Collateral Damage: The Venture Capital Outlook and Potential

Joseph W. Bartlett, Founder of VC

Collateral Damage and our "No Growth" Economic Future; How "Enronitis" Threatens to Stifle Entrepreneurial "Animal Spirits" [1] by Joseph W. Bartlett [2]

Joseph Schumpeter, in a celebrated phrase, noted that capitalism depends, for its foundation and longevity, on the "animal spirits" of the entrepreneurial class in a given region. Absent the turbo charge which the entrepreneurial culture has in the past projected into the U.S. economy, we in this country are in for an indefinite slide to economic stagnation. The national balance sheet is alarming, in the vicinity of insolvency; our manufactures are increasingly non-competitive; our labor force is displacing itself in favor of, e.g., China, our currency is depreciating. I often use hypothetical benchmarks called (by me) the Fidelity Index … an assumed list of factors professional investors are wont to use when rating and distinguishing between the debt of a AAA national credit and a Third World obligor state. Absent robust growth, look at our score card on the Index … increasing debt as a percentage of GDP and GNP; balance sheet insolvency (in legal terms, insolvency 'in the bankruptcy sense'); extraordinary spending in the military sector growing rich/poor disparity; continuing barriers to women's rights; environmental indifference; wide spread tax evasion; attempts by both the Left and Right to politicize the judiciary; elections for sale; tainted election procedures; a state highly dependent on imported capital to recycle its debt.

Can we, as the current administration hopes and plans, grow our way out of the "no" or "slow" growth box? Taking the long view, we can … at least we have in the past and very successfully. But the impetus, the sine qua non ingredient in our success, has been our system of generously rewarding risk takers … from William Penn to William Gates. If, as current trends suggest, our cultural mandarins, our press, our law enforcement personnel, our academics, our opinion makers (from Talk Radio on up) … if all the above (driven by their internal metabolisms and/or perceptions of their personal advantage) are bent on (worst case) criminalizing risk, on making business failure at least a tort and perhaps a crime, on raising the bar of managerial responsibility until it is insurmountable, of bureaucratizing the private economy … of, in a word, reintroducing the once-discredited theses of command, top-down economies [3] … we are on our way to a different economic and social outcome in the years ahead. And the signs are ominous. One of the most disturbing is the growing influence of tort lawyers on the political process … rich enough to buy ball teams (Angelos), a Senate seat and even (perhaps) the Presidency (Edwards). A couple of years ago, I wrote a bullish piece, forecasting a bounce back from the busted 'bubble,' based on a number of positive factors I saw in the tech and human tech sector. Let me quote selectively.

"My point is that there is plausible evidence that we are at the beginning rather than at the end of at least two highly significant technological revolutions [biotech and computer-driven breakthroughs], even assuming that the Internet applications have crested.

"My thesis is modest. To be sure, the Nasdaq has crashed from its high (although it is a long way from where it was a few years ago), and Shiller's prediction in fact came true. But I have lived through those prior meltdowns that seem to occur at the end of each decade. And, this one is different, fundamentally different.

"First, the market did reach high peaks by any standards, and, accordingly, the nosedive has been "irrationally" severe. Yet, there is a buildup of scientific and technological breakthroughs, of energy, of risk capital, of global talent released or newly energized to play in the venture capital game - a host of factors that prove to me at least that we are on the verge of a worldwide sustained boom because the metrics of our economic existence in the developed world are in the process of fundamental change … a tectonic shift, to overuse the cliché.

"I invite you to test this thesis by thinking about your own children or grandchildren. Consider that their average life expectancy in the developed world, absent accident or catastrophe, is likely to be in the 100- to 125-year range, with full functionality until their 902. Then imagine a world in which, by virtue of improved distance learning (streaming video, interactive video, online tutorials), 10 million Chinese citizens have the equivalent of graduate engineering degrees from MIT. Then tell me there is no New Big Thing." [4]

Will all my prediction come true? Maybe not, I fear. Because I was wrong at the time? [5] Perhaps … but the likelier explanation is the shock and awe of "Enronitis," the toxic combination of severe stock market losses (this time involving all hands) and examples of astonishingly bad and stupid conduct which, first, sapped whatever investors confidence was left post 2001, Q1, and, secondly, generated the collateral damage as the victims, through their proconsuls, began the house-to-house search for the villains they somehow knew must be at fault (not including, of course, their own stupidity and bad luck).

