has become the envy of the world, but it is worth underscoring that it is a very young industry. The first venture capital fund was not established until immediately after World War II and it remained a sort of boutique industry through the 1970s. Very recently, venture capital activity has overwhelmed earlier investment levels, rising to an estimated $15 billion to $20 billion in the United States in 1997. Role of Venture Investors A crucial point to keep in mind when thinking about venture capital, Dr. Lerner said, is that funding is often the least important thing going on when all other aspects of financing are taken into account. For a start-up company, the entrepreneur is usually one of the few persons in the world, perhaps the only one, who fully understands the technology. A traditional financial institution may not have sufficient expertise to understand the technology and its market potential. Venture capitalists employ different strategies to address this information problem, from sitting on the board of start-up firms to structuring other sophisticated financing packages. These strategies enable venture capitalists to acquire information about opportunities and problems, something that other financial institutions are not well equipped to do. On the basis of available evidence, namely, that, over time, venture-backed firms tend to outperform similar firms not backed by venture capital, it appears

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--> that venture capitalists fulfill a useful role in the finance and innovation system. Taking the biotechnology industry as an example, this industry has created between 1,500 and 2,000 firms since its start in the early 1970s. Approximately one in three has received venture financing. However, the one-third of biotechnology firms that have received venture financing dominates most measures of innovation in the industry, from number of drugs approved to patents issued. Role of the ATP Given the unique niche that venture financing fills in the financial world, Dr. Lerner and his colleagues turned to the question of where the ATP fits. As noted earlier, his research includes empirical work and case studies and today his remarks would focus on the case-study results. One lesson from the case studies is that, if a goal of the ATP is to assist companies on the path toward commercialization, policy makers should examine whether companies being funded have the potential to attain commercial success. Having done field research on the ATP and the Small Business Innovation Research (SBIR) program, it becomes apparent when talking with ATP and SBIR firms is that there is a clear bifurcation among firms. Some firms view the ATP or SBIR award as a bridge toward commercialization and perhaps an initial public offering (IPO). Others see themselves as contract R&D companies, with the ATP or SBIR grant as a way to conduct research and perhaps license it to others, but not as a vehicle to broader product success in commercial markets. It is questionable as to whether some of these companies would ever be fundable by venture firms. A second lesson is that venture financing is very heavily targeted. Since the early years of the venture capital industry, approximately 80 percent of venture funds has gone to information technologies (computer hardware and software) and the life sciences. There is a much broader range of technologies, such as advanced materials, but venture financing has not focused on them. Today, the venture industry appears fixed on finding the next "whatever.com" at the expense of less fashionable technologies that are nonetheless promising. Public programs may therefore alleviate the tendency of the venture industry to concentrate on a narrow set of technologies. In any event, policy makers should guard against channeling public funds to areas—such as Internet companies or human genome sequencing firms—that already are well funded by venture capitalists. Public money might be better spent in support of companies in areas that venture capitalists are ignoring. The Focus on Precompetitive Technologies Dr. Lerner noted that his final point was likely to be controversial, and is derived from the ATP's enabling legislation, as opposed to administrative deci-

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--> sions by ATP program officials. The ATP's original intent was to encourage pre-commercial R&D. For many small entrepreneurial companies, however, drawing a distinction between pre-commercial and commercial research can be meaningless or counterproductive. Some case studies indicate that there were well-intentioned efforts to keep the R&D of some ATP recipients in the precompetitive realm. However, these efforts may not have been helpful from the company's perspective. Although it is likely that there is no easy answer to this issue, Dr. Lerner suggested that this issue should be raised with the ATP officials and congressional staff. In conclusion, Dr. Lerner made three points: The venture capital market is a substantial one and also is very complicated. Policymakers should carefully consider where public programs fit in the context of venture capital financing. There is a role for well-designed public programs to provide R&D funds for innovative companies, but the program design should be carefully thought through. A Venture Capitalist Perspective Todd Spener Charter Financial To put his remarks in perspective, Mr. Spener noted that Charter Financial is backed by Warburg Pincus, a $7 billion venture capital fund, the largest in the United States and perhaps in the world. Prior to joining Charter Financial, Mr. Spener served as the chief financial officer of a company that received an ATP grant, giving him a unique perspective on the program's operations. Based on his experience, he sees the ATP serves as a validation of technology. Venture capitalists are good at assessing risk when it comes to business execution and business plans. Although some venture capital funds have technology experts on staff, most are more expert on business issues. The ATP serves to mitigate technology risk for venture capitalists. Because ATP is a competitive program, venture capitalists can feel comfortable that an ATP-funded company is technologically sound. Consequently, with an ATP grant in hand, a company stands a better chance of gaining venture capital financing, and also has access to other benefits, which Dr. Lerner touched on, such as qualified business people and strategic partners, both of which will facilitate the commercialization process.

