Venture Capital (posted 10 Mar 99)

There was a day when the two words 'venture capital' would have been an oxymoron for institutional investors. Ventures were for family members or a few rich individuals who wanted to speculate. Capital was for retention or perhaps investment in high quality, tested equities. Those days, the 1950s, were the aftermath of a depression, a world war and the nagging fear that an inevitable postwar depression would follow. But when prosperity seemed on every corner in the latter part of that decade, a new investment approach was born: venture capital.

Venture capital is essentially the institutionalization of private investment. Wealthy private investors, sometimes called 'business angels', and venture capital companies and funds typically put money into startups in their early stages of development in the belief that they offer significant potential to grow substantially and reward investors with exceptional returns over long periods of time.

As private capital, venture investing has become increasingly concerned with business plans - to pass through committees - 'burn rates' - the money a startup is spending in excess of revenues - and exit strategies - a venture capitalist today would never invest without knowing how to get out, either through a buyout or an IPO (see INITIAL PUBLIC OFFERINGS). In the mid-1990s in the United States, venture capital would tend to concentrate on late stage companies, those relatively near IPO status. Then came interest in mezzanine financings for a early takeout. And lately, there has been competition to fund high-tech startups: aggressive venture capitalists hang out at coffee shops to overhear startup conversation and jump in to offer money.

Venture capital guru: Georges Doriot

When venture capital was a new style of investing in the 1950s, the first institutional investor to attract money for it was American Research & Development (ARD) in Boston. This company was the invention of General (ret.) Georges Doriot, a naturalized American who maintained the manner of his native France. He was a senior professor at the Harvard Business School who had served in the American Army during World War II. He returned to his teaching duties convinced that discipline and systems could be applied to investment projects that seemed to defy quantification.

Gen. Doriot, as everyone called him, taught a class called 'Manufacturing', which was a mini-version of what he considered a full MBA curriculum should be. He attracted only top students and demanded that they give his course their highest priority. Students engaged in a major group project of original work, which elsewhere would have been considered a thesis. These projects often resulted in new companies being formed by students following graduation. Federal Express is one of the best known but is far from alone.

Gen. Doriot also served as an active chairman of ARD; the first publicly traded venture capital investor. It was usually the lead investor and did participate with other investors - often, at least at first, the offices of wealthy families. During the 1960s, the ARD portfolio had approximately one hundred positions. It is important to note that only two investments - Digital Equipment and High Voltage Engineering - produced almost all the gains.

There were two lessons about venture investing that Gen. Doriot emphasized. First, invest very carefully but expect that your success ratio will be a tiny fraction of the number of investments. Therefore, run wide, diversified portfolio. Second, prepare to spend time and resources to monitor and nurture your investments during the time you are invested. And his intended investment horizon was perpetual, although his theories suggested that as companies became able to stand on their own feet, ARD should recycle the money elsewhere.

Today, the number of venture capital companies is in the thousands, venture investing is a worthy subject for business school courses and the field is one of the most popular targets for graduating students. Perhaps influenced by a fifty year business and market recovery, we should not find it unusual for investors to be attracted to venture investing in order to take higher risk in the hope for higher return. Venture investment in now highly specialized with some investing in startups; others doing mezzanine investing for companies preparing to raise public market money; others concentrating in particular industries; and still others who tie advice and money in a style that would have been approved by Gen. Doriot.

Counterpoint

Venture capital firms typically manage multiple funds formed over intervals of several years. These funds usually consist of limited partnerships invested in a number of companies. They generally carry high management fees and offer little liquidity since investors have to wait until companies in the portfolio go public or are sold to be able to realize their returns.

And many companies in the portfolio may not offer any return: a general rule for the breakdown of returns among venture capital investments is that 40% will be complete losses, 30% will be 'living dead', while the remaining 30% may generate substantial returns on the original investment. But while the winners might win big, they often take much longer to emerge than the losers. As Bill Hambrecht writes: 'In venture capital, the 'lemons ripen before the plums'; most funds in their early stages have poor (or sometimes negative) returns as the inferior investments ('lemons') take their toll, but after several years, the 'plums' begin to improve returns.'

The challenge can be even greater at the height of a bull market with too much money chasing too few great ideas. In a world where timing is everything, the right investment at the wrong moment can be just as disastrous as making the wrong bet. So a venture capitalist can be left with a lot of sleepless nights, even in the best of times.

Internet firms have been the new frontier of venture capital in the late 1990s (see INTERNET INVESTING). Michael Wolff's book, Burn Rate, is a fascinating cultural account of what it is like to be in the internet business today - the financings, the venture capital, the Wall Street deals, and how business and financing get tied together in some ways that are not terribly constructive for the business. But more than that, it is the tempo of the finger-snapping time, which causes so many people such concern about today's market conditions. The book is about a very good idea - the internet - going awry. And it is the process of financing, with its sense of 'quick bucks', that is making it happen. It is like reading a mystery: how Wall Street was gulled by those peddling the latest in new technology stocks.

Certainly, it seems difficult to apply the old venture capital rules of strong management, proprietary technology and a small market growing fast to the internet business. Perhaps the widely expected crash in internet shares will force lowered expectations on entrepreneurs and make it easier for venture capitalists to invest in new ideas in Silicon Valley and related hotbeds of high-tech business around the world.

Where next?

One of the current stars of venture investing is Bob Lessin, chief executive of Wit Capital, the internet-based capital-raising firm started by Andy Klein (and in which Dean LeBaron, one of this book's co-authors, is an investor). Writing in Fast Company, Lessin describes his lessons for anyone considering starting up or investing in an 'internet-leveraged' business:

· 'Watch the 'burn rate': consider the rate at which a company goes through money. A good benchmark: a company should spend no more than $200,000 a month. Invest only in companies that can put together a year's worth of capital.

· Look for creative CEOs: you need chief executives who can react to the changing faces of business. The true entrepreneur can change course at a moment's notice - and succeed. The litmus test: does the CEO think like an artist?

· Have an exit strategy: invest only in companies that know the end game. You don't want to run a business. You want to create it. Know when you plan to go public or to sell the business to a larger corporation.

· Few assets, few atoms: you want to be as liquid as possible, to own as few assets as possible and to outsource as much of the operation as possible. The premium should be on ideas and dollars. Do as much as you can over the web: finance, distribution, sales, design, supply

· Worship brand equity: look for a strong brand, one that has a stranglehold on its market. Either create a brand or align your startup with an existing brand that rules its market. Everything rests on the strength of the brand.

· The new supreme indicator: the price-to-weight ratio: the less your product weighs relative to its cost, the more secure your investment in the company will be, A computer chip reigns supreme in this regard: it weighs almost nothing but costs a good deal. A silk necktie comes in second. The product doesn't have to be high-tech - but the company that sells and delivers it must be.'

Read on

In print

Andrew Klein, Wallstreet.Com: Fat Cat Investing at the Click of a Mouse - How Andy Klein and the Internet Can Give Everyone a Seat on the Exchange
Michael Wolff, Burn Rate: How I Survived the Gold Rush Years on the Internet

Online

www.fastcompany.com - website of the business magazine
www.techcapital.com - website of a leading magazine of technology business and finance
www.witcapital.com - website of the online investment bank launched by Andy Klein