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 firms with under 100 employees. And, the jewel in the crown, if you like, 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 economic hegemony, has been that activity loosely labeled venture capital. [6] To pick some devious examples of venture-backed company successes, and the impact on our economy, in 1990, Microsoft, Dell, and Cisco had combined sales of $2 billion, in 2000, their combined sales were $80 billion. [7] 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 development in this country, spawning and growing giant multi-national firms (tall oaks from little acorns), firms financed and nurtured by the managers of professional venture capitalist pools. There are a number of reasons why other countries have found it difficult (if not impossible) to mimic this sector of the U.S. economy, detailed in a number of commentaries. The matrix includes, of course, first class science, developed both privately and publicly (and transferable, by virtue of the Bayh Dole Act, from public to private ownership); 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 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. [8] It is the last factor, a critical foundation of entrepreneurial growth, which is of current concern; I am troubled that the government, state and federal is turning against risk-takers, that the cult of victimization (every loss implies a villain) has the ear of ambitious politicians, to the exclusion of any other considerations.

The importance to the U.S. economy of a robust system for financing emerging growth companies is generally conceded (as I think it must be): The question is whether recent events, including but not limited to the Nasdaq meltdown, are life threatening. And, for reasons I outline summarily in this alert, I suspect we are, in our relentless pursuit of 'bad guys,' inadvertently inhibiting the venture sector, to the point that our wealth and job creation engine can and will be substantially compromised.

The Problem

The venture capital process depends on the availability of capital which means, of course, that the asset class has to yield (on average) 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, of course, as an apology for some perfectly extraordinary (at least as alleged) instances of malfeasance. However, the side effects of the criminal, civil and Congressional necktie parties, the collateral damage if you will, will necessarily suggest to future Ken Lays and Bernie Ebbers (even those totally committed to ethical accounting and corporate governance) that the 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. The ultimate evidence of risk aversion is the proliferating appointment of lawyers, e.g. Charles Prince at Citi Group, to the post of chief executive officer of a major U.S. company, the objective being not necessarily to enhance shareholder value (and few lawyers have been proven to be good at that game) but to keep the company out of trouble; as this country adds to its reputation as the most litigious society on the planet there is a non-fanciful possibility the our gross domestic product in the near future will be composed principally of the counsel fees and damage awards. With litigation a constant thorn in the side of every manager and board member of a public company, the attractiveness of public registration begins to approach zero Further, the impact of the new certification rules (congruent with some other unpromising factors) threaten to squelch the possibility of the IPO window ever reopening wide. IPOs historically have been a pillar of U.S. venture capital … an open and liquid public market receptive to high tech companies in relatively early stages of their development. Traditionally, VCs have used the IPO exit in constructing their pricing models, assuming the IPO liquidity as the basis for their assumed terminal values. [9] And, again historically, the IPO exit is an order of magnitude or two larger than the alternative … 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. Moreover, IPOs add to the choice [10] of available public securities for investors to review … and allow venture-backed companies to grow as independents, e.g., Microsoft as an independent and not a division of IBM; otherwise the public markets are the equivalent of a wasting asset, by dint of mergers and company buybacks. Without venture capital backing, Apple Computer, Intel, Lotus, Yahoo, Amazon and e-bay would be ideas, and not mega-corporations. [11]

The IPO market comes and goes, of course. But, so far at least, even though it shuts down every now and then, it has always returned. Now, I am not so sure.

Some mainstream economists, of course, contend that the IPO market recently has been too robust, leading to the bubble and hence, the 'morning after' effect of the meltdown. Point conceded. But the problem is that the remedial overreaction threatens, as they say, to throw the baby out with the bath water. For promising issuers, the detriments of public registration 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 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. [12] Many newly public companies, if not covered by the analysts employed by the investment bank which brought the company public, are not going to have any coverage at all. This means a berth in the so-called "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 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 … bad news all around for the venture industry. [13]

In addition to making the IPO window stickier and harder to open (perhaps, I fear, impossible), 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 comfortable environment) requires extraordinary potential rewards. Simply stated, there is not enough cash around with which to motivate the jockeys to make a change; and fledgling companies need the best jockeys, in view of their vulnerable status. Equity-flavored compensation (a piece of the upside so to speak) is, therefore, an imperative.

