The Rise and Fall of Venture Capital

[Pages:6]The 1994NewcomenPrize Essay

The Rise and Fall of Venture Capital

Paul A. Gompers? GraduateSchoolof Business

Universityof Chicago

Smallfirmsandnewbusinescsreationhavebecomepotentforces of economicdevelopmenint theUnitedStates.Priorto 1980,large firms createdthe majorityof newjobs in the Americaneconomy. Duringthe lastdecadeh, owever,a majorstructurasl hiftoccurred. Fortune500companielsost4 millionjobs.At thesametime,firmswith fewerthan 100 employeeasdded16 millionnewjobs[Birch,1990]. Thiswasthefirsttime in the20thcenturythattheshiftfromlargeto smallfirmsoccurredandit representeadfundamentaclhangein the natureof growthintheAmericaneconomy.

During the same ten year period, the rate of new firm incorporatiornosedramatically.By the endof the decadeo, ver1.3 millionnewbusinessewserebeingstartedannually.Scherer[1991] demonstratetdhatduringthe 1980s,smallfirmsweremoreinnovative thanlargefirms.He foundthatduringthe1980sf,irmswithfewerthan 500 employeescreated322 innovationsannuallyfor eachmillion employeewshilelargecompaniecsontributeodnly225 innovationpser millionemployees.

? I wouldlike to thankJoanneDushayN, ancyKoehn,JoshLerner,ThomasMcCraw, WilliamRodgersR,ichardRubackW, illiamSahlmanA,ndreSi hleifera,ndJeremySteinfor helpfulcommentasndsuggestionAs.nyerrorsoromissionasremyown. Thisresearcwh as fundedby theDivisionof Researchat theGraduateSchoolof BusinessAdministration, HarvardUniversity.

BUSINESS AND ECONOMIC HISTORY, Volume 23, no. 2 Winter 1994. Copyrigh?t1994 bytheBusinesHsistoryConferenceI.SSN0849-6825.

PaulA. Gompers/ 2

Thisdramaticshifttowardsmallfirmsmakesit imperativethat capitasl ourcefsorfundingstart-upcompanieasreefficientT. hispaper exploretsheeffectsoftheunprecedentiendcreasienmoneyflowinginto the venturecapital sectorafter changesin the 1979 Employee RetirementIncomeSecurityAct's(ERISA) "prudenmt an"rule. Prior to 1979,pensionfundswereseverelylimitedbyERISA intheamount of moneytheycouldallocateto high-riskassetsi,ncludingventure capital.The 1979change xplicifiyallowedfundmanagertso investup to 10%of theircapitalin venturefunds.Pensionfundcommitmenttso venturecapitalrosedramaticallyi,ncreasingannualnewcontributions toventurecapitaflundsfrom$100-200duringthe1970sto in excessof $4 billionbytheendof the 1980s.

Thefloodof moneywasa mixedblessingM. anysuccessfufilrms receivedventurecapitalfinancingandcreatedtremendougsrowthin bothtechnologicadlevelopmenatndjobs. Theincreasein capitalalso had negativeeffectson the industry,however. Overinvestmenitn certainindustriesoccurred.Firmsbackedby inexperiencevdenture capitalistswere broughtto market too early. Monitoring of entrepreneuriaplrojectsdeterioratedT.he futurehealthof venture capitadl ependusponmeasuretshatwill aligntheincentiveosf venture capitalinvestor(si.e.thosewhoinvestinventurecapitalfunds)v, enture capitalistsa,ndentrepreneuwrshoseekmoneyto financetheirprojects.

Start-upFinancingand VentureCapital

Entrepreneurosften developproductsand ideasthat require substantiacl apitalduringthe formativestagesof their companies' lifecyclesM. anyentrepreneudrsonothavesufficienftundsto finance projectsthemselvesa,ndtheymustthereforeseekoutsidefinancing. Severalalternativecapitalsourcesexist. The informalrisk capital marketconsistsof individualsknownas"angels."These"angels"are wealthybusinesspeopdloec, torsla, wyersa,ndotherswhoarewillingto take an equitystakein a fledglingcompanyin returnfor moneyto "start-up.W" etzel[1987]estimatetshat250,000individualasreactive in the informalriskcapitalmarketandinvestbetween$20 and$30 billion annually. Firmsthatrequiresubstantiaalmountsof money, howeverm, aynotbeabletoreceivesufficienctapitaflromthe"angel"

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networkbecaustehemarketisdispersewdithlittleinformationsharing andtheamounot f investedcapitaltendstobesmall(usuallylessthan $100,000). Banksareanimportanst ourceof start-upfinancingfor a subsetof newbusinessesC. ompanietshatlack substantiatal ngible assetsand are associatedwith significantex ante uncertaintyare unlikelyto receivesignificanbtankloansh, owever.Thesefirmsface many yearsof negativeearningsand are unableto make interest paymentosndebtobligations.