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--> Obtaining Financing for a Start-up Mr. Spener described the process by which a venture-backed company obtains venture capital. The entrepreneur first goes through the "Rolodex process" in which he or she calls family and friends and tries to obtain funds from them. The next step is the "angel phase" whereby the entrepreneur seeks out an experienced and successful person in the field who understands the technology and has the resources to invest. Two rounds follow: In the first round, the entrepreneur attempts to convince a sophisticated institutional venture capitalist to invest. The second round is a more strategic phase, in which the entrepreneur targets an experienced venture capitalist who understands the field well and is a savvy investor in the field. Such an investor may be a large firm attempting to diversify its portfolio. This process is efficient when assessing business risk. However, when the technology risk is high enough to cause investors to pause, the ATP provides a bridge between the technical and business risks. Private investors, Mr. Spener explained, are motivated by overall returns to their capital. Investors have varying tolerance for risk; high-risk investors may tolerate more losses than risk-averse ones, but they will need some "big wins" to balance their tolerance for risk. Other investors may prefer a greater number of wins, with modest returns, and few large losses. The ATP fits in the picture in that it can provide "catalyst capital," that is, the grant may tilt the decision of a venture capitalist toward funding a particular firm. Using a sports analogy, Mr. Spener said that the ATP provides a ''farm system" for venture capitalists, or a proving ground for technologies, which allows some venture capitalists to call them up to the "big leagues'' of venture funding on the basis of good performance in the ATP competition. ATP and Patient Capital Mr. Spener pointed out that, as recently as the 1980s, inefficient capital markets and the lack of patient capital in the United States were cited as the reasons for poor U.S. economic performance, downsizing or "right sizing" of U.S. companies, and widespread job losses. Today, Mr. Spener noted, our technology industries and system of finance are the envy of the world, raising the question as to what is patient capital. Is it a corporation reinvesting retained earnings into the company for growth? Or is it the venture capitalist who may invest in the Stanford graduate who has a great idea, even though he or she has yet to buy a dress suit? In Mr. Spener's view, the ATP is among the most patient of patient capital. In summing up, Mr. Spener said that the gap in technology investment is the risk associated with new technologies, and the bridge is the ATP.