The problem with most commentaries attacking stock options is that the writers have failed to understand the two features which make options particularly attractive (prominently not including the accounting treatment). First, options represent the only pieces of paper which afford the executive a piece of the upside (at least the only type in current use) and which does not entail a tax as of the date of the award. To return again to the point with which we started this discussion, there is very little cash available to emerging growth companies in their pre-pubescent stage, certainly not enough to fund tax payments to the Treasury (whether the payor is the individual or the company). Stock options work because there is no tax involved as of the date of grant; restricted stock does not do the job because tax is owed when the grant occurs, even though there are no cash profits from which to pay the I.R.S. (Tax can be postponed under Section 83(a) of the Code but that generally, for technical reasons, is a bad idea.) Moreover, restricted stock, which makes the recipient a stockholder, is unlikely to be distributed democratically; [14] only the top echelon will be receiving restricted stock awards … an unlikely policy for the government and the SEC to adopt expressly. Further, if the commentators only knew what they were talking about, they would understand that, in many if not most instances, stock options and restricted stock grants amount, economically and legally, to substantially the same security from the executive's point of view, except that (absent a very expensive company benefit called a "gross up" the executive's motivation be more urgently driven towards short term company performance in the case of restricted stock grants. Well, then, how about phantom stock plans, bonuses keyed to various items of performance? Again, these involve company cash payments, which (if they involve a piece of the upside) could be so large as to be unfeasible.

One may argue, of course, cash payments can be postponed until the company starts to mature and its valuation increases. However, the second virtue of stock options (often neglected as far as I have been able to see) is that the bonus compensation comes from the stock market rather than 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.

To be sure, as Prof. Johnson of Texas Law School has been kind enough to point out, [15] options are not a free good, As he puts it:

"There is of course no such thing as free stock. Management should not just leave it out on the bench for the passerbys to pick up. Stock represents the NPV of a lot of future cash discounted at usurious rates. At least when you go to Bruno the loan shark for credit in advance he will give you a tax deduction for the discount (interest) rate.

"Indeed there should be no accounting differences between phantom stock and future stock distribution plains. As the bargain or distribution accrues it is expense. And indeed if the stock drops the expense is reversed into income because it has shrunk."

Johnson then suggests the use of cash bonuses and, if there is no cash, deferred compensation. [16] The problem, however, with that suggestion (and is by no means alone) is that, as followers of the "new" science (a.k.a.) (art) of behavioral economics point out, people behave the way they behave despite theoretical assumptions they will (because they 'logically' should) behave differently. Assume for purposes of illustration, the investor and management are devising a compensation plan for a promising start up, and let's reference Apollo Computer founded by Bill Poduska. All hands knew that, if Apollo were to prosper, Poduska would give way to a new CEO, a professional manager. Further, Poduska and his experienced VC investors (Warren Hellman, Joe Gall and, in a very minor key, yours truly) realized that an outstanding manager is tempted away from his or her current job (almost all sought-after candidates are currently employed somewhere else) and lured into a key position with a promise of equity. Deferred cash will not cut it, because you cannot make the bogey big enough to get the manager to switch. You cannot tell a Tom Vanderslice (who left IBM for Apollo) that the company will promise to pay him $50 million if Apollo were to work out to be a home run. As they say down South, 'that dog won't hunt.' But you can set aside, say, 10% of the equity for a Vanderslice and he can entertain the thought that maybe he will make $50 million, and at capital gains rates. An Apollo (like a lottery winner) comes along very infrequently, [17] but it can happen. And it is that hope which energizes talented and experienced managers to take the plunge, to leave a cushy job (at IBM in Vanderslice's case) and 'bet the farm' on a new startup. My guess is that, given the failure rate, the odds (if full and fair survey data were available) are against the manager, any manager, realizing his or her bet. In fact, an academic, having the benefit of classical economics, would argue: "Don't do it." Luckily for us, however, founders like Poduska (who left a good job at Prime Computer), and managers like Vanderslice are willing to buck the odds, believing in the power of their own talents to turn the odds around. But, they will not do it for a promise of future cash … or at least any amount of cash at all realistic. They want stock; they want the possibility (regardless of how impossible on paper) of an Apollo-type return; they want to feel they are equity partners in the enterprise, standing pari passu into the capitalists. [18] The critics of stock compensation will simply have to trust the voice of experience on this point; emerging growth finance needs stock options or their functional (in every respect) equivalent. [19]