Venturecapitalfirmswill financethesehigh-riskp, otentially high-rewarpdrojects.Venturecapitalisttsakeanequitystakein the firmstheyfinance,sharingin bothupsideanddownsiderisks. Most firmsthatreceiveventurecapitaflinancingareunlikelycandidatefsor alternativseourceosf funding.Theyhavefewtangibleassettso pledge ascollateraal ndtheyproduceoperatinglossesformanyyears.

A commonmisperceptioisnthatventurecapitalfundsonlyhigh technologcyompaniesA. substantipaol rtionofhigh-techstart-uphsave receivedventurecapital,includingsuchpresent-daiyndustrygiantsas Apple ComputerM, icrosoft,Lotus,andGenentech.Yet 1ow-tech companiesuchas StaplesT, CBY, andFederalExpresshavealso receivedsignificanatmountsof venturecapitalmoney.Eachof these firmshadauniqueideaorproducat ndventurecapitalwasabletohelp theentrepreneuexr ploithatopportunity.

Between1972and1992venturecapitalistbsrough9t 62 firmsto thepublicmarket.Thesefirmshavebeena sourceof innovationand job creation.Table 1 presentsstatisticsfrom thirty venturecapitalbackedcompaniesthat eventuallywent public. The companies represenvtariousindustrieasndfirmsatvarious tageosf development. Total1993salesforthesethirtyfirmstotallednearly$74billion. They employedmorethan420,000peopleandtheirmarketvaluewas$88 billion. This list of firms demonstratetshe importantrole venture capitalisthsaveplayedin shapingtheAmericaneconomiclandscape.

Whetherthe projectis in a high-or low- technologyindustry, venturecapitalistasreactiveinvestorsT. heymonitortheprogresosf firms, sit on boardsof directorsa, nd meteout financingbasedon attainmenotf milestonesV.enturecapitalistrsetaintherightto appoint key managersandremovemembersof the entrepreneuritaelam.In

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Table1.Impactof VentureCapital-backeCdompanies1,993

Company

AppleComputer Au Bon Pain Biogen Chiron Cirrus CML Group CompaqComputer ConnerPeripherals CrayComputer Data General DigitalEquipment Evans& Sutherland FederalExpress Genentech Intel LotusDevelopment Micropolis MicrosoR Oribital Sciences Quantum Raychem Seagate Staples Starbucks SlratusComputer SunMicrosystems TandemComputer Teledyne Teradyne

Well fleet

Sales

($mil)

7,977 123 149 217 354 645

7,191 2,151

352 1,077 14,371

142 7,808

650 8,782

981 382 3,573 190 1,167 1,385 3,043 883 163 514 4,308 2,030 2,492 555

180

Employees EquityMarketValue

(00Os)

($mil)

14,910 1,250 415 2,179 1,353

3,576 223

1,110 2,171

885

5,608 13,010 9,097

383 6,500 94,600 1,100

697 9,978

774 50

271 3,223

132

95,000 2,510 29,500

4,206 3,189 27,082

4,738 2,298 14,430

2,705 99

15,117

1,123 2,455 10,772 43,000 7,539 4,585

315 695 1,581 1,648 1,063 866

2,610 13,300 9,963 21,000 4,500

738

723 2,009 1,368

997 891

784

Totals

3,227

41,148

88,428

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addition,venturecapitalistsprovideentrepreneurwsith accessto consultantisn,vestmenbtankersa,ndlawyers.

