The U.S. Environment for Venture Capital and Technology-Based Start-Ups
General Partner, Asset Management Associates
In response to Bill Spencer's original suggestion, I will talk a little bit about the venture capital business in the aggregate. At the end I will offer some observations and a perspective on current trends.
The broad statistics give us an idea of the magnitude of venture capital investing, but some of the data are pretty ragged. For example, how do we define venture capital? Do we count early stage, later stage, corporate investments, and angel investors? Taking the data available from the National Venture Capital Association (NVCA), the most interesting thing to me is the growth rate. The broad inflow of money into traditional venture capital funds has grown from $1.3 billion in 1991 to $6.6 billion in 1996. The outflows have gone from $1.4 billion to $10 billion. You might wonder how we manage to operate with an inflow of $6.6 billion and an outflow of $10 billion.
There are several kinds of venture investment entities beyond the traditional, professionally managed venture capital firms which are measured by NVCA. Investments into target companies by larger companies such as Adobe and other corporate investors would not show on the inflow but would probably show on the outflow. The statistics are compiled by calling venture capital firms and finding out what companies they invested in. So there are specific corporate entities and others that are investing to make the outflow higher than the inflow. In addition, so-called "angel investing" by individuals does not show up in the statistics. I do not think anyone has particularly reliable numbers for this. Some of the analysis indicates that funding from angels, relatives, friends, mortgaging your house, and small business loans may be 10 times as much as the investment from professional venture capital sources.
These numbers are growing at a ferocious rate. To give you some perspective, in the 1970s inflows into professionally managed venture capital firms on a yearly basis were as low as $50 million in some years. We call these "the good years" because there was not as much competition for good investments, and the prospects for high returns were better. We have seen several cycles over the years: in the 1980s we reached a $3 billion to $4 billion annual inflow, and then it dropped. Now we are back up to a $6.6 billion rate. This is probably bad news in terms of the returns that anyone can accomplish. The capital market is working. When we produce extraordinary returns, the capital flows in, and then the returns go down. This is exactly as it should be.
To put this into perspective, let's take the $10 billion outflow figure as the aggregate number for all venture capital. We are finding more and more people coming under the umbrella of venture capital for later stage investments in retail chains, commercial shopping centers, and other private equity investments outside high- technology. The best estimate I have is that about 60 percent of this money goes into high-technology, broadly including information technology and life sciences or medical technology. So if you take 60 percent of the $10 billion, that says perhaps $6 billion is going into high-technology. However, this also includes later-stage deals and buyouts. There are people raising billion-dollar venture capital funds to do $250 million buyouts of existing companies. I do not consider those sorts of investments as traditional venture capital funding for start-ups or growth-phase companies. For the sake of argument, let's say half of the $6 billion is really early to middle-stage venture capital, or $3 billion. Then if we deduct another third of it that goes into the life sciences, we probably have $1.5 billion or $2 billion going into information technology. People think that this is a massive number, that this is the panacea that will solve all the development problems for our country going forward. I certainly do not believe that.
This $1.5 billion or $2 billion, much of which goes into support of marketing, sales, and manufacturing, comes to less than half the $4.8 billion annual R&D expenditure by IBM, just one company. It is fair to say that, although there is a tremendous amount of innovation and imagination, the scale of venture capital in information technology is relatively small when compared to the rest of the industry. To take another example, the aggregate market capitalization of all the venture-capital-backed biotechnology companies is less than the market capitalization of one large pharmaceutical company. As much as those of us in the venture capital world think that we are creating a lot of value and new products, the scale of the activity is still fairly small compared with the rest of industry.
Moving from this macro view of the economics at a high level, I want to offer several observations about the state of the venture capital business, what is driving it, and how it operates. First, as most of you know, it is an unusual process that is generally unstructured, certainly unregulated, and somewhat unplanned. We have the fortuitous combination of entrepreneurs who are willing to take risks, capital that is willing to take risks, and a culture that is willing to at least
tolerate failure, even if we don't particularly like it. People know how to bounce back and we know how to look with an open mind at individuals who have been part of a start-up that did not work. Perhaps we hope, sometimes wistfully, that they have all of the mistakes out of their systems, but this is often not the case.
In addition, we have a very unusual situation in Silicon Valley, in Austin, in Cambridge and several others places, where there is a community that has grown over a very long period of time. We are frequently asked by other regions in this country and abroad, "How do we build the next Silicon Valley?" We can describe the historical process in a rough way; but it is very hard to manage or organize. If you look at the history of Silicon Valley, probably the most important single force is the core semiconductor industry. If you look at the fourth-generation companies that we are funding now, they were all spawned by the third-generation companies, such as Intel and National Semiconductor and others. These were produced by the second-generation company, Fairchild, where the "traitorous eight" went when they left Shockley Semiconductor, which, in effect, begat the entire industry. This was triggered by William Shockley coming to California. Why did all of this happen? You might think that it is similar to chaos theory, where the outcome is determined by whether the last drop of rain went on the west side or the east side of the continental divide. I believe the story is that William Shockley's mother happened to live in Palo Alto, so when he left AT&T it was the first place he wanted to go. He attracted Gordon Moore, Robert Noyce, and others who came West to join Shockley Semiconductor. Shockley was a fairly aggressive manager and Gordon Moore recently thanked him profusely for having propelled Moore out of Shockley Semiconductor with his management style.
So when people ask "How do we build the next Silicon Valley?" I usually suggest to them facetiously that they find the next Nobel Prize winner, get his mother to move, and wait about 50 years. It does take that much time to develop the infrastructure and feedback loop of venture capitalists, banks, landlords, and others who understand the culture and the dynamic. To reiterate what Chuck Geschke said, I think it is literally true that I can stand in our local grocery store for an hour or two on Saturday and find an entrepreneur, other venture capitalists, a banker that will loan them money just because I say it is a good company, and an investment bank that is ready to take them public as soon as they might have some revenue. If I wait an extra day I could probably fill out the whole management team.