My fear, in short, 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. And, a slow growth model is ominous for this country. Think of the loss of empire, as our military is necessarily cut back; creditor insistence we pay the due bills we have run up with the rest of the world through years of red ink in our current accounts; loss of jobs and economic momentum to, e.g., China; solvency problems with Social Security, Medicare et al. as tax revenues shrink and the population ages; social unrest as more and more people fight for pieces of a shrinking pie … the whole 'nine yards,' as they say. There is no going back, of course, in terms of improved corporate governance. No civilized society can tolerate economic shenanigans of the sort the reforms are designed to remediate. However, my fear, as I say, is collateral damage. I suggest we need to look at the wave of reform, to make sure it doesn't go too far. Moreover, we can, I suggest, counterbalance the collateral damage recent reforms necessarily produced by modernizing some of our ages-old regulatory apparatus. We can remove dead weight and obsolete regulatory burdens, without sacrificing an iota of our reforms; in part tow of this monograph, I will provide some concrete examples of what I mean.

[1] "According to the National Venture Capital Association, venture funded firms now account for: 12.5 million employees, annual revenues of $1.1 trillion. These figures represent: 9.7% of US payroll, 11% of US GDP, 6.7% of US company revenue. For every dollar invested in 1970-1999, there was $9 in revenue during 2000. For every $21,627 of venture capital investment in 1970-1999, there was one job in the year 2000. The success of the VC market [in the U.S.] helps maintain the dominant position of the United States in the world economy." Wang, Wang & Lu 25 J. Financial Research 59 (March 2002).

[2] I want to thank Srishti Jha for her invaluable research assistance.

[3] It should be recognized in this connection that many of the "reformers" have agendas that are essentially anti-capitalist. The proposals are mischievous in that they are advanced by groups either with no appreciation for the likely consequences or indeed a keen appreciation, driven by a conviction that the capitalist system is inherently immoral … a perfectly respectable philosophical position but not one prevailing in the United States today Vida, the notion that the government should make it far easier for groups of shareholders to challenge the managing boards of public companies. To one with experience in contested proxy contests this proposal (if adopted) will have two toxic effects … toxic if you admire our current economic system. First, the rewards will go to (it can be confidently predicted)s to opportunist groups which see the pot of gold at the end of rainbow. Control of a public company is worth money … directors fees, perks, corporate airplanes, warrants and options, the possibility of green mail, break up and topping fees once the company is in play … all the things Carl Ichan realized some 30 years ago and made himself a billionaire in the process, Ichan never created a business; like any good arbitrageur he found a weakness in the system and exploited it … friendly judges on the Delaware Supreme Court, defenseless public companies (pre the poison pill), ability to collect significant equity positions below then-depressed prices, and, once in control, to sell off under-appreciated assets in order to fund the takeover; gullible lenders and a vibrant Milken-led junk bond market. Given this "reform," I would be happy to be in the vanguard, the first group out of the box renewing and refreshing the takeover game. With the current tax structure the way it is … i.e., minimal taxes on capital gains and dividend income, re-shuffling the deck, using corporate securities rather than cards makes more sense than ever, particularly with interest rates as low as they are. Playing the casino capitalism game will be a lot more rewarding than actually the managing companies and working for a fully taxed salary. Moreover, it will be hard to manage a public company profitably in the face of these "reforms." Time and energy will have to be devoted primarily to defending against the inevitable the proxy contest at the next annual meeting and, once that meeting is past preparing for the meeting after that. Annual meetings have turned into very expensive events, proxy materials running several hundred pages, vetted by (usually) two sets of accountants because of the potential criminal penalties, and team after team of lawyers. The accounting costs are liable to go up again; first, the Big 8 merged into the Big 5; then public officials decided that 5 was one too many so it is now the Big 4 with the demise of Arthur Andersen. And, today's news suggests that the SEC has in mind a Big 3, in effect putting Ernst & Young out of business by cutting off its ability to attract new business.