The History of Venture Capital

The ancestorsof modernventurecapitalin the United States developedin thelate 19thandearly20thcentury.Wealthyfamilies beganto lookfor waysto investin potentiallyhigh-returnh, igh-tech undertakings.David Lamplewritesin hishistoryof the Route128 venturecapitalregion:

The city's[NewYork] greatfortunesi,ncludingthoseof the Vanderbilts,Whitneys,Morgans,and Rockefellers,

were based on such ventures as railroads, steel, oil, and

banking. Althoughnotall investorsweresowell known, it was wealthy familiessuchas thesethat bankrolled Boston'searliesht ightechentrepreneursW. hentheyoung ScotAlexanderGrahamBell neededmoneyin 1874 to completehis early experimentson the telephone,for example,BostonattorneyGardinerGreenHubbardand SalemleathermerchantThomasSandershelpedout, and laterputupthecapitalto starttheBell TelephoneCo. in Boston[Lample, 1989]. The marketfor risk capitalremainedlargelyunorganizedand fragmentetdhroughoutht elate19thandearly20thcentury.Thefirst impetusto organizeinvestingcamefromwealthyAmericans.In the 1930sand 1940s,memberstheRockefeller,Bessemera,ndWhitney families hired professionaml anagersto seek out investmentin promisingyoungcompanies. The firstmodernventurecapitalfh'mwasformedin 1946, when MIT presidenKt arlComptonM, assachuseItntsvestorTsrustchairman Merrill Griswold,FederalReserveBankof BostonpresidentRalph Flanders,andHarvardBusinessSchoolprofessorGeneralGeorgesF. DoriotstartedAmericanResearchandDevelopmen(tARD) [Lample, 1989]. The goal of the companywas to finance commercial applicationosf technologiethsatweredevelopeduringWorldWar II. Doriotwastheheartandsoulof ARD andisjustifiablycalledthe "fatherof venturecapital." Doriot's focuswas on addingvalue to

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companiesn, otjust supplyingmoney. Companiesfundedby ARD wereconsideretdo be "membersof thefamily"[SextonandKasarda, 1991.] ARD's staffunderDoriot'sdirectionbeganprovidingindustry expertiseandmanagemenetxperiencteo thecompanietsheybackedin

order to increase their chances of ultimate success.

Doriot servedas ARD's presidentuntil it was acquiredby Textronin 1972. During thecourseof his tenureat ARD, Doriot's visionwasnotoneof "makingmoney"but ratherfm_ancin"gnoble" ideas. The first investmenmt adeby ARD in 1947 was in High VoltageEngineeringCompany. The firm, foundedby severalMIT professors,was establishedto developX-ray technologyin the treatmenotf cancer.ARD investedin thecompanyfor reasonsnoted by Compton'scommentto Doriot:

They [High Voltage EngineeringCompany]probably won'tevermakeanymoney,buttheethicsof thethingand thehumanqualitiesof treatingcancerwith X-raysareso outstandingthat I'm sureit shouldbe in your [Doriot's] portfolio. [Lample, 1989] When High Voltagewentpublicin 1955, the original$200,000 investmentwas worth $1.8 million.

ARD createdthe standardventurecapitalparadigmwith its highlysuccessfuinlvestmenint DigitalEquipmenCt ompany(DEC) in 1957. ARD invested$70,000 for a 77% stakein DEC. Doriot's disdainfor quickprofitswasdisplayedin thedispleasurheeexpressed with KennethOlsen,Digital's founderandpresident,the first time DEC reporteda profit. Doriotwasconcernedthatnotenoughmoney was being reinvestedin researchand developmentand that the companymight sufferin the long run [Kotkin, 1984.] Over the ensuingfourteenyears,the investmenitn DEC increasedin valueto $355million.Almosht alfofallthemoneyearnedbyARDduringits 26 yearexistencweasearnedbyitsinvestmenint Digital. Theconcept of the "homerun"in venturecapitalwassynonymouwsith DEC and thetermwouldbecomepervasivein theindustryduringthe 1980sand 1990s. Everyonewantedto financethenextDEC.

In 1958, theFederalgovernmendtecidedto play anactiverole in promotingsmallfirmdevelopmenbty becominga participanitn and regulatoor f smallfirm financing.TheSmallBusinesAs dministration

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was given the authorityto charternew smallbusinessinvestment companies(SBICs). SBICswereto provideearlystagefinancingfor companiesin variousindustries. The numberof SBICs increased rapidly. By themid-1960s,700 SBICscontrolledthemajorityof risk capitalinvestedin theUnitedStates.