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--> Small Firm Experience in the ATP Mitch Eggers Genometrix, Inc. Origins of Genometrix Dr. Eggers opened his remarks by describing the origins of Genometrix and how an ATP grant contributed to Genometrix's growth. In the early 1990s, Dr. Eggers had a vision of combining microelectronics and electrobiology into what is now known as the electronic DNA chip. Dr. Eggers and his colleagues demonstrated initial feasibility working with Baylor College of Medicine and the Massachusetts Institute of Technology (MIT), and presented the ideas to companies such as Texas Instruments and Hewlett Packard. Researchers at the companies were intrigued, but management at large electronics companies chose not to pursue the manufacture of the electronic DNA chip. Dr. Eggers and his colleagues therefore turned to the ATP for funding and submitted an application with eight other institutions. Although MIT provided the manufacturing facility to build prototype chips, no one seized the manufacturing opportunity on a commercial basis. Genometrix was incorporated in 1993 to pursue commercial opportunities and, in 1994, received $300,000 in a convertible note from a venture capitalist to begin operations. Dr. Eggers emphasized, however, that it would have been impossible to raise the venture financing without the ATP grant in hand. Genometrix won the largest ATP award in 1994, $9 million from the government and another $9 million from collaborative partners. Since 1994, Genometrix has grown from 3 employees to 40 full-time employees, 20 percent of whom have doctorates. The company has over 20 partners, including MIT and Motorola. Revenues for Genometrix were $2 million last year, projected to be $7 million for next year, with an initial public offering (IPO) planned for next year. The ATP grant has played an important role in the company's growth. Social Value of Genometrix Technology Recalling the earlier discussion about social versus private returns, Dr. Eggers said that Genometrix's technology has a social dimension to it. Genometrix's DNA chip is a very efficient way to develop "genotype services," which involves obtaining a DNA fingerprint from a blood sample. The DNA fingerprint then is correlated with a patient outcome. A pharmaceutical company then can access a database with thousands of records containing the DNA fingerprint and patient outcomes and tailor medications more precisely to patients' genetic makeup. In the future, rather than people taking medications that may or may not work, medications will be crafted for a patient's individual needs. A DNA test would be

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--> done prior to prescribing medicine, and the test would reduce the number of adverse reactions to medication. This is a serious problem; over 100,000 people in the United States die each year from adverse reactions to medication, the fourth largest killer in the country. For tens of dollars, Genometrix's, simple DNA test can largely eliminate this problem. This kind of testing could not have been done in a cost-effective way two or three years ago. Recently, Genometrix completed a study for the Food and Drug Administration (FDA) in which the company took over 800 samples of patients' blood—which would contain more than 10,000 different genotypes—and determined the correct genotypes. The FDA already had determined the genotypes on its own and this had taken FDA one year. Using its automated platform, Genometrix correctly determined the genotypes in one week. Genometrix projects that, within a year, it will be able to do the same task in one day. The Genometrix technology therefore will have strong social returns as it improves the quality of patient care and saves lives, in addition to commercial impacts when the company goes public. For Genometrix, the ATP has meant an opportunity for individuals such as Dr. Eggers and his colleagues to take a revolutionary idea and move it into the commercial market. Small Firm Experience in the ATP Mark Pittenger Osiris Therapeutics ATP's Role in Osiris Dr. Pittenger described Osiris Therapeutics as a young biotechnology company from Baltimore that has been organized to commercialize mesenchymal stem cell technology. Osiris isolates stem cells from bone marrow and uses the cells to generate tissue. Osiris is directing its technology toward cancer therapy, cartilage regeneration, and bone generation. Gene therapy is another potential use of Osiris's technology. The ATP grant to Osiris was made to develop muscle regeneration techniques, specifically for cardiac muscles. When the heart is damaged, the lack of stem cells in the heart prevents it from repairing itself. With Osiris's technology to generate stem cells, the regeneration of cardiac muscle is now possible. For cardiac muscle regeneration and other purposes, Osiris uses stem cells from bone marrow to regenerate other tissues elsewhere. The ATP funding has allowed Osiris to venture into areas where the company otherwise would not go, because of competing demands internally on Osiris's resources. As the principal investigator on the cardiac project, Dr. Pittenger has