[4] Bartlett, "Rational Exuberance," J. of Wealth Management, 1 7 (Summer 2001).

[5] Dick Foster & Sarah Kaplan, the authors of Creative Destruction are gifted observers, top drawer consultants beating the drum for innovative … the key to economic survival in their view. As they point out, constant innovation is the key to long range survival in the S&P 500. And, venture capital is key to the equation. To paraphrase their material, There is a difference in energies in the conventional R&D model of corporate innovation and in a venture capital where new development funds are run by partners with their own funds involved. The level of skill and adaptability is at a much higher level. Foster & Kaplan, Creative Destruction: Why Companies That Are Built to Last Underperform the Market - and How to Successfully Transform Them, 174 (2001). The irony is that Dick and Sarah's paradigms for imaginative company re-inventions includes Enron, under former McKinsey partner, Andrew Fastow, without for a minute excusing appalling Enron behavior, the central failing at Enron is just that … the strategy failed. Cf. Samuel Gompers' quote that the worst sin an employer can visit on its employees is the failure to make a profit.

[6] "[C]ompanies backed by venture capital generate twice the sales, pay three times the federal tax and invest far more heavily in research and development as their traditionally financed counterparts … companies backed by venture capital generate $643 in sales for every $1,000 in assets, compared with traditional companies, which have only $391 in sales. Venture-backed firms also spend considerably more m money on research and development costs: $44 per $1,000 in assets compared with $15 for others." Johnson, "The Impact of Venture Backing; Recipients' Sales, Spending Top Traditionally Funded Firms," The Washington Post, June 26, 2002.

[7] Berenson, "Market Watch," New York Times, March 4, 2001, Section 3.

[8] Venture capital has benefited inordinately over the years from some quiet but highly influential, and in bureaucratic terms, bold changes in the way government and the emerging growth economy interact. I will name a few which will, I suspect, be generally unfamiliar, i.e., the Plan Asset Regulation, Rev. Proc. 93-27; the de facto relaxation of the ban on general solicitation and general advertising in Rule 502(c); Bayh Dole; the rise of LLCs and Check-the-Box. The first released literally trillions of dollars for investment to the venture asset class, the second cleared the way for efficient methods of compensating the managers of venture funds, thereby attracting the best and the brightest to the field; the third allows, albeit, haphazardly, issuers to widen their search for private capital; the fourth effectively gives private industry a crack at government-owned research and development; and the fifth simplifies the tax rules affecting private entities, and reduces the risk of entity level tax. If you want to have some fun, and understand part of the problem we currently face in the venture sector, pose a short quiz to any and all so-called experts on private equity finance, which includes the following questions: First, give the two principal reasons why stock options are vital to the prosperity of emerging growth companies (if you include accounting treatment, go to the rear of the class). Secondly, identify the profound and positive implications of the above cited.

[9] "Because of cultural, language, and geographical factors, most high-tech companies face too many difficulties in listing on foreign stock markets … Black and Gilson (1998) study the VC market from the angle of the market structure and attribute the VC market success in the United States to the VC exit mechanism. They find that a strong stock-market-centered capital market is essential to the success of the VC market, because it enables VCs to exit earlier from the companies in which they have invested and earn more by taking their portfolio firms public … A VC market requires an active stock market to support its exit." Wang, Wang & Lu, supra. n. 1 at 60.

[10] "Do you know what companies like Starbucks, Intuit, Palm Computing, RF Micro Devices, Shiva Corp. and Wind River Systems (to name only a few) have in common? They all received their initial funding from venture capitalists in the most recent dark recessionary period of 1990-1992?" Goodman, Venture Capital Journal (Dec. 2001).