We like to think that this is unique to Silicon Valley, but I do not believe it is unique. We have had fortuitous circumstances and more time to mature. For those of you who are familiar with Palo Alto, there is a trendy restaurant called Il Fornaio. It is a frequent breakfast spot, where you do not want to go to have a "secret" meeting. In the morning, if I go there for breakfast, it takes me about 10 minutes to sit down because I have to say "hello" to all the other venture capitalists, entrepreneurs, managers, and headhunters. You have to wonder when you
see this headhunter with that CEO. Is the CEO hiring the headhunter to replace one of his vice presidents? Or is the headhunter trying to recruit the CEO to go to another company? You might be terrified if he is the CEO of one of your companies, so you have an interesting dynamic.
However, if you go to the branch of the same restaurant located in Beverly Hills, there is a very similar dynamic—except the activity revolves around the film industry. I go down there with some friends occasionally and we have brunch at Il Fornaio in Beverly Hills, and I am completely at sea as I watch the exact same process going on. But it is directors and agents and other people in the industry that dominates southern California (which, by the way, traces its history to having good weather and being a better place to make movies than New York). I think there are some very unique characteristics that operate to our advantage in places such as Silicon Valley, probably the most developed, followed by Route 128 and a couple other areas in the United States, and growing here in the Washington area. There are signs of this growth abroad as well. It is not nearly as well developed, but it is starting to emerge in Cambridge, England, which possesses a major research university with a strong program in computer science, a history of entrepreneurship, and a growing group of venture capitalists.
My second observation is that it is important to recognize that while there are many great successes that have come from venture capital, there are also many failures. It is important that we can bounce back from failure, move quickly, exploit innovations, and identify markets. However, start-up companies are probably not great places to do fundamental knowledge-driven research that will have value for a broad array of potential businesses. Such a start-up is pretty hard for us to invest in. The truth is, I have invested in some projects like that. Those are what we call "mistakes" in which we thought the technology was ready for the marketplace but it turned out that not all the fundamental issues were solved. We needed to go back to the drawing board and either do some fundamental work or see if we could develop a new application of the technology. One example of this is the laser industry. If you go back and look at the evolution of Coherent Radiation and Spectra-Physics, the two primary independent laser companies, they had some very ragged early years as people tried to figure out what to do with this unusual technology. We look to universities and the corporate industrial labs as a far more appropriate place to do this sort of research than small start-ups.
The third observation I will make is about shortages. There are various kinds of shortages in this process. Entrepreneurs always complain that there is a shortage of risk capital, but this usually means that there is a shortage of capital willing to invest in their specific deal. Those of us who are investors competing for the good deals think that there is too much capital around and we complain that there is a shortage of good ideas. I think we all complain that there is a shortage of good managers and good technologists. To repeat another point of Chuck Geschke's, we welcome anybody from anywhere with the right skills who can contribute to the growth of these companies. Many of these start-ups are classic "rainbow
coalitions" of people with very diverse backgrounds working hard to build the company.
The fourth observation is one I hinted at earlier, and is directed to those who are tempted to think that this is an easy business. It is actually highly cyclical. I believe the data indicate that the capital markets are working. The extraordinary returns of the past decade have attracted a massive amount of new capital into the venture capital field. This will cause us to do bad deals, pay prices that are too high, and lose money. Then the cycle will start up again, eventually. I hope we get through it pretty quickly.
The fifth observation I would like to make is on the broad question of "picking winners" in industrial policy. These are loaded phrases and it again depends on where you are sitting. As a venture capitalist, I am completely opposed to picking winners when you have picked a winner that is not one of my companies. But when you have picked a winner that is one of my companies, I appreciate the profoundly wise investment in the core scientific base of the country. In a similar way, Congress's problem with picking winners and setting industrial policy is that if you invest in a plant in someone else's district it is very bad industrial policy, whereas if you invest in a company in my district, it is a valuable investment in the infrastructure. We have seen many of these programs and there are some gray zones. The Advanced Technology Program of the Department of Commerce or the Small Business Innovation and Research grants are selected competitively, based on the merits of the idea. We are frustrated when a targeted grant goes to some university that everyone in industry knows does not have any competence in this area other than that its Congressman is on the appropriate committee. When I complain about them, I am told to shut up or they will kill the whole program, so let that one go by. We have seen many of these programs where there is fair competition on the technical merit for precompetitive technology, for infrastructure development, or for the development of tools. It can be an extremely effective way to lever public dollars along with our equity dollars.
My final observation reinforces some things that Chuck Geschke and Dick Thornburgh said earlier on the issue of tort reform and securities litigation. I know that, for many people here who primarily focus on broader policy issues, this must seem like an incredibly irrelevant, narrow point. We have had the adoption of the federal laws that have helped to reduce the number of what I consider extortionary lawsuits.
This is how they typically work. The lawyers file a class-action lawsuit against a company because it has a highly volatile stock that bounces up and down. They say that either management knew the stock was going down and was negligent for not doing anything, or was negligent because they were too stupid to know it was going down. These suits are usually settled in the $5 million to $15 million range with the vast majority of that going to the lawyers and a small fraction to shareholders. The federal legislation, that we are very appreciative of,
has provisions that allow class-action lawsuits for genuine fraud but helps to reduce frivolous lawsuits. The problem now is that the battle has moved into the state venues and therefore you will hear continued interest in the so-called National Uniform Standards for securities class action law suits. I regret that we have to spend time on it, but it is an important reality in our business environment.