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--> had to struggle to find space, personnel, and resources to pursue the research. The ATP grant has greatly alleviated that struggle. Sources of Financing for Osiris Because Osiris has been able to obtain financing from other private sources, it has not sought venture capital. In the past two years, Osiris's expansion has been enabled by a joint venture with Novartis Pharmaceuticals. In regard to the ATP grant, the technology being developed under that grant has not advanced to the point where Osiris has sought outside partners. In 1997, Osiris planned an IPO, but market forces outside its control caused the company to delay that plan. Thus, the ATP money was even more important and enabled Osiris to assemble a team that would not have been possible absent the ATP grant. Given the presence of strategic partners, it was sensible for Osiris not to pursue venture capital, but the mesenchymal stem cell technology was too attractive to ignore. This made the ATP an excellent source of funds, as opposed to pursuing venture capital, which may have been hard to obtain and simply was not the route the company wanted to take. Another attraction of the ATP grant is that it is a competitive process with which Osiris is comfortable, and the process allows the quality of the technology to drive the decision making. Finally, the ATP is a useful bridge between outside corporate financing and venture financing, especially because Osiris's stem cell technology was probably too far from commercialization to interest venture capitalists. The ATP, Dr. Pittenger concluded, has played an important role for Osiris, and the company is pleased to have recently won a second ATP grant. Questions from the Audience Dr. Nelson observed that Osiris is an example of an important ATP grant producing exciting results, but he added that intellectual property rights must be considered. He asked Dr. Pittenger what Osiris's intent was with respect to licensing its stem cell technology. It was Dr. Nelson's belief that the stem cell technology would have wide applications for university researchers and other companies. An objective of the ATP, said Dr. Nelson, should be to encourage broad dissemination of the technology. Is that Osiris's intent? How did discussions between Osiris and the ATP proceed on intellectual property? Dr. Pittenger responded that Osiris would like to commercialize the technology as much as possible. As a small company, Osiris recognizes that it does not have the capacity to exploit every commercial potential so as to maximize the health benefits of stem cell technology. Osiris has had discussions about how to provide the technology to the research community, and much of the information of interest to researchers would be published "quite shortly." As a company, Osiris would like to commercialize the technology as much as possible.

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--> Dr. Flamm followed up Dr. Nelson's question by asking whether the technology would be made available to universities, certainly not for free, but on some preferential basis. Dr. Pittenger said that the Osiris technology would be readily available to university researchers. Dr. Lerner commented that this discussion was related to Claude Barfield's remarks earlier in the day. Dr. Lerner said that there is a fundamental tension between the desire to place technology in the hands of small companies, which may be effective at commercialization and able to create many new jobs, versus the worry that publicly funded R&D will fall into the hands of a single large company that may not disseminate the technology. Many firms, small ones especially, may find it difficult to obtain venture capital or find strategic partners unless they can obtain exclusive rights to publicly funded technology. Nicholas Vonortas of George Washington University asked Dr. Lerner what would happen to the supply of venture capital funds if the stock market dropped. Dr. Lerner responded that a forthcoming paper of his to be published in the Brookings Papers on Microeconomics explored the sources of venture capital. The most critical determinant in the availability of venture capital is the "supply of good deals" or good investment opportunities. This was more important than the level of the stock market. Factors such as technology-transfer policy and policies that effect incentives for entrepreneurs (e.g., capital-gains tax rates) in turn determine the availability of investment opportunities. These results hold for the United States and other countries. Clark McFadden of Dewey Ballantine recalled that several speakers said that venture capitalists were good at assessing business risk, whereas the government was good at assessing technical risk. Why specifically is government better than venture capitalists or others in the private sector at assessing technical risk? Is there some special expertise that government brings? Mr. Spener said that a venture capitalist is unlikely to invest in a technology solely on the basis of validation by the government. A venture capitalist will look for technical assessment and validation and factor it into the funding decision. Whether the validation comes from a government expert or from the private sector is irrelevant. The quality of the expertise, not the source, is most important. By way of follow-up, Mr. McFadden asked whether the government had any special advantage at the outset in contrast to the expertise of the venture capitalist, or the expertise available to the venture capitalist. Is there anything that leads to a different assessment by the ATP, by virtue of its public status, than by the venture capitalist? Mr. Spener said that it makes no difference whether the expert conducting the assessment is from the government or the private sector. The background of the assessor, independent of public or private status, is key. Dr. Pittenger responded that the ATP, and the National Institute of Standards and Technology (NIST) more broadly, has a wide range of experts from which to draw, and these experts see many proposals come into the program. This pro-