[11] Some would argue that IPOs are toxic, shell games designed to intrigue a gullible public into overpaying for junk. The point is that there are IPOs and then there are IPOs. If one looks at venture-backed IPOs, vs. the entire array, quite a different picture emerges. "A recent study shows that of the companies that have gone public since 1986, the ones that were backed by venture capitalists had the biggest rise in their stocks. The Securities Data Company, a financial information company based in Newark, reported that offerings backed by venture capital rose an average of 135.1 percent during the period, while offerings without venture capital rose an average of 35.5 percent, while the others averaged a mere 10.9 percent." Marcia Vickers, "Nothing Ventured, Less Gain," The New York Times, 1996.

[12] Bartlett, "Cover Me, I'm Going In," Buzz of the Week (8/2/2001),

[13] If the sell side analysts do not get paid by the investment banking side of the house, the question is who does pay them, particularly to cover small cap stocks; the volume of tickets written by an under $1 billion market company is not sufficient to provide the wherewithal for compensation. To be sure, there are silver linings to this cloud … Vista Research, for example (I am an advisor), a new player bent on selling research without a bias because Vista has no affiliation with either side. But, as a general matter the prospect of fewer analysts is also not promising for venture capital. Bringing a company public only to see it fall into so-called orphanage, is not a prospect anyone would relish. See Buzz of the Week, "Cover Me, I'm Going In," supra. n. 6.

[14] Barry Diller has announced that USA Interactive will (i) expense option grants and (ii) in the future give up the plan entirely in favor of restricted stock grants, because options are "far too democratic." Microsoft to the contrary notwithstanding, it is highly likely, because of the tax effects, that Diller's forecast will be affirmed … companies will use restricted stock for, and only for, "key" executives.

[15] See Johnson, Stock Compensation: The Most Expensive Way To Pay Future Cash, Tax Notes 351 (Oct. 18, 1999). Johnson uses the following eye catching example to prove his point:

"Assume a corporation that pays a secretary a $1,000 year-end stock bonus, Johnson says. Stock is long-term investment, so assume the stock remains outstanding for 73 years. Discount rates for large company stock have been running at 28 percent a year. After 73 years, the corporation must redeem the stock for $65 billion dollars. Since the $65 million is not deductible, they must make $100 billion to pay taxes to have $65 billion."

[16] Johnson argues against the "stock is free" psychology. Whatever the academic merit of his observation, it does not obtain in private equity. The dilutive impact of the stock option pool is a highly negotiated item in any of today's term sheets. I in fact have just finished a negotiation in which, as is the current practice in today's climate, the founders and the VCs negotiated intensely, to the point of deal impasse, over which category of owner should absorb the dilutive effect of the option pool. Nobody in private equity is insensitive to the three most important issues in venture finance … dilution, dilution and dilution.

[17] I don't know the exact number on what Vanderslice made but, given the Apollo story, $50 million is not far off.

[18] One has to understand the psychology of risk takers. The process can be financially rewarding but it is also fun. And to have fun in this business, one must legitimately feel one is a partner, not an employee. The partnership concept may be diluted when a Microsoft gets to the mutli-thousand employee level but it is paramount in early stage. See Tracy Kidder, The Soul Of A Machine; Udayan Gupta, Done Deals. If economic science is built on the assumption people are solely rational in their economic chores, please explain why millions of people play the lottery.

[19] I daresay that in the last forty years, I have participated as a principal, an agent, and/or a service provider in (perhaps) a thousand venture-backed transactions, starting with the 'founder's round' (I have been on occasion a founder myself); the 'friends and family round;' the 'angel round;' and, as current nomenclature styles it, the 'Series A' round. These are the principal way stations whereby an entrepreneur grows his or her firm into a major (sometimes) multi-national … 'from the embryo to the IPO' (as I have put it in the past) or to company sale. And, I submit, if one were to dissect the fundamental elements of venture-backed deals (pick any number for the sample … say, a hundred thousand), in over 95 percent of those transactions the major compensation element, an element installed as early as the friends and family round, consists of stock options, which in turn leads to the obvious point: You had better be careful in fooling with stock options if you want to preserve the venture capital process and, to repeat, it is a process, I hope we have agreed, worth preserving … and in fact enhancing. Competitors in the world economy would almost literally kill to be able to duplicate the advantages our economy draws from venture capital.