Buzz

The Uncertain Future of Venture Capital

Joseph W. Bartlett, Founder of VC Experts.com


The numbers, any way they are sliced, are compelling. The extraordinary post-war performance of the U.S. economy has been driven, in large part, by small business. And the jewel in the crown of that growth, that element of the post-war economy which distinguishes the United States from the rest of the industrial world, which has provided us with much of our economic hegemony, has been that activity loosely labeled "venture capital." Despite intensive efforts around the globe by governments and private institutions, it has been difficult for other nation states and economic regions to recreate that felicitous combination of resources, talent, and financial technology which has been the engine of economic and technological invention in this country, spawning and growing giant multi-national firms. There are a number of reasons why other countries have found it difficult to mimic this sector of the U.S. economy, detailed in a number of commentaries. The matrix includes first class science, developed both privately and publicly; a fair system of taxation, encouraging capital formation; a fair, predictable and enforceable legal system, including protection of intellectual property; a rational bankruptcy code, meaning the entrepreneurial risk is not life threatening, and worthy firms can be rehabilitated; reasonable laws governing employment so that vulnerable firms can downsize in hard times without catastrophic expense; and a political structure which adjusts, both quickly and quietly, to changes the players in this sector require in order to maintain the growth curve.

The importance to the U.S. economy of a robust system for financing emerging growth companies is generally conceded: the question is whether recent events on the corporate scene are life threatening. And, for reasons I outlined below, I suspect we are inadvertently inhibiting the venture sector, to the point that our wealth and job creation engine can be substantially compromised. The venture process is suffering some significant wounds, as unintended consequences of the current initiatives to punish corporate misdeeds and "greed."

The venture capital process depends on the availability of capital, which means that the asset class has to yield superior returns, given the high risk in any single venture investment. In the current climate, one of the significant sub-themes is that, in the public company context at least, the chieftains of Corporate America have been taking unnecessary risks and should be punished. The existence of a victim (i.e., people who lose money in the stock market) necessarily implies the existence of a villain. This is not meant as an apology for instances of malfeasance. However, the collateral damage of the criminal, civil and Congressional necktie parties will necessarily suggest to future Ken Lays and Bernie Ebbers that risks of the 'bet your company' variety will wind up being punished in the court of public opinion and maybe in civil and criminal courts as well. Further, the impact of the new certification rules threaten to squelch the possibility of ever reopening the IPO window, and IPOs historically have been a pillar of U.S. venture capital. Traditionally, VCs have used the IPO exit in constructing their pricing models, assuming the IPO liquidity as the basis for their assumed terminal values. And historically, the IPO exit is an order of magnitude or two larger than a company sale. Use of IPOs in the standard models invigorates the process up and down the line, justifying a portfolio of risky investments on the theory that, if some percentage of the same turn out to be "portfolio makers" as a result of IPOs, then the VCs can take risks they would not otherwise be in a position to take ... i.e., if company sale were the only way to monetize their investments.

The IPO market comes and goes, of course. Even though it shuts down every now and then, it has always returned. But this time I'm not so sure. Concededly, some mainstream economists contend that the IPO was too robust in the last few years, leading to the bubble and, hence, the 'morning after' effect of the meltdown. But, the problem is that remedial overreaction threatens to 'throw the baby out with the bath water.' For promising issuers, the detriments of public registration now threaten to outstrip the benefits. Thus, for a fledgling company, the ability to deal with the Draconian certification requirements on the CEO, CFO, audit committees, and board members is constrained by finance. A big public company can hire a myriad of experts to review the disclosures backwards and forwards, it can create an internal audit mechanism reporting to a well paid audit committee, with experienced hands as independent directors; it can collect opinions of counsel, certificates from staffers, etc. and construct a paper trail which takes the sting out of the new rules. Fledgling companies do not enjoy that kind of resource base.

Further, the undeclared war on the analyst community will reduce coverage below the unsatisfactory level which currently exists. Many newly public companies, if not covered by the analysts employed by the investment banks which brought the company public, are not going to have any coverage at all. This means a berth in the "orphanage," with the stock price trailing off, liquidity diminished to the "trading by appointment" level and hence, the benefit/burden analysis tilting strongly against the IPO at an exit mechanism. Add in the geometric increase in strike suit plaintiffs' litigation by the plaintiffs' bar, the most powerful end of the law business and well funded to take on new assignments, and you have a situation where an increasing number of issuers in the venture space will simply dump the IPO prospect and sell out at the first opportunity, which is bad news for the venture industry.

In addition to making the IPO window stickier and harder, the companion assault on equity flavored compensation is disturbing. Stock Options are about the only method early stage companies can use to attract the experienced and high quality management they need. Since this business began, VCs have recognized that you 'bet the jockey and not the horse.' However, in order to attract qualified jockeys to run emerging growth companies, the parties have to find a way to pay the potential managers in a currency the issuer can afford. To get someone to take a high risk job (and leave, in many cases, a highly comfortable environment) requires extraordinary potential rewards. Simply stated, there is not enough cash around with which to motivate the better jockeys to make a change; and fledgling companies need the best jockeys, in view of their vulnerable status. Equity-flavored compensation is, therefore, an imperative.

The problem with most commentaries attacking stock options is that the writers have failed to realize the two features which make options particularly attractive (prominently not including the accounting treatment). First, options are the only compensations with upside potential which do not entail a tax as of the date of the award. As noted above, there is very little cash available in most start-ups, certainly not enough either to substitute for equity or to hand over to the Treasury in order to pay taxes. Stock options work because there is no tax involved until, generally, the holder has a gain; restricted stock does not do the job because tax is owed when the grant occurs, even though there are no cash profits. (Taxes can be postponed under Section 83(a) of the Code but that generally is a bad idea.) Moreover, restricted stock, which makes the recipient a stockholder, is unlikely to be distributed democratically; only the top echelon will be receiving restricted stock awards, a result the government would not consciously adopt as policy. Well, then, how about phantom stock plans, bonuses keyed to various performance events? Again, these involve cash payments. To be sure, cash payments can be postponed until the company starts to mature and its valuation increases. However, the second, often neglected virtue of stock options is that the bonus compensation comes from the stock market than rather from the company. The company is able to use its cash internally; the market itself is the one that makes the jockey's trip worthwhile.

My fear is that the appetite of prosecutors, politicians and commentators, many of whom have little understanding of the stakes they are playing with, will permanently depress a vital engine of our post war economy. There are, I believe, fixes for the process, but they do not involve any of the remedies I have seen currently proposed. I am in the process of outlining initiatives to support this vital activity, contained in a series of upcoming papers, some previewed in previous Buzz of The Week columns (see "IPO Reform: Some Immodest Proposals, Parts 1, 2 and 3) and all to be included in the VC Library, tentatively entitled "Research From the Academy; Works in Progress by Leading Scholars and Practitioners."


joe@vcexperts.com