SBICsdifferedmarkedlyfromARD. SBICstendedto provide little morethanmoney. Mostmanagersof SBICshadlittle industry expertiseandcouldnot provideentrepreneurwsith informationor accessto industryexperts. SBICsdid notmonitorthef'Lrmsasactive investorsb,utinsteadreliedontherepaymenot f loansto evaluatethe succesosf a project.

ProblemqsuicklydevelopedI.n aneffortto leverinvestmenitns small business,SBICs were able to borrow four government guaranteedollarsfor eachdollarof equitycapitalin the investment company.BecausSeBICsneededtomakeperiodicinterespt ayments, theychoseto financefirmswithdebtratherthanequity,asARD had chosento do. Hadtheyusedequity,SBICswouldnothavebeenable to servicetheirowndebtobligations.Becausehigh-riskprojectsare unsuitedfor leveragedcapitalstructurest,he useof debtfinancing

meant that SBICs focused on more stable industries.

A secondmajorconcernwastheincentiveproblemsinherenitn governmengtuarantees.As therecentS&L crisissuggestsw, henthe managers of certain financial institutionsunderstandthat the governmenwt ill bail outthedepositorisf thingsgowrong,theyhave little incentiveto monitortheirinvestmentcslosely.The implicitput option offered by the governmentgave individualinstitutionsan incentiveto gamble.

The initial publicoffering(IPO) marketof thelate 1960swas extremelyactive, andmany SBICswere able to bring a numberof companiepsublicduringtheboom. ButtheIPO "bubble"andadverse investmenitncentivescausedby the loanguaranteesled to increased investmenitns riskyprojects.Therecessioanftertheftrstoil embargo of 1973-1974hit youngfirmsparticularlyhard. IPO activitydropped to one-tenthits previouslevel andmanySBIC-backedf?rmsbegan losingmoney. SBIC-backedcompaniesw, hichwereoftenfinanced with debt, couldnot meet interestobligations. At the sametime, SBICs themselveswere highly leveragedand couldnot meet their

PaulA. Gompers/ 8

interestand principalrepaymentschedules.Many were forcedto liquidate. By 1978, only 250 were still active. In 1988, SBICs accountefdorjust7% of venturecapitalfinancingt;heyprovidedover 75% of theinvestment2s5 yearsearlier. CompanielsikeARD andthe firmstheyfinancedsurvivedmanyrecessionbsecausetheyreliedon equity financing of both the venture capital fund and the entrepreneuriaflirm.

The earliest venture capital fn-ms were organized in the Northeast, centeredboth in Bostonand New York. It was not until 1957 that West Coastventurecapitalcame into existence. Arthur Rock,thenaninvestmenbtankeratHayden,Stone& Co. in NewYork City, wassenttoinvestigataepotentiapl rojectin California[Venture Capital Journal, 1991]. Rock called various individual and institutionailnvestorsto securefinancingfor EugeneKleineranda group of ShockleyLaboratoryemployees. Rock's efforts led to ShermanFairchild,thelargestholderof IBM sharesat thetime,who invested$1.5 millionto formFairchildSemiconductorF.ouryears later,Rockmovedto Californiato formthefirst of two earlyventure capitalfundsin SiliconValley. His investmentisn suchindustry leadersasIntel, ScientificDataSystemsT, eledyne,andApplehave hada tremendouismpactin transforminhgigh-techin California.

By 1992, WestCoastventurecapitalhadbecomeoneof the nation'scentersfor entrepreneuriaalctivity. Figure 1 showsthatin

1992, 48 % of the dollars investedwere investedin the West Coast

regionof thecountry.TheNortheasatccountefdor 20% of invested venturecapital. While otherregionsof the countryseemto be underrepresentevde,nturecapitailsexpandingrapidlyin theMidwest

and Southwest.

The dramaticsuccessof ARD inducedindividualsto startnew, private venturecapitalfirms in the 1970s. Someof the earliest imitatorswereactuallyformermembersof theARD team,including Bill CongeRont,heARD associatwe ho initiatedthe DEC investment. This spawningproducedprivateventurecapitalfirmsthatcarriedthe spiritof DoriotintonewcompaniesT. hegoalwasalwaysthe"home run" while themodusoperandwi asalways"hands-onm" anagement. The "new" venturecapitalist(unlike the managerof the SBIC) provided many servicesto the entrepreneurincludingaccessto

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