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--> vides a base of experience in assessing proposals in the government that a venture capitalist would find hard to ignore. Dr. Flamm characterized this as a "portfolio of opinions" theory, in that a venture capitalist would be wise to fold the government's assessment into the family of assessments being considered in a funding decision. Dr. Lerner said that there is "so much clutter out there" facing venture capitalists with the shear volume of business plans that come to them. Any extra signal, especially for a small firm, can make a difference in the funding decision, and ATP validation, or SBIR for that matter, is bound to carry weight. Mr. Spener added that the fact that the ATP is a competitive program adds prestige to the validation when an ATP grant is awarded. Mr. Gibson of X-Ray Optical Systems said that, although he was not sure whether the government in general had special assessment expertise, he believed that the ATP and NIST did. For his company's technology, and he suspects for that of many other companies, there are many dimensions to the technology. When talking with people in the private sector and most public agencies, Mr. Gibson usually faced one expert. This expert could see one aspect of X-Ray Optical's technology, but not the whole package. At NIST, however, the agency brought together a panel of experts to review the technical aspects of his company's proposal. For his company, the NIST technical review was different in quality than what X-Ray Optical Systems experienced elsewhere. Chris Hill from George Mason University said that, if part of ATP's objective is to make ATP-generated knowledge widely available, whether one calls this precompetitive technology or genetic technology, what are the mechanisms for the transmission of knowledge by the firms represented on the panel? Dr. Eggers said that Genometrix has a policy whereby it publishes its research results widely in professional journals. Genometrix does secure intellectual property protection and, for areas that are crucial to its business, Genometrix guards the intellectual property quite carefully. For developments that are not central to Genometrix's core business, the company will license. For example, Motorola came to Genometrix and asked for access to some DNA chip technology to enable Motorola to develop a "point-of-care" technology, that is, DNA testing on the spot. Genometrix recognized that, as a small firm, it could not expect to develop every commercial facet of its technology. Motorola, moreover, has tremendous expertise and market presence in portable electronic devices. This was a natural partnership opportunity, and Genometrix licensed the technology to Motorola. Dr. Pittenger said that, like Genometrix, Osiris published its research in journals and it had relationships with Johns Hopkins University and the University of Florida. The announcement of the ATP award to Osiris raised the profile of the Osiris technology, which led to invitations for Osiris to present its technology to others. As long as the intellectual property is protected, Osiris is happy to disseminate through journals and conference presentations. Dr. Long of Business Performance Research Associates asked whether, if

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--> certification on technical merit from the ATP or another government agency is a good thing, a venture capitalist should ask a candidate firm if it had applied for a grant from the ATP or other programs and if the firm's application had been denied? Dr. Long also made an observation about Dr. Nelson's comment about intellectual property and knowledge dissemination. Dr. Long said that it is possible to have a rigidly enforced patent and large spillovers. Turning to his second question, Dr. Long noted that there had been no mention about ATP funding displacing venture capital funding; he asked panelists to comment on this apparently missing element in the panel's discussion. Mr. Spener responded first by saying that he doubted that many venture capitalists had ever heard of the ATP; therefore, it would be unlikely that a venture capitalist would ask whether a firm had applied for, or been denied, an ATP grant. In response to the second question, Mr. Spener did not believe that venture capitalists saw the ATP as competing with them. There are many different kinds of capital in the market, and a provider of capital probably would view the ATP as enhancement to the many types of capital, from venture to mezzanine, that might be provided. Bill Spencer of SEMATECH pointed out that the venture capital industry has grown tremendously in recent years, leading to the concern that there may be more money than good ideas worthy of financing. With the apparent abundance of capital, whether from venture capitalists or the government, is there a danger of a scarcity of good ideas next year, or 10 years from now? Dr. Lerner responded by saying that, even with the growth of venture capital in recent years, at $20 billion—if you accept that as a high-end estimate of the venture capital industry—it still represents less than 1 percent of the U.S. capital market. And a typical venture capital firm will fund only 1 out of 100 business plans submitted to it. The growth of venture capital is more attributable to the removal of artificial restraints on the industry, namely the prohibition on pension fund investments in venture capital, than so-called "irrational exuberance" surrounding today's economic environment. In short, Dr. Lerner concluded, it is hard to argue that there is too much venture capital relative to the economy as a whole.