What's wrong with VC

One of the better articles on what's wrong with Venture Capital that's out there lately - and there certainly are alot of them out there!

April 16, 2009, 06:42 PM EST
Guest Column: Venture Capital Under Attack --> -->

(The following is a guest column from Adam Grosser, a general partner with Menlo Park, Calif.-based venture capital firm Foundation Capital, where he has worked since 2000. Foundation Capital last year raised a $750 million fund dedicated to information technology, consumer products and services and clean technology.)

By Adam Grosser

As a venture capitalist, my job is to find great ideas and turn them into great companies.
The journey to find these ideas has taken me from inventors’ basements, to obscure research labs, to, in one case, a smoky Milwaukee bowling alley renowned for its fried Twinkies. With a lot of hard work and a little luck that journey ends on the floor of a stock exchange, witnessing a company you helped build go public. It’s a helluva ride.

What concerns me today is that for too many venture capitalists – and thus too many innovators and small businesses – that ride is coming to an end.

That’s not just bad for venture capitalists. It’s bad for America.

Although venture capital represents just 0.02% of U.S. GDP, it is responsible for an astounding 10% of all U.S. jobs and 18% of U.S. revenues.

Over the last 35 years, one job was created in the U.S. for every $25,000 of venture capital invested. That’s about 10 times cheaper than even the most generous estimates of job creation in the recent federal stimulus package.

Yet today, fear is so dominant, credit so tight, and regulation so onerous that many promising startup companies can’t get off the ground.

Financial markets have little understanding or tolerance for “small-cap” companies, and without a robust public market, potential acquirers are either sitting on the sidelines or bottom-fishing. Few are willing to invest the seven to 10 years and $50 million to $100 million it takes to build a new company.

This general climate of fear is being compounded by three deep structural problems: 1) a dysfunctional technology investment-banking ecosystem; 2) diminishing support from institutional investors for VC-backed enterprises; and 3) an increasingly onerous and counterproductive regulatory environment.

In the 1990s, a vibrant group of four small investment banks helped usher in a golden age of technology investment. Alex Brown Inc., Hambrecht & Quist Group, Robertson Stephens & Co., and Montgomery Securities – dubbed “the Four Horsemen” – underwrote a large share of venture-backed IPOs, which averaged about 130 a year before the dot-com bubble, compared with about 40 a year since. Those full-service boutiques employed a large group of research analysts that offered potential investors insight into the latest technologies being developed, and held conferences where technology companies could present to these investors.

Today, the Four Horsemen have vanished and so has the sell-side ecosystem that brought venture-backed IPOs to the market. America has now gone two straight quarters without a venture-backed company completing an IPO - the first time that’s happened since we started keeping records in the 1970s.

The second most pressing problem facing VC is pension funds, endowments and other buy-side investors running out of patience with small growing companies. Historically, buy-siders have understood and accepted that most economic value isn’t created until five years after a company’s IPO. But now, a focus on unfavorable current EBITDA multiples is displacing long term predictors of success such as market size, growth rate, technology and management experience.

Finally, we have counterproductive regulations such as Sarbanes-Oxley, and could see two more regulatory measures that will end up undermining the already tenuous value proposition for venture capitalists and their limited partners.

The populist movement to punish short-term profit seekers from the hedge fund and private equity industry by treating carried interest from long-term capital gains as ordinary income would end up applying to venture capitalists as well. There is a material difference between what venture capital firms do and what many hedge funds and private equity firms do. We make a long-term commitment to company-building. They don’t. Equally misguided are signals from Treasury Secretary Timothy Geithner that venture capital firms may be forced to submit to onerous Securities and Exchange Commission reporting requirements to ensure that we aren’t “a threat to financial stability.” This demonstrates a gross misreading of what venture capitalists actually do. Many VC-backed companies don’t utilize any debt at all – meaning that if a company fails, the price is paid only by the immediate investors and employees. Unlike a hugely leveraged hedge fund deal gone bad, a failed VC startup causes minimal collateral damage to financial intermediaries. If we start regulating VCs like hedge funds, it will stymie the risk-taking needed to grow promising but unproven startup companies.

These problems threaten the very foundations of venture capital, and therefore the American economy. So what can we do?

First, build great companies. I can’t speak for the entire industry, but I can attest that my firm, Foundation Capital, has five to 10 companies mature enough to meet all the historical criteria to be successful standalone public companies. We need to keep proving our worth through our work, and telling our story.

Second, we need to find some brave, charismatic bankers to reconstitute an ecosystem that recognizes the needs of rapidly growing innovative companies. The VC community needs to proactively give lead-managed business to the equity-oriented boutiques that care about small companies and are willing to do small IPOs. If there aren’t enough such firms, we should seed some with VC money.

Third, we need to re-educate the buy-side as to why growth companies are so central to building long-term value. The entire system needs to respect the IPO buyer. We can’t rush companies to market that aren’t ready just because an IPO window is open. Offerings must be priced conservatively because as noted before, most of the returns of the VC hall of fame have occurred long after the IPO.

But we also need to appeal to a larger universe of buyers. As Frank Quattrone recently suggested, we should “cultivate a broad array of smaller institutional investors for whom 1% to 10% allocations of smaller ($25 million to $50 million) IPOs would matter.” This would allow potentially game-changing young companies to get the funding they need to reach their full potential.

Lastly, and critically, if the data I began with is as compelling to you as it is to me, we need to make sure every legislator and policy maker knows: Venture capital is how America wins.
This is how America will engineer solutions to energy independence. This is where the breakthroughs in life sciences will come from. This is where tens of thousands of skilled new jobs will be created. Venture capital is the engine of the innovation economy, and we are in grave danger of shutting it down for good.